What Is the Employee Stock Option Scheme?

An employee stock option scheme is a compensation system that grants employees of a company options on their employer's stock. Employers choose such a compensation scheme for a variety of reasons, with the most popular being its favorable accounting treatment, strong motivational aspects and low cash requirements. It also refers to a specific piece of legislation in India.

How Options Work

Employee stock options are a simple contract between the employee and the employer. Under this contract, the employee can buy a specified number of shares in his employer at a fixed price on some future date. These options have value if the fixed price is lower than the stock's market price, since the buyer can then sell these shares for a quick profit. Most option schemes grant employees options over several years to ensure long-term loyalty.

Why Companies Use Options

Many companies use stock options because they align incentives. Stock options appreciate in value when the company does well, so if the company grants stock options to key employees, they will have an incentive to maximize their employer's growth and profitability. Stock options also require no initial cash outlay, which makes them ideal for early stage, cash-strapped employers. This is one reason options are a common compensation feature for start-ups, especially in the technology field.

Why Employees Choose Companies With Stock Option Schemes

Some employees prefer a predictable salary, but for many, stock options are a favorable part of the company's compensation scheme. In most cases, these stock options give an employee participation in the value that she creates through her job. This gives her a sense of ownership, and a literal ownership stake in the company, all of which leads to more productivity and better morale. The only downside to this is that a decrease in the company's stock price can hurt employee morale more.

India's Stock Option Scheme

In India, the government has created a specific law governing "Employee Stock Option Schemes." This law primarily defines terms that other laws use, such as "employee," "option," or "promoter." It also stipulates extensive and detailed procedural rules governing how and when companies can offer employees stock options. It provides some standard parameters for the terms of options contracts, include the length of time covered by the option and the voting rights that options confer.

References

• National Center for Employee Ownership: Stock Options, Restricted Stock, Phantom Stock, Stock Appreciation Rights (SARs), and Employee Stock Purchase Plans (ESPPs)
• CNN Money.com: Employee Stock Options
• Securities And Exchange Board Of India (Employee Stock Option Scheme And Employee Stock Purchase Scheme) Guidelines, 1999