Employee stock options (ESOs) are a type of equity compensation offered by companies to their employees. In the case of employee stock compensation, employees are granted derivative options on the stock, instead of shares of stock directly. These options are offered as standard call options. This gives the employees the right to buy the company’s stock at a specified price, within a stipulated timeframe. Options have a vesting date and an expiration date. One cannot exercise the options before the vesting date or after the expiration date.
Stock options are said to be especially beneficial for startup companies, who have inadequate working capital. They could use stock compensations to lure and retain high-quality employees. Also, when the companies go public, companies benefit from these stock compensations. Fast-growing and ambitious companies also offer these options as an incentive for employees to create value for the company’s shares. These options are cancelled if the employees resign before they vest. ESOs do not include any dividend or voting rights.
Types of stock compensations
Here are the types of stock compensations:
Stock Appreciation Rights (SARs): SARs provide the rights to increase the value of a designated number of shares. Such an increase in value is paid in cash or company stock.
Restricted Stock Grants:These stocks give employees the right to acquire or receive shares under specific terms and conditions. This might include working for a certain number of years or meeting certain targets.
Phantom Stocks:This kind of stocks include a future cash bonus equal to the value of a defined number of shares. This does not involve any legal transfer of share ownership. Such stocks may be convertible to actual shares if certain events take place.
Employee Stock Purchase Plans:This kind of ownership gives the employees the right to purchase company shares, often at a discount.
Benefits and drawbacks of stock compensation
There are many benefits of stock compensation. Firstly, this is an opportunity to share the profits of a company through stock options. This makes the employees feel like an actual shareholder. A sense of ownership again motivates and drives an employee work harder for the company’s success. As per the plan, such stock compensation may offer the potential for tax savings upon sale or disposal of the shares. This is also sometimes used as a potential exit strategy for the owners.
However, experts feel that stock compensations can dilute share value, which might not bode well for shareholders in the long run. Stock compensations can be challenging to value. This could result in high compensation to executives for mediocre business performance. Moreover, retained earnings are counted in the exercise price. An individual employee is often dependent on the collective output of all employees and management for an incentive.
The value of stock compensations is based on several factors such as the price of the underlying stock, volatility and time to expiration. Hence, it’s important to factor all these in before opting for stock compensation. It’s essential to weigh all pros and cons before considering stock compensations for both the companies and the employees.
ESO holders should be well versed with the company’s stock options plans and as well as the agreement to understand restrictions and clauses. It’s also advisable to consult a financial expert to squeeze the maximum benefit out of this component of compensation.