Employee Stock Option Plan (ESOP) – Defined
An employee stock option plan is an employer-employee plan or agreement whereby the employee earns or is awarded the right buy a specific amount of the company’s stock shares at a specified rate. The option to purchase must generally be exercised within a specified period of time.
A Little More About Employee Stock Option Plans
Employee stock options are a method for employers to incentivize and retain employees. New employees may need to wait a specified period of time before being allowed to take part in an employer’s ESOP.
The grant of stock options can come as a contractual salary benefit. Otherwise, employees can contribute to ESOP in the form of payroll deduction. The “strike price” or exercise price for the option is generally the fair market value of the shares at the time of grant. This means that the options only have monetary value if the value of the purchasable shares rises. This also means that the employee is not taxed for receiving the stock option at the time it is granted.
The ESOP incentivizes employees by providing them a stake in the company’s success. Let’s assume that the company grants stock options to an employee. The plan allows an employee to buy 500 shares at the strike price of $10 per share. The options vest (are owned by the employee) after two years.
Now, assume the prices of shares jump up from $10 to $15 after the grant. Employees can exercise stock option to acquire the 500 shares for $5,000. They can then sell them into the market, back to the company, or to other shareholders for for $7,500. In this way they make $5 gain per share or total of $2,500 gain.
Instead, if the prices did not increase then the employee has no obligation to purchase the share. She will simply let it expire. As noted earlier, the stock option must generally be exercised within a specified period of time.
References for Employee Stock Option Plans
Academic Research on Stock Option Plans
- Employee Stock Option Plan
- ● Estimating the value of employee stock option portfolios and their sensitivities to price and volatility, Core, J., & Guay, W. (2002). Journal of Accounting research, 40(3), 613-630. This paper presents an accurate method of estimating option portfolio value and the sensitivities of option portfolio value to stock price and stock‐return volatility that is easily implemented using data from only the current year’s proxy statement or annual report.
- ● Valuing employee stock option plans using option pricing models, Smith, C. W., & Zimmerman, J. L. (1976). Journal of Accounting Research, 357-364. This paper aims to ease the accounting problem of valuing an employee stock option plan using results from current finance research in option pricing.
- ● Stock option plans for non-executive employees, Core, J. E., & Guay, W. R. (2001). Journal of financial economics, 61(2), 253-287. This paper examines determinants of non-executive employee stock option holdings, grants, and exercises for 756 firms during 1994–1997. Results show that firms use greater stock option compensation when facing capital requirements and financing constraints. These results are consistent with firms using options to attract and retain certain types of employees as well as to create incentives to increase firm value.
- ● Employee stock option exercises an empirical analysis, Huddart, S., & Lang, M. (1996). Journal of Accounting and Economics, 21(1), 5-43. This paper describes the exercise behavior of over 50,000 employees who hold longterm options on employer stock at eight corporations.
- ● Employee stock options, Huddart, S. (1994). Journal of Accounting and Economics, 18(2), 207-231. This paper examines the valuation of employee stock options (ESOs).
- ● Market valuation of employee stock options, Aboody, D. (1996). Journal of accounting and economics, 22(1-3), 357-391. This study investigates whether investors incorporate the value of a firm’s outstanding employee stock options into its stock price.
- ● Broad‐based Employee stock options in us ‘new economy’firms, Sesil, J. C., Kroumova, M. K., Blasi, J. R., & Kruse, D. L. (2002). British Journal of Industrial Relations, 40(2), 273-294. The article examines the use of broad-based employ stock options plans by new US companies.
- ● The effects of financial reporting costs on the use of employee stock options, Matsunaga, S. R. (1995). Accounting Review, 1-26. This study uses data on 123 firms over an 11 year period to examine whether the accounting for employee stock options permits them to be used as part of an income management strategy.
- ● How to value employee stock options, Hull, J., & White, A. (2004). Financial Analysts Journal, 60(1), 114-119. This paper explores the difficulty in calculating the fair value of employee stock options at the time of acquisition. The main aim is to present an approach to calculating the value of employee stock options that is practical, easy to implement, and theoretically sound. Upon the implementation of this approach, different conclusions are met.
- ● Causes and effects of employee stock option plans: Evidence from Singapore, Ding, D. K., & Sun, Q. (2001). Pacific-Basin Finance Journal, 9(5), 563-599. This study highlights the determinants for the adoption of employee stock option plans (ESOPs) in Singapore and measures the impact of ESOP announcements on the shareholder wealth of adopting companies.
- ● Real investment implications of employee stock option exercises, Bens, D. A., Nagar, V., & Wong, M. F. (2002). Journal of Accounting Research, 40(2), 359-393. This paper examines a real cost of awarding employee stock options. Results indicate that ESO exercises potentially impose a real cost on the firm in terms of foregone investment opportunities.