A Guide to Employee Stock Option Plans

////A Guide to Employee Stock Option Plans

A Guide to Employee Stock Option Plans

Employers can compensate their employees in three primary forms: cash, benefits and stock. Cash compensation – as would be expected – includes hourly wages, salaries, bonuses, contract income, benefit plan payouts and matching retirement plan contributions. Benefits include vacation, sick time, insurance, tuition, childcare, and other perks like expense accounts and company vehicles.

Employers can also reward employees by giving them the option to purchase shares of stock in the company, usually at a discount. These are referred to as employee stock option plans (ESOPs). Employee stock options can be extremely popular but also carry potential drawbacks.

How Employee Stock Options Work

While the fundamentals of employee stock compensation vary among companies, the underlying rationale is to enable employees to purchase company stock at reduced prices and, eventually, sell them. This is typically done in steps. (For related reading, see: Introduction to Employee Stock Purchase Plans.)

First, the employer grants a certain number of shares to employees or gives them the right to purchase it. The date upon which the employee can exercise his/her option to purchase the stock is known as the grant date.

Second, the employee exercises his/her option to purchase the stock according to plan rules during a specified period – typically several years – until the expiration date when the offer is rescinded. Generally, the employee can purchase the stock at a predetermined price or at its market price on the grant date. If the stock has risen during the specified period, the employee may be able to purchase the stock at a discount, depending on the company’s plan.

Finally, the employee has the right to sell his/her shares. This is called liquidation. The choice of whether to keep the shares until retirement or beyond, or to sell them, is up to the employee since, essentially, she/he owns said shares. If the stock has risen considerably during the period in which the employee can continue to purchase shares at a predetermined price, then she/he can realize instant per-share gains by simply purchasing shares at the discounted price which are immediately valued at the higher price in the open market.

Types of Stock Ownership Plans

Basic ESOP

A basic ESOP is a qualified plan that is funded completely with company stock. Employees can put their company stock into a plan where they can sell those shares back to the employer at retirement. From a tax perspective, these are the simplest plans because income derived from the stock is not recognized until it is distributed upon retirement like other qualified retirement plans.

Stock in a 401(k)

In some cases, employers can offer stock within an employee’s 401(k) plan. However, regulators attached closer scrutiny on these types of plans. In order to protect themselves, employees should ensure their retirement portfolios are adequately diversified based on their investment objectives and risk tolerance.

Phantom Stock Plans

Phantom stock, also known as shadow stock or synthetic equity, is so named because certain employees – typically senior management – are provided the benefits of stock ownership without actually giving them actual shares. Even though there are no actual physical stock shares, the phantom stock mirrors the price movement of the real stock and the employee is paid any profits which may arise. Some companies use phantom stock as an incentive to stimulate company performance or as a bonus for employees who meet certain criteria. (For related reading, see: Get the Most out of Employee Stock Options.)

Phantom stock plans are either “appreciation only” or “full value” plans. In the first case, only the value of increase is paid out. In the second case, the value of the increase as well as the value of the original stock are paid out.

Because phantom stock has few restrictions, the company can use it however it chooses to. Additionally, this type of stock can also be easily changed at the discretion of the owner, CEO, or other ruling body of the company.

Stock Appreciation Rights

Similar to phantom stock, stock appreciation rights (SAR) are a type of phantom stock program, also largely made available to upper management, that provides incentives based on the company’s increasing value. SAR are particular valuable to employers in that they can safeguard employee retention during periods of internal volatility.

Vesting

In order for an employee to have full access to any employer-contributed retirement funds, whether cash or stock, they must be fully vested. By definition, vesting refers to non-forfeitable ownership by an employee of his/her retirement account balances which are contributed by the employer. Pursuant to the Tax Reform Act of 1986, vesting rights are bestowed upon employees based on their years of service, starting by the end of the third year with full vesting rights within five years, but no longer than six. Vesting is used ensure employee longevity and provide a schedule as to when benefits are attainable.

Even though an employer provides stock options as part of a retirement plan, if the employee is not 100% vested, they usually do not have full ownership rights of the shares until becoming fully vested. Typically, ESOPs vest in chunks at predetermined dates pursuant to the company’s vesting schedule.

Pros and Cons of Stock Options

Employee stock option plans have pros and cons for both employees and employers. For employees, stock options equate to additional compensation that takes the form of discounted purchases to be redeemed for a profit. In addition to the value of the stock itself, the options themselves can have a tangible value, particularly if the employee can exercise said option at a price below where the stock is currently valued. However, if the stock value declines, then so do the employee’s options and/or shares. Additionally, the immediate sale of a large volume of stock option-purchased shares may also create short-term capital gains which are taxable.

For employers, rewarding their employees with stock shares is much less expensive and easier than providing cash compensation. Additionally, ownership of a part of the company can increase employee motivation, morale and loyalty. In fact, a 2000 study by Rutgers University found that companies with ESOPs grow approximately 2.3% faster after setting up said program and performance improvements demonstrate even more substantial gains.

On the downside, if company stock loses value it can affect employee morale and production. This can create a vicious cycle of driving down the stock even further, amplifying employee dissatisfaction.

Read more of Todd Wilhoit’s article at Investopedia.