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Week 7

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Employer Stock Options

This is an offer made by a company to its workers selling them its shares at a fixed discounted price for a number of years (Businessdictionary.com, 2013). The employees are given a better offer than ordinary customers who would also want to buy the same shares. It is one way of making the employees feel like they are also participating in the direct control of the company. This offer is made for a specific period and could be called off if the management of the company identifies reasons to do so. The management of the company might also decide to use this option as a way of remunerating its workers after several years. Employees who have been given stock options usually hope to sell these stocks at a higher price in the future than at the prices they bought them.

Reasons for Using Employee Stock Options

Despite the fact that they are expensive, employee stock plans are an effective way of retaining valuable employees. Companies nurture their employees from junior positions to senior positions, and by the time most employees have enough experience, they feel the need to move from one company to the other. In order to counter these migratory ambitions, companies then have to look for ways with which to hold on to their established employees. Most employees take these offers instead of moving to another company where they will be paid less money than what the employee stock option will eventually generate. Companies also issue employee stock options as a way of securing and generating flow of money within the company. The flow of money is realized when new shares are released and sold to employees, and when tax deductions are made on employees’ earnings from the sales of their shares.

Some companies also offer employee stock options to their management teams as a motivation towards working harder. Management teams make crucial decisions in the daily operations of companies and, therefore, rewarding them is seen as a way of boosting their input into the company. In some instances, employee stock options may also be offered to non-management level staff in companies where there are other avenues to compensate this expenditure. Employee stock options may also be offered to non-employees like promoters and suppliers as a way of rewarding them for their good work (Olagues & Summa, 2010). Apart from rewarding already established employees, companies also use employee stock options as a way of attracting new employees.

Features of Contract

This offer is made by the company to the employee on a private basis and involves several features stipulated in the employee stock option contract.

Overview. That depending on the period after the offer was made, the employee has the liberty to sell his or her acquired shares at the current market price and not the price used during the initial trading of the shares. That the employee may withhold his or her stocks from being traded by the company for as long as he or she wishes. Contract differences. There are certain differences between stocks owned by employees and stocks owned by normal share holders: i. Exercise price for the offer. The exercise price for the offer is the present price of the share at the time of trading shares. ii. Quantity. The basic employee stock option has one hundred shares in one employee stock option contract. However, this number may be changed by the concerned parties depending on the total number of shares being sold. iii. Vesting. In selected cases, some options may stipulate that the employer who bought shares must keep on working in the same company for a selected number of years before trading their shares. Shares can also either be traded all at once or in stipulated portions over a duration of time. Some companies also restrict the sale of acquired shares to specific events or occurrences like public trading of shares or change in company management. iv. Expiration of shares. Different companies have different maximum maturity periods for their shares. Shares sold to normal shareholders have a maturity period of not more than thirty months unlike employee stock plans that could have maturity periods of up to ten years. v. Transfer of shares. In most cases, traded shares are non-transferable and the buyer must sell them before the expiration date or let them expire having no value on the contract termination date. It is advisable that traded shares be sold several years before the expiration date to avoid possible losses. vi. Possible risk. Employee stock options are traded on a private basis with a clear statement from the company on possible credit risks in the future. This is to inform the employee that in case the company will be unable to raise the accumulated money at the appointed maturity time, then employee will have slim chances of pressing charges in a legal court. vii. Taxation. Taxation is viewed by the company as a way of recovering expenditures made in the employee stock option process. Compared to normal shareholders, taxation of employee’s stocks is less.

Taxation, Accounting and Valuation

There are specific share pricing models used in valuing the price of employee stock options. Lattice models are however used more than any other type of valuation model because they have detailed problem-solving mechanisms for set backs that might come up during valuation. The valuation process should consider all features of the contract as outlined above. In American accounting principles before 2005, stocks offered to employees were not recognized as expenditure in a company’s financial statements but were just included in the notes section of the statements. On taxation, shares that have just been traded cannot be taxed for a specific period until their new market value can be accurately determined. However, when the employee decides to sell his or her shares, taxation will be mandatory.

Criticisms to Employee Stock Plans

One criticism is that stock options offered to employees are most of the times hard to valuate because of frequently changing market conditions. Another criticism is that this plan is a way of overpaying management teams at the expense of other workers in the company. According to Ehrhardt and Brigham (2008), the rewards given through employment stock plans are most of the times uncalled for and should be eliminated because they increase the expense of the company while providing no immediate compensations (Kolb, 2011). This situation is aggravated in situations where the company is performing averagely yet the management team goes ahead to reward themselves. Critics also point out that in case the shares are diluted during the maturity period, then the shareholder will incur huge losses that will not be fully compensated as stated in most employee stock option contracts.

References

Brigham, F. E & Ehrhardt, M. (2008). Corporate Finance: A Focused Approach. Cengage Learning.

Business Dictionary.com. (2013). Employee Stock Plan. In BusinessDictionary.com. Retrieved from http://www.businessdictionary.com/definition/employee-stock-option-plan.html.

Kolb, W. R., Kemper, K., Overdahl, A. J., & Simkins, B. (2011). Financial Derivatives: Pricing and Risk Management. John Wiley and Sons.

Olagues, J., & Summa, J. F. (2010). Getting Started In Employee Stock Options. Upper Saddle River, NJ: John Wiley & Sons.

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