This guest post by John Olagues covers common types of equity compensation and a look at the future of the stock-option industry.
It has been recently estimated that over 12 million employees in the US annually receive equity compensation in the form of Employee Stock Options (ESOs), Restricted Stock, and various hybrid forms like Stock Appreciation Rights (SARs) and Restricted Stock Units (RSUs).
The number of equity plans and grantees have steadily increased despite an uncertain and somewhat stagnant economy over the past several years. What is driving this growth? Why do companies create plans that require generally risk-averse employees and executives to assume risky positions for substantial periods of time?
Stories of expected wealth from the Facebook initial public offering (IPO) and the millionaires who will be created from the ownership of ESOs and Restricted stock provides a clue. But success stories such as Facebook only account for a minute portion of total equity compensation provided to employees.
Before looking into some of the answers generally given, let us review the major differences between a few types of equity compensation.
Employee Stock Options
The type most mentioned and formerly the predominant types offered are Employee Stock Options (ESOs). These are contracts between the employee/grantee and the company whereby the employee has the right to buy a specific number of shares at a specific price throughout a period determined by the contract. She is not obligated to do so.
The company has the liability to issue new shares and sell them to the employee if the employee exercises her right to purchase such shares. The value of the options can be calculated using theoretical pricing models. Using various models, reasonably accurate theoretical prices for ESOs can be calculated on the grant day or afterwards.
There are two types of ESOs. Non-qualified ESOs (NQESOs) make up 85% of the ESOs granted. Qualified ESOs are the second type and are sometimes called ISOs. Neither type of ESO is taxed when granted but they are taxed when exercised.
When NQESOs are exercised, the company gets a tax deduction. The main difference between the two is in the way the taxes may be calculated when the options are exercised. ISOs are taxed more favorably to the grantee and the company gets no deduction upon exercise. ISO grants are also restricted to employees only.
Restricted Stock (RS) is the second most popular type of equity compensation and has seen a rise in quantity of grants as a result of the same stagnant stock market and a 2006 ruling by FASB and the SEC. That ruling requires Employee Stock Options to be theoretically valued when granted and expensed against earning as the ESOs vest.
Formerly there was no such requirement to value or expense the ESOs. The valuation of Restricted Stock shares is relatively simple as a discount of between 5-10% of the fair market value of unrestricted shares gives a reasonable value at grant. RSs are taxed to the grantee when they vest and not when granted.
Stock Appreciation Rights
Stock Appreciation Rights (SARs) are a hybrid form of Employee Stock Options which allows the company to avoid dilution of earnings by paying the “intrinsic value” to the employee in cash upon exercise rather than issuing new shares and selling to the employee at the exercise price.
SARs are valued near equal to ESOs with the same exercise price and expected expiration and volatility. SARs are taxed when exercised and the company then gets a tax deduction from its income.
Restricted Stock Units
Restricted Stock Units (RSUs) are hybrids of Restricted Stock, whereby the company can pay to the employee upon vesting in shares of stock or in cash. RSUs are treated for tax purposes the same as Restricted Stock.
All of the forms have “vesting periods” which must expire before the employee actually owns the options or restricted shares. They may also require certain performance, sales, or earnings targets before the equity compensation will vest. These performance targets add complexities to the valuations of the grants as well as decreasing the grants’ values.
Sounds Complicated. Why Bother?
The purpose of granting equity compensation varies by company, but may include the following:
- To align the interests of the employees and executives with the interests of the shareholders.
- To attract and keep long-term loyal employees and executives.
- To have the grantor company preserve its cash position and then, in the case of employee stock options, increase their cash as a result of exercises and tax credits.
- In the case of Restricted Stock and RSUs, cash is preserved and early cash flows occur from tax credits when the Restricted Stock and RSUs vest.
- In the case of SARs, the cash flows could be small compared with ESOs as the companies can design the SARs to reduce dilution which requires cash outlays by the company.
Below are some current articles and views of the current situation with equity grants.
- An ESOP Association article of February 8, 2012 illustrates some of the success that equity ownership may accomplish.
- A slideshare presentation by Professor David Larcker of Stanford Graduate School gives a more reserved appraisal of the success of equity grants.
- Another recent article (Feb 8, 2012) mentions how some Congressmen, especially Senator Levin D- Mich. are trying to limit the tax deductions of employee stock options and therefore reduce the tax credits to companies. Or his bill will increase the required expenses against earnings.
The granting of equity compensation seems to be here to stay and is increasing but the benefits of its use may vary greatly in different environments. For start-ups and smaller but growing companies, equity compensation could be one of the most important ingredients in a compensation package.
John Olagues is a New Orleans native and Tulane grad with a major in baseball and a minor in math. He is a former stock options market maker on the CBOE and PSE, author of “Getting Started in Employee Stock Options,” Wiley 2010, consultant on managing equity compensation grants and inventor of Dynamic Employee Stock Options.
Do you have questions about equity compensation or employee stock options for John? Leave them in the comments and he’ll try to address them in a future post!