Last week I talked about stock options and how they work from the employee’s perspective. This week I want to spend a little time talking about how they work from the company’s perspective.
Current accounting standards take the view that when a stock option is granted, something of value has been given to the employee and that value needs to be recognized as an expense to the company. This creates three basic issues that must be dealt with when accounting for stock options.
- What is the value of the option at the date of grant?
- When should the expense be recognized?
- What do I do with the difference between the value I put on the option at the grant date and the value the employee gets from the company when the option is actually exercised?
Accounting standards say we should first look to an actively traded market when determining the value of a financial instrument such as a stock option. And while stock options are actively traded on many markets, the problem for us accountants is that the terms of the options traded on a market are usually significantly different from the terms of employee stock options. While both have an exercise price for the option, traded options generally have no vesting period and usually have much shorter (less than a year) exercise periods, so the market prices of options are not relevant in determining the value of employee stock options.
Instead, we use a financial model, the most common of which is called the Black-Sholes model named after Fisher Black and Myron Scholes who developed the model and first published a paper on it in 1973. For those of you not versed in finance speak, a model is just another word for guess, but I don’t think the FASB would appreciate me pointing out that accounting standards require us to book expenses based on a guess. But I digress.
Once the model guesses the value of the option, we then need to decide when to recognize that value as expense. When it comes to compensation, we should generally recognize such expense over the time period the employee is working for the compensation. For salary earned over a week it should be recognized as expense that week. For stock options, we look at the vesting period of the option. If the vesting period is two years, then we recognize the value of the option as compensation expense ratable over that two year period. Of course, not every employee granted stock options stays for that two year period, so we have to estimate (guess) how many employees will forfeit their options over the vesting period and not recognize expense for those employees. Finally, we have to periodically look at the actual number of employees leaving early and adjust the forfeiture rate (re-guess) over time if our original rate (guess) was wrong.
Finally we have to deal with the difference between the guessed, I mean modeled, value of the option we used to book expense and the amount we actually paid the employee when they exercise the option. Keep in mind that the odds that the model value exactly equals the value the employee receives when they exercise the options are about the same as your odds of winning the Power Ball lottery, so we will always have a difference in value to deal with. Accounting standards view that difference as an equity transaction between the employee and the company not as compensation expense (note that tax laws view it differently resulting in a permanent difference between the accounting records of a company and the tax records of that same company).
Let’s assume the company valued the option at $5 and recognized that much expense over the vesting period. In the first scenario let’s assume the company did well and the stock price went up $10 so the employee received $10 of value when they exercised the option. In this case the company has to recognize an additional $5 as a debit (decrease) to stockholders equity, just like they would if they went out and bought shares on the open market from other stockholders. In the second scenario let’s assume the company did not do as well so the stock price only went up $2. The employee still exercises their option, but in this case the company has to offset the $5 they accrued for compensation expense. The $3 difference between that amount accrued and the amount the employee received is recognized as a credit (increase) in stockholders equity.
Obviously, this is a very simplified discussion of the accounting for stock options; the rules are almost a couple of a hundred pages long and accounting firms have written guides on the topic that can run over 400 pages. I hope however, these two blogs have given you a sense of the difference between the way options are viewed by employees and the way they are viewed by companies which is part of the reason they have lost some of their luster as the preferred form of share-based compensation over the past few years and, as a result, why the use of restricted stock is on the upswing. In the future, I will spend some time taking about how restricted stock works and how it functions very differently from both the employee and the company perspective.
The first question I received was:
My daughter just accepted a position at a high-tech company. The offer for employment included 2,000 stock options as well as an annual salary. Just how do stock options work, and how could the options affect her time with the company?
First let’s talk about how they work from the recipient’s point of view.
A stock option is a right to buy a share of stock at a specified price at some future date or range of dates. While you can also buy and sell options on the open market, the terms of employee stock options are usually different from those you can buy on the open market. Generally there are three critical factors in a stock option offer.
- How long before the option can be exercised? That is, how long before the holder can actually use the option? This period is called the vesting period and can vary greatly by company from less than 1 year to as many as 5 years. Generally, if the employee leaves before the vesting period is completed, the employee forfeits all of the options (they get nothing).
- What is the exercise price of the option? That is, what is the price they must pay to buy the share of stock the option entitles the holder to purchase? Often employee stock options have an exercise price equal to the stock price on the date the option was granted, but options can also have exercise prices above the grant date stock price or below the grant date stock price.
- How long before the option expires? That is, when does the employee no longer have the right to buy a share of stock at the option price? This varies by company as well, but often you see exercise periods of 5 to 10 years. Almost always the exercise period is several years longer than the vesting period discussed on number 1 above.
The basic point of an option is for the employee to share in the benefits if the stock price (and therefore value) of the company increases. The idea is that by sharing in that increase in value, the employee will be incented to help the company increase its value and therefore benefit the stockholders of the company. If the exercise price of the option is $30 and after a period of time, the stock price is $40, then your daughter can exercise the option, buy the share for $30 and turn around and sell the share of stock for $40 and make $10. On the other hand if the stock price is $20, then the option is essentially worthless because no one would pay $30 for a share of stock they could simply go out on the market and buy for $20. And that is the issue with stock options as compensation. They are great and do an excellent job of retaining employees because no one wants to leave if the stock price goes up, but they are lousy and have no retention benefit at all to the company if the stock price goes down.
When it comes to actually exercising options, many employees don’t have thousands of dollars sitting around to buy the shares (per the example above 2,000 shares at $30 per share would cost $60,000) before they turn around and sell them, so companies often set up “cash-less” exercise programs. These programs essentially allow the employee to exercise the options and get paid the difference between the exercise price and the current stock price. In the example above, with an exercise price of $30 and a stock price of $40, if she exercised all 2,000 options in such a program she would receive $20,000 (the difference between the current value of the stock $40 * 2,000 shares and the payment she would have to make to buy the stock $30 * 2,000 shares). Of course she would have to pay income tax on the $20,000 and almost all cash-less exercise programs include automatic withholding of taxes so she would only get the after tax amount, not the full $20,000.
There are many financial and tax planning opportunities around options. Should you exercise the option as soon as it vests or wait for it to continue to go up in value until the very last day it can be exercised? Of course it can also go down in value (remember the stock market crash of 2008). Should you actually buy the stock rather than take advantage of the cash-less exercise program and then hold onto the stock for a period of time in an effort to turn some of the taxable income into capital gains income rather than ordinary income (which is generally taxed at a higher rate than capital gains in today’s tax rules)? Of course, if you don’t have $60,000 sitting around, this may be a moot point.
2,000 options is probably not enough to get really serious and seek expert financial advice on what to do, but if she continues to move up in the company and is granted additional options that become worth a considerable sum of money, she should seek out advice from an expert such as a CPA or a CPA-PFS (a Personal Financial Specialist credential offered only to CPAs) to help her work through the financial and tax planning aspects of the options.
Next week I will talk about how options work from the company’s point of view.