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An Overview of Stock Options

posted in Corporate formation, Securities, Startups, Stock Options, Taxation by

What is an option?

Options are financial instruments that are a contract allowing for an exchange in the future based upon a certain value. Option holders are afforded the right to consummate the exchange at their discretion, while options suppliers are obligated to honor a demand for an exchange. The important distinction of options is that purchasing an option does not consummate the acquisition of any good; it only confers upon the option holder the right to complete a purchase in the future, and upon the option supplier the duty to provide for such a demand.

Employee Stock Options

Employers can use options to their benefit through Employee Stock Options (ESOs). These options provide employees an opportunity to be compensated with common stock in their company instead of cash. Through the use of options, employees can align their interests with those of their employer by investing themselves in the firm’s future. ESOs can also be issued to non-employees, such as consultants or independent contractors, as compensation for services rendered.

In an ESO, employers and employees enter into a “call” option, with the employer acting as seller and the employee as buyer. Buyers in this type of option acquire the right to buy as much or as little of a commodity as they wish at a set price up to a predetermined quantity. The exercise of the option to complete the purchase can take place at any point during a defined time frame. In the case of an ESO, the commodity consists of stock in the employing company and the set price is typically the current market value of that stock.

Option holders engage in this type of option in the hope that the value of the commodity (stock) will rise in the future, because the price that they pay remains constant. Thus, as the differential between market price and the set price of the option rises, option holders enjoy increasing possible profit. In ESOs, employees as buyers are rewarded with additional potential profit as the market price of stock rises.

ESO v. Exchange-Traded Options

ESOs differ from exchange-traded options in several ways. First, exchange-traded options are typically standardized in price based upon a certain reference point. On the other hand, the exercise prices of ESOs are usually set at the current stock price, resulting in variable prices between option grants. This characteristic can lead to employees holding ESOs with a multitude of different exercise prices. Exchange-traded options are also usually mobile assets with a standard quantity sold per transaction, whereas ESOs vary in quantity and have transferability restrictions.

Additionally, ESOs exhibit attractive tax advantages over their exchange-traded counterparts, and are classified by their different tax treatments. In the next segment of this three part newsletter, we will review the different aspects of each category of ESO and the tax benefits associated with each.

ESOs are complicated, multi-faceted constructs. For additional information concerning or assistance enacting such programs, contact Larry Horwitz at lhorwitz@horwitzarmstrong.com.

02 Jul, 12

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