Employee Stock Option Agreement
Common stock, partial ownership and control of a company, is an important vehicle for investment. But, the issuance of stock, or the option to buy stock, has also become an important form of compensation for the executive staff, or even lower level staff of firms that issue stock.
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Common Stock
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"Equity" refers to ownership. Equity instruments, then, describes those tools with which companies raise funding for operation or expansion by selling part of the ownership and control of the firm. Common stock is the most prevalent example of this and confers both ownership and control to the holder of that stock in proportion to the ratio of the outstanding stock that he controls. While stock holders have the power to vote on various issues, the most important of these is usually the appointment or dismissal of high-level executives, who make the day-to-day decisions in governing the firm.
Stock is initially issued at a certain price, determined by the firm and the investment bank facilitating the issue. However, once the stock has been issued, its price is dynamically altered by market forces. A company posting consistent profits will be attractive to investors and they will compete with one another to purchase its stock, driving the price up. The stock of companies in financial trouble will not be seen as so valuable and as investors sell it, its easy availability on the market will devalue it.
Options
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Because the price of stock "floats" according to the strength of the company, investors often try to buy the stock of a company before it shows an improvement in its performance. "Buy low, sell high" is the war-cry of the speculator. However, buy low and later (when the price has gone up) sell high, is only the most simplistic way of making money in the stock market. If you can buy at a discount, then immediately sell at the price everyone else has to pay, then just as much profit can be made. The ability to buy at this discount is called an "option". Options exist for many types of investment vehicles, common stock being one of them.
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Employee Stock Options
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Stock options can be purchased as a contract giving the holder the right (but not obligation) to purchase or sell a security at a specified price within a specified time frame. Some companies offer stock options to their staff as a form of non-monetary compensation. By doing so, the firm attempts to align the employees' interests with those of the firm. The employees can purchase the stock at a specific price in the future, regardless of what the market price of the company's stock is at that time. If the company's stock price is considerably higher than this specified price (called the "strike price"), then the option holder can realize substantial profit.
From the company's perspective, it is securing some assurance that the employees so compensated will (from their self-interest as option-holders) behave in such a manner as to make the company more profitable (thus driving the stock price up). Additionally, as "equity-based compensation" the issuance of stock options does not strain the coffers of the firm in the present, which can be an important factor for start-ups or companies pursuing potentially lucrative, but initially expensive new endeavors.
Differences
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There are some important differences between employee stock options and typical option contracts. Like common stock itself, option contracts are typically transferable. ESOs often have limited transferability. The typical window during which the option must be exercised is about 30 months. ESOs offer a more extended period, sometimes as much as ten years. Because the loyalty and continued service of such incentivized employees is important, a vesting schedule is typically employed. This means that as an employee serves with the company, the number of shares available to purchase at the strike price increases.
Drawbacks
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There are critics of ESOs and they raise valid points. According to "The Trouble with Stock Options", an academic paper by Brian J. Hall of Harvard Business School and Kevin J. Murphy of the Marshall School of Business, companies tend to perceive ESOs as "free". While they do cost nothing at issue, an interest that does well has to eventually sell stock to these option-holders at below market price. Also, the asymmetries between the tax treatment and accounting treatment of options cause companies to favor options when the firms would be better served by alternative forms of compensation. Other critics, like Aswath Damodaran of the Stern School of Business, warn of the danger of companies using options as a currency to address operating expenses or purchase supplies.
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References
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