What is the Employee Stock Options Plan (ESOP)?
Employee stock option plan (ESOP) is an “option” granted to the company employee carries the right, but not the obligation, to buy a promised number of shares at a pre-determined price (known as exercise price). These are complex call options granted by the companies as a part of the remuneration package. When stock options are exercised in large quantities, it can have a significant impact on the total number of outstanding shares thereby diluting the EPS and negatively affecting the valuations of the firm.
Employee Stock Options is different from exchange-traded options as they are not traded and don’t come with put component. Also, please note that the pre-determined price is also called a Strike PriceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. or the Exercise price.
How does Employee Stock Options Work?
Have a look at this options table from Colgate’s 2014 10K. This table provides details of Colgate’s outstanding stock options along with its weighted average exercise price.
Source – Colgate SEC Filings
- Employers issue Stock Options under the Stock Option Compensation Plan
- Stock Options can be exercised if the Market Price is greater than the Exercise Price or the strike price. (in-the-money)
- Once stock options are exercised, the company issues “shares” to the holder of the option.
- This, in turn, increases the total number of outstanding sharesOutstanding SharesOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet..
- Earnings Per ShareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. (Net Profit/number of shares outstanding) decreases as the denominator increases.
How Employee Stock Options affect the EPS?
To understand this concept, you should be aware of two important terminologies – Options Outstanding and Options Exercisable.
- Options Outstanding is the total number of outstanding options issued by the Company, but not necessarily vested. These options may be in-the-money or out-of-money. In Colgate, the Options outstanding are 42.902 million.
- Options Exercisable – Options that are vested as of now. These options again could be in-the-moneyIn-the-moneyThe term "in the money" refers to an option that, if exercised, will result in a profit. It varies depending on whether the option is a call or a put. A call option is "in the money" when the strike price of the underlying asset is less than the market price. A put option is "in the money" when the strike price of the underlying asset is more than the market price. or out-of-money. For Colgate, the Options exercisable are 24.946 million.
Let us take the example of Colgate 2014 10K; as noted above, there are 24.946 million employee stock options that are exercisable. For considering the effect of dilution, we only take the “options exercisable” and not the “Options outstanding,” as many of the outstanding options may not have vested.
Let us compare the average exercise price of $46 with the current market price of Colgate. As of the closing of June 13, 2016, Colgate was trading at $76.67. Since the Market Price is greater than the exercise price, all 24.946 million are in-the-money and therefore, will increase the total number of shares outstanding will be 24.946.
Basic EPS of Colgate
- Net Income 2014 of Colgate = 2,180 million
- Basic Shares = 915.1 million
- formula of Basic EPSFormula Of Basic EPSBasic EPS represents the income of the company for each common stock. In other words, it is the value appreciation of the common shares resulting from equal distribution of the company's profit as dividends among the common stockholders. = 2180/915 = $2.38
Impact of Stock Options on Diluted EPS of Colgate
- Net Income 2014 of Colgate = 2,180 million
- Oustanding Shares = 915.1 million + 24.946 million = 940.046
- Diluted EPS = 2180/940.046 = $2.31
As you can see that the EPS decreased from $2.38 to $2.31 due to the impact of stock options;
If the amount of stock options issued by the company is large, it can have a significant impact on the EPS of the company, thereby negatively affecting the valuation of the firm. Do have a look at the PE ratio for further details.
Taxes on Employee Stock Option Plan
Here we are going to discuss the taxes on the employee stock option plan –
#1 – When Option is Allotted
At the time of allotment of share on the exercise date, the difference between the fair market value at the time of exercise date and the price employee had paid at the time of subscription or at the time of exercise calculated accordingly. The value which we get after calculating the difference between the market value and the value at the time of subscription and that taxable value called prerequisite value. The difference calculated eligible for tax deducted at source.
#2 – When Employee Sells his Stock
In the second situation, when an employee opts to sell his share, the profit made by the employee is considered a capital gain. Taxes are applicable to capital gain, and it is calculated by the difference between fair market value on the exercise date and the sale value of the share.
Examples of ESOPs
For more clarification take help of the following example
ESOP taxation – while exercising the option – First condition for taxation
- Prerequisite value of ESOP (at the time of allotment)
- Market value = 120
- Exercise price = 70
- and the number of shares allocated under ESOP is 6000
Calculation of Prerequisite value of ESOP
Prerequisite value of ESOP = (fair market value- price at the time of exercise)* No of share
The above value is the prerequisite value of ESOP that is 300000, and this 300000 is the part of the salary of the employee, and it will be taxable at the time of allotment of share.
ESOP taxation- At the time of sale(capital gain)
- Sale proceeds at a price = 100
- fair market value at the time of allotment of share = 80
- Number of share 6000
Calculation of Capital Gains
Capital Gain = (Sale proceeds – Fair market value at the time of allotment of share)*No of share
= (100-80)*6000 = 120000
So, in this case, the tax will be applicable to the capital gain that is 120000, and the tax rate will depend upon the holding period.
This has been Guide to Employee Stock Option and its definition. Here we discuss how employee stock option plan (ESOP) Works along with examples, taxation issues, and more. You can learn more about financing from the following articles –