Primary navigation:

QFINANCE Quick Links
QFINANCE Topics
QFINANCE Reference
Add the QFINANCE search widget to your website

Home > Business Strategy Best Practice > Employee Stock Options

Business Strategy Best Practice

Employee Stock Options

by Peter Casson

Why Companies Use Employee Share Options

Companies grant stock options to attract, retain, and motivate employees and executives. In addition, start-up companies and companies with weak cash flows may grant stock options to compensate for the below-market cash wages that they can afford. Finally, options may be granted to capture taxation and/or accounting benefits.

Stock options attract employees and executives for the following reasons. First, individuals whose abilities match the needs of the company may be attracted by stock options because they believe that their abilities will improve company performance and that this will be reflected in an enhanced stock price. Second, the offer of stock options may attract those employees who are most optimistic about the company’s future prospects. Their optimism may lead them to overvalue the options, so reducing the company’s overall employment costs. Finally, stock options may attract relatively less risk-averse employees who meet the needs of the company.

Employee stock options can be used as a way to increase employee retention. The vesting conditions usually found in the options encourage employees to remain with the company until the options become exercisable. In addition, employees will forego the time value of vested options if they are forced into early exercise by leaving the company. Finally, as employees build up a portfolio of options over time, it becomes more costly for a competitor to attract the company’s employees, as the competitor may have to compensate them for the value foregone from forfeiting unvested options or from suboptimally exercising options.

Holders of employee stock options have an incentive to act in a way that increases the value of the options. The fair value of employee stock options is, as described above, sensitive to the company’s stock price, the expected volatility of the stock, and the dividends expected to be paid on the stock during the life of the options. Employees may act, through enhanced performance, to increase company performance, and that in turn may be reflected in the stock price. Although grants of stock options to CEOs and senior executives may be effective in increasing company performance, the incentive effects of grants to other employees are questionable, as there are significant free-rider problems. The other incentive effects are confined to options held by senior executives, especially CEOs. Senior executives holding stock options may make riskier investment decisions and/or increase the company’s leverage with a view to increasing the expected stock volatility. Stock options may also reduce the dividend on the company’s stock.

Stock options may be used by start-up companies and companies experiencing cash constraints. Here employees may sacrifice part of their cash compensation in exchange for stock options. Although financial institutions are usually seen to be in a better position than employees to bear the risks associated with lending, employees may be willing to do so because: (1) options attract risk-seeking individuals, who, if the company fails, will move to another company; (2) they possess superior knowledge and so perceive the risk differently to financial institutions; or (3) they do not understand the risks.

Companies may use stock option compensation because of preferential tax policies, although this depends on the tax regime of the country in which the employee and the company are resident. Stock option compensation may, depending on the jurisdiction, be taxed at the time of grant, or at the time the option is exercised, or when the stock acquired on the exercise of the option is subsequently sold. Employees may be charged either to income tax or to capital gains tax on their stock option compensation. Finally, stock option compensation by the company may or may not be tax-deductible. A country’s tax regime may offer favorable tax treatment to stock option schemes that have particular features. In such cases, the provisions of the tax regime may shape the option schemes that companies use.

Stock option compensation may also be used because of the way it is accounted for in company financial statements. The accounting treatment of stock options was seen in the past to be advantageous when stock options were recorded at their intrinsic value at the time of grant. As options are usually granted with an exercise price equal to the fair value of the stock on the date of grant, the intrinsic value of the option is zero. This meant that there was no charge against income. However, both international and US accounting standards now require companies to charge the fair value of stock options, as measured at the time of grant, against income.

Case Study

BG Group plc1

BG Group plc is a UK-listed company engaged in the discovery, extraction, transmission, distribution, and supply of natural gas. BG has about 5,000 employees, more than 60% of whom are located outside the United Kingdom. The company operates two stock option schemes, a company share option scheme (CSOS) and a sharesave scheme. The CSOS is open to UK and overseas employees above a certain grade. The number of CSOS options granted to individuals depends on their past performance and their expected contribution to the company. The CSOS scheme aims to “drive real earnings growth over the long term.” Options granted under this scheme, which have an exercise price equal to the fair value of the company’s shares at the time of grant, have a vesting period of three years, and vested options may be exercised at any time until the tenth anniversary of the grant. Options vest to the extent that there has been real growth in earnings per share (EPS) over the vesting period. All the options will vest if EPS growth over the vesting period is at least 30% more than growth in the retail prices index (excluding mortgage payments) (RPIX), and half the options will vest if EPS growth is at least 15% more than RPIX growth.

The sharesave scheme, which is approved by the UK tax authority, allows eligible employees to acquire shares in the company using the proceeds of a tax-exempt monthly savings plan. BG Group uses the scheme as a way of encouraging share ownership in the company.

Back to Table of contents

Further reading

Book:

  • Wheeler, Peter R. Stock Options + Grants: The Executive’s Guide to Equity Compensation. Sunnyvale, CA: AdviserPress, 2004.

Article:

  • Hall, B. R. “Six challenges in designing equity-based pay.” Journal of Applied Corporate Finance 15:3 (2003): 49–70.

Website:

  • National Center for Employee Ownership (NCEO): www.nceo.org

Back to top

Share this page

  • Facebook
  • Twitter
  • LinkedIn
  • Bookmark and Share