What it means
When an employee is granted an option, the company sets an exercise price, which is usually the share price on the grant date. The employee typically has to wait through a vesting period, often several years, before the options can be used.
If they leave early, unvested options are usually lost. The financial logic is easy to follow.
If the exercise price is $5 and the share price later reaches $12, the employee can buy each share for $5 and the shares are worth $12, giving a gain of $7 per option. If the price never rises above $5, the options are worth nothing and the employee simply does not exercise them.
For the company, options are an expense even though no cash leaves the business at the start. Accounting standards require the cost to be measured using an option pricing model at the grant date and spread across the vesting period.
The expense reduces reported profit and increases equity by the same amount. Exercising options usually creates new shares, which dilutes the ownership of existing shareholders.
Investors therefore pay attention to the number of options outstanding, and diluted earnings per share includes the effect of options that are in the money. Some companies buy back shares to offset the dilution.
Tax treatment depends on the country and on the type of scheme, and it may apply when options are granted, exercised or sold. Some approved schemes offer favourable tax treatment if conditions are met, while unapproved ones tax the gain as employment income.
Employees and employers both should take specialist advice. Options are particularly popular in start-ups and growth companies, where cash is limited and shares may be expected to rise sharply.
They give staff a stake in the success of the business, though they carry the risk that the shares never reach a value above the exercise price.
In practice
Real-world examples
Example 1
A technology start-up grants its first ten employees options over 1% of the company each. The options vest over four years, with nothing vesting in the first year. When the company is sold, the early staff exercise their options and receive a share of the proceeds.
Example 2
A listed manufacturer grants its senior managers options with an exercise price equal to today's share price of $20. Three years later the share price is $26 and the managers exercise 5,000 options each. Each makes a pre-tax gain of 5,000 x 6 = $30,000.
Example 3
A finance team prepares year-end accounts for a company with several option schemes. It calculates the expense for each grant, adds it to the employee costs and discloses the number of options outstanding. The auditors review the valuation model and assumptions.
Think of it
Imagine a landlord gives you a voucher to buy their house in five years for today's price of two hundred thousand pounds. If the neighbourhood booms and the house becomes worth three hundred thousand pounds, your voucher lets you buy it at the old bargain price and sell it for an instant profit.
Formula
Calculation
Intrinsic value = (Market price per share - Exercise price per share) x Number of options
Annual expense = (Grant-date fair value per option x Number of options) / Vesting period in years
Suppose an employee is granted 10,000 options with an exercise price of $5. Later the market price is $12.
Intrinsic value = (12 - 5) x 10,000 = $70,000.
For the company's accounts, suppose the grant-date fair value is $3 per option and the options vest over 4 years.
Total expense = 3 x 10,000 = $30,000.
Annual expense = 30,000 / 4 = $7,500 a year for four years.Case study
Seen in the real world
Falconer Biotech is an illustrative, fictional private company that could not afford to match the salaries offered by larger rivals. To recruit a head of research, it offered a lower salary plus 20,000 options at an exercise price of $4 per share.
The finance manager estimated that each option had a fair value of $1.50 at grant and that the options vested over four years. The accounting expense was therefore 20,000 x 1.50 = $30,000 in total, or $7,500 a year, which did not affect cash.
Three years later the company's shares had reached $10, and the research head's options were worth (10 - 4) x 20,000 = $120,000 in intrinsic value. The illustrative lesson is that options can attract talent without cash, but they cost shareholders through dilution and must be tracked in the accounts.
Watch out
Common mistakes
- Believing options cost the company nothing because no cash is paid at grant.
- Assuming options always have value, when they are worthless if the share price stays at or below the exercise price.
- Ignoring dilution when assessing the value of existing shares.
Questions
People also ask
What does vesting mean?
Vesting is the period or condition that must be satisfied before the employee can exercise the options, such as staying with the company for a set number of years.
What is the difference between share options and shares?
An option is a right to buy shares at a fixed price in the future, whereas a share is actual ownership of part of the company.
Do share options affect earnings per share?
Yes, because the potential new shares are counted in diluted earnings per share, and the expense also reduces profit.