Employee Stock Option Plans and Your Portfolio
The employee stock option plan is a popular benefit geared to align employee interests with the long-term viability of the firm. Here, employees might also emerge as owners, if they commit to purchasing shares of company stock at prices well beneath market value.
Be further advised that employee stock option plans are separate and distinct from employee stock ownership plans (ESOPs).
Employee stock options grant rights for you to purchase shares of company stock at a set strike price. You will exercise employee stock options when the stock market price for company shares exceeds your strike price.
For example, you may be granted employee stock options that carry rights to purchase shares in Corporation X for $50. You would consider exercising your stock options, if Corporation X were to trade above $50 per share in the stock market.
Employee stock options are central to the ongoing stakeholder movement in corporate finance. Employees are now also considered owners, who actively participate and benefit from the growth and profitability of the firm.
Employee stock option valuations track underlying share price performance. In turn, we expect for corporate managers to take actions that drive stock prices higher – to improve their respective total compensation packages.
Employee stock option plans do present complicated tax ramifications – because these financial instruments combine employee compensation along with an investment component. Here, tax ramifications are triggered when you exercise employee stock options, and not when the options are first granted.
When you exercise options, the difference between your strike price and market value for company stock will be treated as employee compensation and subject to ordinary income taxes.
For example, you may exercise stock options to buy Corporation X shares for $50, while it trades for $75 in the stock market. You could then owe taxes on $25 worth of ordinary income. From here, you may ultimately sell Corporation X shares for $120, after three years. You would then be subject to long-term capital gains taxes on the $45 in profits ($120 – $75 = $45).
Financial Risks and Investment Strategy
All that glitters, of course, is not gold, and employee stock option plans do expose both employee shareholders and outside investors to significant financial risks.
Firstly, existing shareholders will be diluted, when the corporation issues new shares when employees exercise options. More shares of outstanding common stock translate into lower ownership percentages for each individual share.
Corporations typically buy back stock to protect shareholder interests and mitigate dilution. These tactics are especially rampant within the technology space, where buybacks often simply balance out the issuance of new shares.
Prospective investors are highly encouraged to review corporate balance sheets and cash flow statements to further assess employee stock options as they relate to buy back policy.
Lastly, as an employee, employee stock options may leave your finances too concentrated within one company. Alarmingly, a Company Man may desperately find himself out of a job and holding worthless stock at the very same time that his employer was to fail.
To manage financial risks, you may consider immediately selling company stock after you exercise options and directing the cash proceeds into a diversified stock market portfolio.