In Employee option plan the company offers its employees option to purchase the shares of the company at the pre-determined price, known as the exercise price, at some future pre-set date where the exercise price is always less than the current market price of the company and this method is used for retaining the employees in the company and to improve the mechanism of remuneration.
What is the Employee Stock Options Plan (ESOP)?
Under the Employee stock option plan (ESOP), 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. Employee Stock Options 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 Price 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 shares
- Earnings Per Share (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, Options outstanding are 42.902 million
- Options Exercisable – Options that are vested as of now. These options again could be in-the-money or out-of-money. For Colgate, 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 EPS = 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 impact of stock options.
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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 PE ratio for further details.
Taxes on Employee Stock Option Plan
Here we are going to discuss the taxes on employee stock option plan. In the case of employee stock options taxes are applied in two ways.
#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 which 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 are considered as 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 tax will be applicable to capital gain that is 120000, and 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 –