What Is the Meaning of an Employee Stock Option Plan?
As of 2008, over nine million American employees participate in ESOPs. An ESOP typically gives an employee an option to purchase the employer's stock at a stipulated grant price. Typically, the grant price equals the market value of the stock on the day the employer grants the the option. The employee may hold these options, and exercise the option at some later time when the market value has risen, sometimes very substantially.
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Why Companies Grant Stock Options
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Employee stock option plans (ESOPs) allow companies to reward employees with the promise of wealth at some future time without the present cost of distributing that wealth. Delaying compensation allows companies to retain capital that would otherwise become a current operating expense. A well-conceived ESOP attracts, compensates and retains valuable employees the company might otherwise not have sufficient operating capital to adequately compensate.
Why Employees Like Employee Stock Option Plans
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As an employee in a U. S. company, you will probably need to put away part of your income for retirement. An ESOP helps you do that. An ESOP with regular distributions of options gives you tax-advantaged income. You don't pay any tax on the option when your employer grants it. You will have to pay the tax on the option when you exercise it, but this could be years later. Effectively, you've sheltered the income. An ESOP with regular distributions also encourages saving, both generally and for your retirement.
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Some ESOP Complications
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If you contribute to your IRA, you pay taxes when you withdraw the money. In this sense, IRAs and ESOPS both shelter your money until you use it. Over time, however, your IRA also earns money at whatever investment return rate you achieve. While you may invest and shelter only $100,000 over 20 years, the IRA may eventually be worth $300,000. Invested funds compound your earnings. Meanwhile, the ESOP, while it will have appreciated in value, may not have earned that much. When the grant price exceeds the exercise price, the option has no value at all.
Another ESOP Problem
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A well-planned IRA investment enjoys the benefits of diversification. One IRA strategy consists of buying a broad selection of mutual funds. This protects you from the dangers inherent in an undiversified investment--of having all your eggs in one basket. But an ESOP constitutes a completely undiversified investment. While you can exercise your option, sell the stock and then buy diversified investments, you've then minimized the tax advantage of holding the option.
Intangible Advantages of ESOPS
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Despite certain limitations ESOPS remain popular with employees. For one thing, they give you a feeling of ownership that connects you to your company. If your option plan has an Incentive Stock Option structure (ISO) and you hold the stock for at least two years after you exercise the option, you pay only the lower long-term capital gains rate on the sale.
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