What is a stock option?

Stock options give an employee the right (option) to buy stock from the employer at a specific price (strike price) within a given time period (exercise period — typically up to 10 years). This option has time value.

Options expire, there’s not a fixed number of options that can be issued. They can be bought and sold like stock.

Currently, stock options aren’t as desirable as cash and stock due to the rise in interest rates and the state of the economy.

Overall, even for dot-com’s options are not as effective or enticing as they once were. Half of all options granted for ’97-’99 are underwater.

At Philip Morris, they are rewarding retention bonuses and the company is paying dividends on option grants which entails underwater options to give employees a quarterly check.

What are the advantages for a company to granting stock options?

From the employer’s standpoint, stock options enable a company to attract and keep talent without draining cash flow on high salaries.

Options also align the goals of executives and shareholders. If options are sold, this is no longer true. Therefore some firms ban sales by contract.

What are the differences between Qualified and Non-Qualified Stock Options?

There are two types of stock options, qualified or non-qualified. Qualified stock options, otherwise known as statutory, mean that they meet the legal requirements to receive preferential tax treatment. Non-qualified stock options, otherwise known as non-statutory, mean that they do not meet the legal requirements to qualify as an ISO or a purchase plan option.

Qualified Stock Options fall into two categories:

Incentive Stock Options (ISO’s) which have specific restrictions on how the option is structured and when the option can be transferred and also have preferential tax treatment. This type of option has specific restrictions on the structuring and when the option can be transferred.

The employee is not taxed at exercise date, however the gain amount is an adjustment made for AMT purposes.

The employee is taxed only upon disposition of the option stock, the gain is all capital gain for a qualifying disposition, sale, exchange or transfer of legal title.

Generally, the employer cannot take a deduction for an ISO.

Employee Stock Purchase Plan (Purchase Plan Option) are another type of stock option that receives preferential treatment. Like a stock option, it enables employees to share in the growth of the company’s stock. Simply put, it enables employees to use automatic deductions to purchase.

Non-Qualified Stock Options . also known as non-statutory stock options

Most employers that are using non-qualified stock options are trying to achieve the same effect as qualified options without the necessity of conforming to the Code and legal requirements.

The employee is taxed at the grant date if there is a fair market value (FMV). This would be applicable for mainly public companies. If there is no obtainable FMV as in the case of most non-public companies, the options are taxed at exercise date.

Non-qualified options are taxed as ordinary income as opposed to qualified stock options which are normally taxed at capital gain rates which would typically be lower than the ordinary income tax rate.

The employer does get a tax deduction at the time the option is exercised.

Non-qualified stock options may be subject to certain restrictions, imposed by the employer. For example, upon termination, the employee may be required to sell the stock back to the company at book value. This is typical for a closely held corporation. The tax treatment of “restricted property,” may differ as well depending upon restrictions.

What is the difference between call options and put options?

Call Options is the right to buy stock at a specific price on or before a certain date. It works like a security deposit does on an apartment. You secure your right to buy. If you don’t buy, you lose the security deposit.

Put Options is the right to sell a stock at a specific price on or before a certain date. It can insure a stock at a fixed price. If value falls you can exercise at the insured price.

What are the cash flow implications of exercising my stock options?

No Cash Turnover

You do not have to actually pay anything. The cost to buy the shares and sell them is done in the same transaction, so they just offset each other and you will receive the difference.

Immediate Exercise

This will cost you money. You must buy the stock at the option price and hold on to it and sell it as you would any other investment.

Exercise Later

This will cost you the same amount but the advantage of waiting is that the share may go up and the cost will be the same to you.

What is Hedging?

Hedging is selling derivatives or unexercised options. Options are a form of derivative. Derivatives are financial bets about interest rates, stock prices or other financial fact.

Hedging stock options is usually illegal.

Every firm should address hedging in their contracts because it is unknown what new legislation might do to the laws.

Usually hedging is not blocked by contract but rather by securities law and tax law (basket hedging) but hedging stock is not illegal.

What is Repricing?

Repricing in a nutshell is fixing broken options by exchanging them for new ones at lower prices. Repricing is not as easy due to FASB ruling and substantial charges to companies. Shareholders are normally not supportive of repricing because the effect is that CEO’s have different interests than shareholders.

It’s usually rationalized as a retention maneuver.

What upcoming legislation might change stock options?

Super Stock Option

Allows employees no tax and exercise. If held >1 year, it falls under the capital gain tax of 20% which is lower than ordinary income tax.