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Stock Options, Restricted Stock, Phantom Stock, Stock Appreciation Rights (SARs), and Employee Stock Purchase Plans (ESPPs)
There are five basic
kinds of individual equity compensation plans: stock options,
restricted stock and restricted stock units, stock appreciation rights,
phantom stock, and employee stock purchase plans. Each kind of plan
provides employees with some special consideration in price or terms.
We do not cover here simply offering employees the right to buy stock
as any other investor would.
A few key concepts help define how stock options work:
· Exercise: The purchase of stock pursuant to an option.
· Exercise price: The price at which the stock can be purchased. This is also called the strike price or grant price. In most plans, the exercise price is the fair market value of the stock at the time the grant is made.
· Spread: The difference between the exercise price and the market value of the stock at the time of exercise.
· Option term: The length of time the employee can hold the option before it expires.
· Vesting: The requirement that must be met in order to have the right to exercise the option-usually continuation of service for a specific period of time or the meeting of a performance goal.
A company grants an employee options to buy a stated number of shares at a defined grant price. The options vest over a period of time or once certain individual, group, or corporate goals are met. Some companies set time-based vesting schedules, but allow options to vest sooner if performance goals are met. Once vested, the employee can exercise the option at the grant price at any time over the option term up to the expiration date. For instance, an employee might be granted the right to buy 1,000 shares at $10 per share. The options vest 25% per year over four years and have a term of 10 years. If the stock goes up, the employee will pay $10 per share to buy the stock. The difference between the $10 grant price and the exercise price is the spread. If the stock goes to $25 after seven years, and the employee exercises all options, the spread will be $15 per share.
Kinds of Options
Options are either
incentive stock options (ISOs) or nonqualified stock options (NSOs),
which are sometimes referred to as nonstatutory stock options. When an
employee exercises an NSO, the spread on exercise is taxable to the
employee as ordinary income, even if the shares are not yet sold. A
corresponding amount is deductible by the company. There is no legally
required holding period for the shares after exercise, although the
company may impose one. Any subsequent gain or loss on the shares after
exercise is taxed as a capital gain or loss when the optionee sells the
1. The employee must hold the stock for at least one year after the exercise date and for two years after the grant date.
2. Only $100,000 of stock options can first become exercisable in any calendar year. This is measured by the options' fair market value on the grant date. It means that only $100,000 in grant price value can become eligible to be exercised in any one year. If there is overlapping vesting, such as would occur if options are granted annually and vest gradually, companies must track outstanding ISOs to ensure the amounts that becomes vested under different grants will not exceed $100,000 in value in any one year. Any portion of an ISO grant that exceeds the limit is treated as an NSO.
3. The exercise price must not be less than the market price of the company's stock on the date of the grant.
4. Only employees can qualify for ISOs.
5. The option must be granted pursuant to a written plan that has been approved by shareholders and that specifies how many shares can be issued under the plan as ISOs and identifies the class of employees eligible to receive the options. Options must be granted within 10 years of the date of the board of directors' adoption of the plan.
6. The option must be exercised within 10 years of the date of grant.
7. If, at the time of grant, the employee owns more than 10% of the voting power of all outstanding stock of the company, the ISO exercise price must be at least 110% of the market value of the stock on that date and may not have a term of more than five years.
If all the rules for
ISOs are met, then the eventual sale of the shares is called a
"qualifying disposition," and the employee pays long-term capital gains
tax on the total increase in value between the grant price and the sale
price. The company does not take a tax deduction when there is a
Exercising an Option
There are several ways to exercise a stock option: by using cash to purchase the shares, by exchanging shares the optionee already owns (often called a stock swap), by working with a stock broker to do a same-day sale, or by executing a sell-to-cover transaction (these latter two are often called cashless exercises, although that term actually includes other exercise methods described here as well), which effectively provide that shares will be sold to cover the exercise price and possibly the taxes. Any one company, however, may provide for just one or two of these alternatives. Private companies do not offer same-day or sell-to-cover sales, and, not infrequently, restrict the exercise or sale of the shares acquired through exercise until the company is sold or goes public.
Under rules for equity compensation plans to be effective in 2006 (FAS 123(R)), companies must use an option-pricing model to calculate the present value of all option awards as of the date of grant and show this as an expense on their income statements. The expense recognized should be adjusted based on vesting experience (so unvested shares do not count as a charge to compensation).
Restricted stock plans
provide employees with the right to purchase shares at fair market
value or a discount, or employees may receive shares at no cost.
However, the shares employees acquire are not really theirs yet-they
cannot take possession of them until specified restrictions lapse. Most
commonly, the vesting restriction lapses if the employee continues to
work for the company for a certain number of years, often three to
five. Time-based restrictions may lapse all at once or gradually. Any
restrictions could be imposed, however. The company could, for
instance, restrict the shares until certain corporate, departmental, or
individual performance goals are achieved. With restricted stock units
(RSUs), employees do not actually receive shares until the restrictions
lapse. In effect, RSUs are like phantom stock settled in shares instead
Phantom Stock and Stock Appreciation Rights
rights (SARs) and phantom stock are very similar concepts. Both
essentially are bonus plans that grant not stock but rather the right
to receive an award based on the value of the company's stock, hence
the terms "appreciation rights" and "phantom." SARs typically provide
the employee with a cash or stock payment based on the increase in the
value of a stated number of shares over a specific period of time.
Phantom stock provides a cash or stock bonus based on the value of a
stated number of shares, to be paid out at the end of a specified
period of time. SARs may not have a specific settlement date; like
options, the employees may have flexibility in when to choose to
exercise the SAR. Phantom stock may offer dividend equivalent payments;
SARs would not. When the payout is made, the value of the award is
taxed as ordinary income to the employee and is deductible to the
employer. Some phantom plans condition the receipt of the award on
meeting certain objectives, such as sales, profits, or other targets.
These plans often refer to their phantom stock as "performance units."
Phantom stock and SARs can be given to anyone, but if they are given
out broadly to employees and designed to pay out upon termination,
there is a possibility that they will be considered retirement plans
and will be subject to federal retirement plan rules. Careful plan
structuring can avoid this problem.
Employee Stock Purchase Plans (ESPPs)
Employee stock purchase
plans (ESPPs) are formal plans to allow employees to set aside money
over a period of time (called an offering period), usually out of
taxable payroll deductions, to purchase stock at the end of the
offering period. Plans can be qualified under Section 423 of the
Internal Revenue Code or non-qualified. Qualified plans allow employees
to take capital gains treatment on any gains from stock acquired under
the plan if rules similar to those for ISOs are met, most importantly
that shares be held for one year after the exercise of the option to
buy stock and two years after the first day of the offering period.
· Only employees of the employer sponsoring the ESPP and employees of parent or subsidiary companies may participate.
· Plans must be approved by shareholders within 12 months before or after plan adoption.
· All employees with two years of service must be included, with certain exclusions allowed for part-time and temporary employees as well as highly compensated employees. Employees owning more than 5% of the capital stock of the company cannot be included.
· No employee can purchase more than $25,000 in shares, based on the stock's fair market value at the beginning of the offering period in a single calendar year.
· The maximum term of an offering period may not exceed 27 months unless the purchase price is based only on the fair market value at the time of purchase, in which case the offering periods may be up to five years long.
· The plan can provide for up to a 15% discount on either the price at the beginning or end of the offering period, or a choice of the lower of the two.
Plans not meeting these
requirements are nonqualified and do not carry any special tax