Non-Statutory Stock Options

When corporations want to give their senior personnel greater incentives to improve company performance, they often issue employee stock options. The term "non-statutory" is used to distinguish one type of employee stock option from the other common type, incentive stock options. A non-statutory stock option gives senior employees the opportunity to cash in on gains in the company's stock price without risk and without having to invest their own money.

Identification

Like other types of stock options, a non-statutory stock option grants the holder the right to buy a given number of shares of stock at a guaranteed price, called the strike price. Non-statutory options are normally issued with the strike price set at the market price of the stock at the time of issue. The option is good until its expiration date, called the expiry. If the stock goes up in price, the employee can exercise the option, buying the stock at the lower strike price.

Types

Companies that issue non-statutory stock options get a tax break. Non-statutory options are not eligible for capital gains tax rates. The other major type of employee stock option, incentive stock options, does allow capital gains and confers no tax advantage to the company. Employees also assume risk with incentive stock options, because the stock itself must be held for one year after the option is exercised, but they do have significant tax advantages.

Function

When an employee chooses to exercise a non-statutory stock option, he pays the strike price for the shares. The company bears the cost of the difference between the strike price and the market price, either by paying for shares on the market or by issuing new shares. The employee can then sell the shares, keeping the difference between the strike price and the market price. With a large number of shares, this may be worth hundreds of thousands or even millions of dollars. For example, if the strike price is $25 per share, and the stock is exercised when the market price is $35 per share, the employee makes $10 per share. With non-statutory stock options for 25,000 shares, that works out to $250,000.

Reload

Some non-statutory stock options have a "reload" feature. The option is exercised like a regular employee stock option. However, the employee is then issued another stock option with the same expiration date but with the current market price as a new strike price. If the stock goes up to a still higher price, the option can be exercised again at any time up until the expiry.

Cashless Exercise

From the employee's standpoint, there is only one real problem with this arrangement: she has to come up with the cash (perhaps hundreds of thousands of dollars) to pay the strike price and exercise the option. In practice, that isn't necessary. Instead, the employee executes a "cashless" exercise by taking the option contracts to a broker. The broker advances (loans) the money for the strike price, purchases the stock and then resells it on the market. The broker gets his money back (plus a fee), and the employee gets the profit from the exercise.