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Employee stock option

An employee stock option is an option to purchase company stock offered to an employee usually either as compensation or as a performance incentive.

Contents

Expanded Definition

The life cycle of an option

The employee's view

An employee stock option is a right to buy one or more shares of the company at some future time at a set price called the exercise price. This right is given by the company to the employee. When properly done, the exercise price is set equal to the company share price on the date of the award. The options will vest (become owned by the employee) over some schedule, such as 25% per year.

At some future time, if the company's stock price has gone up, the employee can exercise the option and pay that price to the company. The company then delivers a share of stock to the employee. Note, this share comes from either shares the company had purchased on the open market or from the non-issued shares out of the pool of authorized shares that the company's charter had set up. (It is only the issued and outstanding shares that are counted in the market cap, so those non-issued shares, and the ones the company had repurchased previously, weren't "outstanding" until they were sold to the employee. This point is used shortly.)

What the employee has, now, is a share of stock purchased at a price lower than the current market price. From the moment of exercising the option, the newly received shares act just like any other shares of the company and can be kept or sold. The difference in those prices is taxable income to the employee and many times, the employee sells enough shares to cover the tax bill. The employee can either keep the rest or sell them on the market, pocketing the difference between the selling price and the exercise price.

Many employees (executives, especially) view options as part of their compensation and you will see that they regularly exercise them and then sell them to get the money. In fact, there's an approved plan (on file with the SEC) that allows this to be done on an automatic basis, so they aren't taking advantage of share price movements and insider information. If the number of options is not unduly large, if the executives continue to have a stake in the company from other areas, and if they do not get lots and lots of new options to keep doing this forever or at a higher level, then the regular exercising of options and selling of shares (which has to be filed with the SEC) should not be of huge concern.

The company's view

As far as the company is concerned, what has happened is that the outstanding shares have been increased. (See? Here's that point from above.) This is the dilution that everyone is/was worried about when options were real common. People who already owned shares had their ownership stake (percentage) reduced by this increase in outstanding share count. Now, the company can either let this situation continue (and watch its EPS growth be smaller than it would otherwise be) or it can repurchase the shares from the market.

But here's the rub. The company sold the shares to the employee at the (lower) exercise price. It is now buying shares from the market at a much higher price. (Those repurchased shares can either be retired (removed completely) or stored, to be sold to the next employee exercising an option.) The difference in price between what the company receives from the employee and pays to repurchase is lost, gone, vanished ... spent. In other words, the company is spending shareholder money to subsidize employees. It either does that or sees its earnings per share shrink.

How to align interests

The whole reason for stock options comes from something called the "principal-agent" problem. How do the owners of a company (the shareholders, the "principals") align the interests of the people who work for the company (management and employees, the "agents") with the owners' interests? After all, management and employee interest is usually to earn (or get) as much money as they can. That could occur in several ways which may or may not be good for the company and its owners. After all, if an employee works overtime (to earn more money) but is playing solitaire on his computer instead, he's fulfilling his or her own interest, but not the owners' interests.

So how to get the employees' interests to align with the owners (who want the value of their investment to increase)? One way is to give the employees a vested interest in the company itself, through ownership.

But what if the employee cannot afford to buy shares of the company or they are not generally available, such as is often the case in privately-owned companies? Well, you can give the employees an option to buy shares of the company at a certain price (the strike price or exercise price). Even better, you can space out the "vesting" of the options so that only a portion of them become "owned" by the employee each year. Then, over time, as the stock price (hopefully) rises above the strike price, those options will become valuable to the employee. The employee could exercise the option then immediately sell the shares, use some of the proceeds to pay for the exercise and pocket the difference. Thus, the employee will work for the good of the owners, because he becomes an owner, too.

Well, sort of.

A couple of problems

The option isn't really ownership of a stake in the company. It is the right to buy ownership at some future date. And this causes two problems.

First, if the stock price falls below the exercise price, so the options are "underwater," then why should the employee exercise the option? They'd have paid for something that is worth less than what they spent and who does that if they can avoid it? (But doesn't that make the employee want to work harder to bring the price back up? M-m-maybe. Actually, some companies re-price the option, lowering the exercise price to the then-current stock price, which doesn't seem very fair to outside shareholders.)

Second, unless the employees have the funds to pay the exercise price out of their own pockets (and even if they do), they will certainly sell at least some, and maybe all, of the newly purchased shares and use the proceeds to pay for the exercise itself. And if they sell all their shares and pocket the cash, and there is nothing to prevent this, where's the ownership then?

The justification

Companies that are not generating very much revenue or profit and companies that are growing quickly, reinvesting all their profit back into the company, generally don't have money to pay large salaries to employees and management. But they need good, hard-working employees to grow the company to a point where they can afford to do so. So instead, they often "pay" their employees with options, counting on the growth of their stock prices to compensate the employees in the future.

Used reasonably with employees who are anxious to see the company grow, this is a perfectly valid method of paying people, as long as they get paid in some cash, too. After all, you can't spend these options to support your family this month.

The abuse

During the late 1990s and early 2000s, things got out of hand.

No expensing

For one, options were not treated as an expense on a company's books -- they were treated as "valueless" -- unlike such mundane things as salary and wages. Those have to be deducted from revenue on the way to calculating net income. This came about after the 1973 Employee Retirement Income Security Act, which created tax incentives for companies to set up employee stock option plans. The real kicker, however, came with the special tax treatment of stock options, which allowed companies to defer taxation on compensation based upon options. While compensation comprised of cash or stock is taxed at market value, stock options were assumed to have zero value at issuance -- so the employee paid no tax and the company recorded no expense until the options were exercised.

In other words, no expense to the company = "free." That is, the company could use as many as they wanted to pay employees, especially management. And they did. Grants of thousands, even millions of options became commonplace. And when the difference between the exercise price and the stock's trading price measured in the tens of dollars, all of a sudden we're talking about tens or hundreds of millions of dollars of compensation that didn't have to be accounted for by the company. Woo hoo! Give 'em to everybody!

But were stock options really worth nothing when they were issued? If so, then why were they such a significant component of compensation? Or, as Warren Buffett said in 1998: "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And if expenses shouldn't go into the calculation of earnings, where in the world should they go?"

Indeed. This is an interesting dichotomy of logic: Companies calculate depreciation schedules for the value of assets based on estimates of their expected useful life and the recovery value, but they claimed to be incapable of putting together an estimated value for stock options. Hmm.

Dilution

When the options vested and were exercised, the shares had to come from somewhere. And where they came from was usually out of stock that the company had repurchased at some time previously. In other words, the company was spending shareholder money to buy shares on the open market at full price, only to turn around and give them to employees who exercised their options at a price much lower than full price. That difference between full price and strike price, effectively, went right into the pockets of the employees and out of the pockets of shareholders.

Worse, by selling shares to the employees as they exercised the stock option, the outstanding share count of the company increased. (The shares come from those repurchased shares held by the company or from non-issued shares from the total authorized by the company's charter. In both cases, these sources do not count toward the outstanding share count.) This meant that current shareholders were "diluted" in their ownership stake. They got smaller pieces of the pie. Dilution amounts of 10% or more per year were not unheard of.

Backdating

The abuse got to be so prevalent that some companies broke the rules. The rule is that the strike price is the price of the company's stock on the day the stock option was granted. But nobody can truly control the stock price, so that might turn out to be the highest or lowest or middle price of the quarter or the year, totally by chance.

However, some companies "adjusted" the date the grant was "issued" to make it appear that it was issued at a relatively low price. They did this so often that it could be shown that the odds of that happening by chance were quite small. In other words, they "backdated" the options, giving the holder an even bigger spread (profit) between the strike price and the share price. Apple, among others, was caught with its hands in the cookie jar.

Shareholder apathy

One major problem that allowed the abuse to get out of hand was that the owners of the company abdicated their part of the principal-agent problem. They didn't care. Stock prices were going up, so the value of their ownership stakes was increasing. So what if the employees (especially management) were gaming the system a bit? As long as I got mine, let them have theirs seemed to be the attitude.

Expensing

In 2004, after several scandals over egregious abuse of options, the FASB, the body which sets the rules for GAAP, issued FAS123(R) which required companies to record as an expense option grants given to employees, beginning in fiscal years starting after June 15, 2005. Remarkably (or not), the number of stock options granted to employees dropped rather dramatically once the expense of them had to be shown up front.

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