The Basics of Stock Options Paulin 1999 What
The Basics of Stock Options (Paulin, 1999) What are Stock Options? • Stock options are rights to purchase shares at a specified price during a specified period of time. • Stock options are the most popular long-term incentive compensation approach used in U. S. companies. MBAO 6600 - Executive Compensation
The Basics of Stock Options (Paulin, 1999) Goals of Stock Options • Reward Stock price growth • Provide opportunities for Managers or Employees to be Shareholders to improve incentive alignment. • Retention of key Employees/Managers • Reflect Competitive Compensation Trends MBAO 6600 - Executive Compensation
The Basics of Stock Options (Paulin, 1999) Option Events 1. Grant date - time begins on an option at this date. Strike price is usually FMV & set at this date. 2. Vesting date - when option recipient can first exercise option & realize a profit. 3. Exercise date - when option recipient purchases the shares and takes control of the options. 4. Sale - when option recipients sells the shares and takes the option profit. 5. Expiration date - end of option term, normally about 10 years after grant date. MBAO 6600 - Executive Compensation
The Basics of Stock Options (Paulin, 1999) Decision Area Common Practice Alternatives Type of Option NSOs ISOs Option Price FMV at grant discount/index/ premium Option term 10 years < 10 - any type > 10 - NSOs Vesting 2 -5 years partial Cliff vesting; Ch. Control prov. Post-termination 0 -90 days after quit > 90 days Payment cash, cashless or stock firm loans MBAO 6600 - Executive Compensation
The Basics of Stock Options (Paulin, 1999) Option Types • NQOs - Non qualified stock options – – related to market price of shares at grant date most popular option taxed at exercise and taxed at sale - less likely to hold no limit on dollar size of grant • ISOs - Incentive stock options – – related to performance hurdles & market price of shares capped at $100 K per year not taxed at exercise, taxed as capital gains at sale manager more likely to own stock after exercise MBAO 6600 - Executive Compensation
The Basics of Stock Options (Paulin, 1999) Option Price • Fair Market Value - determined on day of grant • Strike Price - is the option price • Alternatives: – Premium options: Above FMV of grant date – Discounted options: Below FMV on grant date – Indexed options: tied to stock index such as S & P 500 or industry average - these are variables and cannot be fixed in advance MBAO 6600 - Executive Compensation
The Basics of Stock Options (Paulin, 1999) Vesting Schedules: Partial Vesting: ownership rights given over 2 -5 year period on 1/3/ 1/3 or 1/4 1/4 basis Cliff Vesting: 100 percent vesting given during a 2 -5 year period (all or nothing). Must wait full term. Performance vesting: vested when a performance hurdle is fully or partially satisfied. Accelerated vesting: change of management control such as merger/acquisition triggers full vesting rights automatically for key managers. MBAO 6600 - Executive Compensation
The Basics of Stock Options (Paulin, 1999) Post Termination Exercise: Events Retirement: 2 -5 years is standard Quit: zero to 90 days is standard Death: one year after death is standard (for survivors) Termination for cause: specified in contract. Options may be accelerated or rights forfeited depending on situation. MBAO 6600 - Executive Compensation
The Basics of Stock Options (Paulin, 1999) Payment at Exercise 1. Cash exercise - company takes cash and uses it to buy stock back and reduce dilution. 2. Stock for stock - lowers dilution buy exchanging stock for other stock (from earlier grant) as payment. 3. Cashless exercise - no investment or risk on part of recipient. Broker buys & sells shares and delivers cash to recipient for option profits (could be paid in stock instead of cash). Often used with NSOs because income tax is due at MBAO 6600 - Executive exercise. Compensation
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