Equity Issued as Compensation: Stock Options
Firms develop compensation plans to attract, retain, and motivate employees. Many of these plans include cash compensation that is fixed or that varies with levels of employee performance, often defined by an accounting-based income measure (such as return on equity) or stock returns. In a typical compensation arrangement, firms give employees the right, or option, to acquire shares of common stock at a fixed price. If share prices increase over time, employees can exercise their option to purchase shares at a price that is less than the market price of the shares. These arrangements are referred to as stock options, and their use skyrocketed during the 1990s and early 2000s. Firms in the technology sector have used options as a dominant component of their employee compensation packages
Stock options permit employees to purchase shares of common stock at a price usually equal to (or just above) the market price of the stock at the time the firm grants the stock option. Employees exercise these stock options at a later time if the stock price increases above the stock option exercise price. Corporations grant stock options because they have characteristics that align the interests of the employees with those of the shareholders. Clearly, an increase in stock price benefits shareholders, which is the same way stock options reward employees. Unlike compensation in the form of salaries, however, stock options do not require firms to use cash during the period in which the stock options are granted. In addition, the ability of a corporation to attract and retain employees is enhanced when firms offer equity incentives such as stock options as part of the compensation package. Employees with unvested stock options have an incentive to continue their employment with the company until they can exercise their options. An understanding of the accounting for stock-based compensation requires understanding several key parameters:
Firms develop compensation plans to attract, retain, and motivate employees. Many of these plans include cash compensation that is fixed or that varies with levels of employee performance, often defined by an accounting-based income measure (such as return on equity) or stock returns. In a typical compensation arrangement, firms give employees the right, or option, to acquire shares of common stock at a fixed price. If share prices increase over time, employees can exercise their option to purchase shares at a price that is less than the market price of the shares. These arrangements are referred to as stock options, and their use skyrocketed during the 1990s and early 2000s. Firms in the technology sector have used options as a dominant component of their employee compensation packages
Stock options permit employees to purchase shares of common stock at a price usually equal to (or just above) the market price of the stock at the time the firm grants the stock option. Employees exercise these stock options at a later time if the stock price increases above the stock option exercise price. Corporations grant stock options because they have characteristics that align the interests of the employees with those of the shareholders. Clearly, an increase in stock price benefits shareholders, which is the same way stock options reward employees. Unlike compensation in the form of salaries, however, stock options do not require firms to use cash during the period in which the stock options are granted. In addition, the ability of a corporation to attract and retain employees is enhanced when firms offer equity incentives such as stock options as part of the compensation package. Employees with unvested stock options have an incentive to continue their employment with the company until they can exercise their options. An understanding of the accounting for stock-based compensation requires understanding several key parameters:
- The grant date is the date a firm gives a stock option to employees.
- The vesting date is the first date employees can exercise their stock options
• Employees cannot exercise options before the vesting date or after the end of the option’s life.
• To enhance employee retention and increase motivation during the vesting
period, firms usually structure stock option plans so that a period of time
elapses between the grant date and the vesting date. • Firms may preclude employees from exercising the option for one or more years, or they may set an exercise price so high that employees would not want
to exercise the option until the stock price increases.
n The exercise date is the date employees elect to exchange the options plus cash
for shares of common stock.
period, firms usually structure stock option plans so that a period of time
elapses between the grant date and the vesting date. • Firms may preclude employees from exercising the option for one or more years, or they may set an exercise price so high that employees would not want
to exercise the option until the stock price increases.
n The exercise date is the date employees elect to exchange the options plus cash
for shares of common stock.
- The exercise price is the price specified in the stock option contract for purchasing the common stock
- The market price is the price of the stock as it trades in the market.
- In theory, the value of a stock option has two elements: (1) the benefit realized on the exercise date because the market price of the stock exceeds the exercise price (the benefit element) and (2) the length of the period during which the holder can exercise the option (the time-value element).
The amount of the benefit element is not known until the exercise date. In general, stock options with exercise prices less than the current market price of the stock (described as in the money) have a higher value than stock options with exercise prices exceeding the current market price of the stock (described as out of the money). The time-value element of an option results from the benefit it provides its holder if the market price of the stock increases during the exercise period. The greater the market price of the stock exceeds the exercise price during the exercise period, the greater the benefit to the option holder. This time-value element of an option will have more value the longer the exercise period, the more volatile the market price of the stock, the lower the dividend yield, and the lower the discount rate. Note that a stock option may have an exercise price that exceeds the current market price (zero value for the benefit element) but still have value because of the possibility that the market price will exceed the exercise price on the exercise date (positive value for the time-value element). As the expiration date of the option approaches, the value of the time-value element approaches zero.
Fair value is the basis for stock option accounting.Firms must measure the fair value of stock options on the date of grant. Because the value of employee stock options typically cannot be measured with an observable value established by trading in an active market, most firms will estimate the fair value of the options with the Black-Scholes model or a lattice model (for example, the binomial model). A detailed discussion of option valuation models can be found in the finance literature and is beyond the scope of this text. However, any model employed must incorporate a variety of factors, including the exercise price of the option, the term of the option, the current market price of each share of underlying stock, expected stock price volatility, dividends, and the risk-free interest rate.
Once the firm estimates the fair value of stock options as of the grant date, it must recognize this amount as compensation expense ratably over the period in which an employee provides services (commonly, the vesting period) and disclose the effects of the stock option grants on total compensation expense, the methodology (model) used to value the stock options, and the key assumptions made to estimate the value of the stock options.
Fair value is the basis for stock option accounting.Firms must measure the fair value of stock options on the date of grant. Because the value of employee stock options typically cannot be measured with an observable value established by trading in an active market, most firms will estimate the fair value of the options with the Black-Scholes model or a lattice model (for example, the binomial model). A detailed discussion of option valuation models can be found in the finance literature and is beyond the scope of this text. However, any model employed must incorporate a variety of factors, including the exercise price of the option, the term of the option, the current market price of each share of underlying stock, expected stock price volatility, dividends, and the risk-free interest rate.
Once the firm estimates the fair value of stock options as of the grant date, it must recognize this amount as compensation expense ratably over the period in which an employee provides services (commonly, the vesting period) and disclose the effects of the stock option grants on total compensation expense, the methodology (model) used to value the stock options, and the key assumptions made to estimate the value of the stock options.
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