Share options, known in the United States as stock options, are rights granted by a company to its employees, directors or executives to buy a fixed number of the company's shares at a set price, the exercise or strike price, during a future period. The strike price is usually the market price on the day the options are granted. If the share price later rises above it, the holder can buy at the old price and keep the difference; if the price falls below it, the options are simply worth nothing at exercise.
Employee share options are a form of pay, widely used by start-ups funded by venture capital and by large listed companies for senior managers. They are close cousins of the exchange-traded call options described under options contracts, but they are issued by the company itself, cannot normally be sold or transferred, and are usually settled by creating new shares rather than by delivering existing ones.
Imagine a bakery owner telling a new baker: "Stay with me for four years and you can buy a slice of the business at today's price." If the bakery becomes famous and its value triples, the baker buys in cheaply and shares the gain. If the bakery struggles, the baker simply never uses the offer and has lost nothing but hope.
The owner's aim is to make the baker think like a part-owner, and to stay. The catch is that the baker's reward depends heavily on the bakery's value on a particular day, which can tempt someone to chase a good-looking result on that day rather than a healthy business over time.
How employee options work
Options pass through several stages. At grant, the company sets the number of options and the strike price. Options then vest over time or on performance targets: under cliff vesting nothing vests until a fixed date, while linear vesting releases a slice each month or year; a common start-up schedule is four years with a one-year cliff. Once vested, the holder may exercise, paying the strike price to receive shares, until the options expire, often ten years after grant. Leaving the company usually shortens the exercise window.
The gain on exercise is:
- is the share price on the day of exercise.
- is the strike price.
- is the number of options exercised.
An employee holding 10,000 options with a strike price of $20 who exercises when the shares trade at $35 gains dollars before tax. If the shares were at $18, exercising would make no sense and the options would be "underwater".
Tax and accounting
Tax treatment varies by country and largely determines how options are designed:
- United States. Non-qualified stock options are taxed as ordinary income on the gain at exercise. Incentive stock options can qualify for capital gains tax treatment if holding-period rules are met, but only up to $100,000 of options first exercisable in any year.
- United Kingdom. Approved schemes such as Enterprise Management Incentives (EMI), aimed at smaller trading companies, allow options to be taxed mainly as capital gains rather than income.
- Elsewhere. India taxes the gain at exercise as salary and again on sale, while many emerging markets have no special regime.
On the accounting side, options were long recorded as costing nothing if granted at the market price. International standard IFRS 2 (from 2005) and the US rule now known as ASC 718 (effective for most companies from 2006) require companies to estimate the fair value of options at grant, usually with the Black–Scholes model or a lattice model, and charge it as an expense over the vesting period. Fischer Black and Myron Scholes published their option-pricing formula in 1973; Scholes and Robert Merton received the Nobel memorial prize in economics for related work in 1997.
The debate over options as pay
Supporters argue that options align managers with owners and so reduce the principal-agent problem and its agency costs. They let cash-poor start-ups attract staff, and they reward employees only if shareholder value actually rises.
Critics raise several objections:
- Asymmetric risk. Holders share in gains but not losses, which may encourage excessive risk-taking.
- Short-term focus. Large grants that vest on fixed dates can encourage short-termism, earnings management or share buybacks timed to lift the price.
- Rewarding luck. In a bull market, options pay out even for average managers because the whole market has risen.
- Dilution. New shares created on exercise reduce existing owners' slice of earnings per share.
Abuses have also occurred. In 2006 US regulators investigated more than 100 companies for backdating, choosing grant dates after the fact when the share price had been low, which led to restatements, settlements and some criminal convictions. Partly in response, many companies have shifted toward restricted shares and performance shares, and shareholders vote on pay policies through proxy voting in many markets.