Understanding Employee Stock Options

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An employee stock option (also called personnel option) is a call option issued as a compensation alternative for companies to provide to their  employees, usually those at management level.

The employee receives the right for a certain period which is the period of the option at a predetermined price per share (the exercise price of the option) to buy shares in a company.

Employee options are a form of equity compensation under share based incentives and equity incentives. Share based rewards are part of the remuneration policy (also known as pay policy) of organizations.

The remuneration policy, in turn, is again part of the staff incentives of an organization, share based rewards are variable and almost always long-term rewards.

Employee purchase option is a right and not an obligation to buy. An employee stock option grants the employee an economic advantage, if the actual market value of the share at any time during the period exceeds the exercise price. The employee is in principle free to decide whether the shares acquired by exercising will be maintained in whole or partially sold.

Employee type stock options can also be extended to non-employees such as suppliers, consultants or lawyers. Essentially, employee stock options are identical to warrants, which are call options provided by an entity with regards to its own stock.

The exercise price of an option (or strike price) is the price at which the employee may purchase shares of the employer. Listed shares at the exercise price is generally set at the actual value of the share on the grant date or an average of the actual values of the share during a period immediately preceding the grant date. These options are then called at-the-money options.

Employee options generally have a so-called vesting period or blocked period. This is a period beginning on the grant date and ends on a certain future date, it is granted before the end of the contractual term. During the vesting period, the option is not exercised by the employee.

The value of an employee stock options conforms to the valuation techniques employed for standardized options. Hence, they are also valued using models such as Black-Scholes and the binomial model.

An employee option can have more than one qualifying date. In such cases, they often settle options in annual tranches (from the grant date) with the option to share exercisable until the option becomes fully exercisable.

And in the United States, employee stock options are expensed under US GAAP. Every firm should set about expensing stock options by the first reporting period of a financial year.



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