Even before a job interview, a candidate already has an idea of the type of compensation and benefits a company offers. From salary compensation, health benefits, to government-mandated benefits, people also prefer applying to companies offering additional incentives such as receiving shares or owning a part of the company. Hence, share options attract the best talents that benefit the company and the future employees as well.
But what are share options and how do they work? If you’re thinking of offering this employee benefit, then you need to learn more about this type of equity compensation plan below.
What Are Share Options?
One of the types of equity compensation offered by companies to their employees is employee share options or employee stock options (ESOs). It means that employees who were granted an equity compensation plan can buy a company’s share or stock at a set price for a limited period. Share options provide an opportunity for employees to share in the company’s success by owning a stake or stock holdings.
On the other hand, employers use share options as a tool to recruit and retain top talents. Employers can manage their equity like a pro by using a cloud-based software system such as Cake Equity. Tools like this can help employers handle vesting triggers and rules, issue shares, and provide the features they need such as e-signing and document storage.
How Do Share Options Work?
Learn how share options work by learning the following aspects:
The Grantee And The Grantor
In an employee share option compensation plan, the two parties include the grantee or ‘optionee,’ who is the employee, and the grantor or the employer. Equity compensation plans have applicable restrictions, which include the vesting period or the time duration employees should wait to exercise ESOs or sell shares. Hence, share options give employees motivation or incentive to perform at their best and stay loyal to the company.
Drafting Share Options Compensation Plans
As a business owner who wants to provide shares or stocks to key employees, it’s important to know how to draft equity compensation plans to reward your employees. The Internal Revenue Service or IRS requires the employee share option plan to satisfy different conditions (taxation of ESO will be discussed further below).
The Board of Directors drafts the share options agreement, which provides all the details of the grant like the vesting schedule, the shares represented, and the strike price. The strike price refers to a price at which the grantee can sell the share. For instance, if the grantor sets a strike price of USD$15, the employee can sell the stock at USD$15 regardless of the market value.
Employees can negotiate some parts of the agreement, especially executive employees. Usually, they negotiate the vesting schedule to expedite the process. They may discuss the share options agreement with their financial planner before signing the share option agreement.
Vesting
ESOs help improves employer-employee relationships. Share options allow employees to buy shares at predetermined dates to be compensated beyond what their paychecks can provide. Vesting in ESOs pertains to the process of earning an asset over time.
For instance, the employee may be allowed to buy 500 shares and vest 15% yearly for more than five years with a 10-year term. With 15% of the ESO, the employee can buy 75 shares in a year after the grant date and every year thereafter for up to 10 years.
If the grantee doesn’t exercise the 15% of the vested ESOs after one year, the exercise options will have a cumulative increase. So, it means that in the second year, the employee will have 30% vested share options. After ten years, the employee can’t buy shares anymore since the agreement has already expired.
A reload option can be agreed upon by the grantee and the grantor. This provision grants employees more share options when they exercise their existing ESOs.
ESO Taxation
One common point of concern about stock shares is whether they are taxable or not. Here are the important things to know about ESO taxation:
- Share Options Grant: The ESO granted to the employee is not taxable. It means that the grantee won’t face immediate tax liability once the shares options are granted.
- Time Of Exercise: The employees will only face taxes at the time of exercise since the IRS considers it as a form of employee compensation.
- Stock Sale: The sale of the shares triggers is also taxable. It’s a short-term capital gain if the grantee sells the acquired stocks for one year or less after exercise. A short-term capital gain is taxed following ordinary income tax rates. For acquired shares sold over a year after exercise, they’re eligible for a lower capital gains tax rate.
ESO Time Value And Intrinsic Value
Time value refers to the expected time and volatility until the expiration of the ESO. The time value for ESOs is calculated using a theoretical pricing model such as the Black-Scholes. The contributory pricing factors include the time remaining, the exercise price, the stock price, and the risk-free interest rate.
On the other hand, the ESO intrinsic value can be explained by this example:
The company grants a top employee 5,000 stock options to buy shares of the common stock at USD$40 per share. The strike price is USD$25 per share. So, each stock’s intrinsic value is USD$15 (calculated by deducting the exercise price from the common stock market price).
If the employee decides not to sell shares yet, the employer needs to record USD$150,000 in compensation expense. A vesting period is needed before the employee can exercise share options. For example, if the vesting period is three years in this scenario, the company would record USD$50,000 in compensation expense every year (US$150,000 divided by three years, which equals US$50,000).
Conclusion
Share or stock options are an appealing type of equity compensation wherein employees can take part in the earnings and success of the company. Employees can sell their granted shares at an agreed price to generate profit. Business owners can offer this compensation benefit to promote employee retention and loyalty.
Danis Woods in Businessman, investment banker and stock exchange traders. On the same time he loves writing financial blogs to shed lights on different aspects that new and existing businessman are not aware of.
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