It’s estimated that more than 10 million people in the United States are granted employee stock options (ESOs) every year, with many millions globally. And those numbers are rising.
However, the landscape has changed in recent years. There has been a shift from options toward restricted stock in the United States ever since the Financial Accounting Standards Board (FASB) in 2006 required companies to theoretically value ESOs when granted and expense the value of the grants against earnings. Prior to 2006 companies did not deduct the grants from earnings, but they did deduct the intrinsic value of the ESOs from taxable income when a grantee exercised the options. Despite this change, ESOs and a hybrid instrument called Stock Appreciation Rights (SARs) are still the dominant type of equity compensation to executives, managers and employees.
There are often concerns in connection with ESOs’ long-term effectiveness in aligning the interests of employee and employer with the resulting hoped for increases in earnings and stock prices. Claims of executive compensation abuses also are being debated. On the other hand, there are virtually no discussions about how grantees (whether executives, managers or secretaries) can manage those equity grants maximally to reduce the inherent speculative risk of holding ESOs and get the highest expected returns from those holdings. Here, we’ll illustrate how to best manage those ESO holdings to accomplish both goals.
The cost of exercise
ESOs are contracts between the company and the grantee, whereby the company has the obligation to issue and deliver a certain number of shares to the grantee at a specified price if the grantee exercises the right to purchase those shares. The specific terms of the ESO contracts are outlined in two documents: The company stock plan document and the options grant agreement. The ESOs generally have a 10-year maximum life compared with the maximum of three years for exchange-traded calls. But the grantee’s rights in the ESOs have restrictions that exchange-traded call options do not have.
After the ESOs are granted, there is a period called the vesting period, which may last from one to five years. Until the vesting period expires, the grantee cannot exercise any rights in relation to the stock options and does not yet own the ESOs.
In addition, ESOs generally never can be sold, transferred or pledged as collateral, but there typically is no prohibition against selling calls or buying puts to hedge the risks. After the ESOs are exercised and the grantee holds stock, restrictions by company contracts generally no longer apply. However, grantees holding ESOs or stock who may have non-public material information may be restricted by various Securities & Exchange Commission (SEC) statutes and rules. Officers and directors also are subject to Sections 16b and 16c of the Securities Act of 1934 even if they have no inside information.