Fair market value for employee stock options

In its simplest terms, the value can be calculated as the fair market value of the stock less the grant price multiplied by the number of shares. Using our example above, each share has a value of $49, which is the difference between the current market value and the grant price.
Table of contents

• What does my Exercise or Strike Price Mean?
• Stock Options
• For the Last Time: Stock Options Are an Expense
• Technology

The fair value of an ESPP depends on both the structure of the plan and the economic assumptions used in the valuation model. In this article, we will describe the basics of ESPP valuation, walk through some valuation examples, and examine some of the accounting challenges for certain types of ESPPs. For a typical ESPP, employees withhold either a fixed dollar amount or a stated percentage of the employee's salary over a specified period to purchase stock. Plans with this design are known as a look-back feature since the purchase price is using the lesser of the grant date or purchase date stock price.

The accounting standard requires these types of ESPPs be accounted for in a specific way, considering the value of the stock option-like features. Specifically, the fair value of an ESPP is calculated as a sum of components, depending on the features of the plan. The valuation method is unique compared to employee stock options, which are valued as one component using a Black-Scholes or lattice model. This is because the potential value delivered to ESPP participants is very different compared to an option. An option only delivers value to award holders when the value of the stock increases over the exercise price, while an ESPP with a look-back and a discount delivers value to an award holder whether the stock price stays the same, declines or increases.

Offering Date Stock Price: The price on the first day of the offering, which is generally the closing stock price, as described in the plan document. Common variations include the closing price on the trading day prior to the offering date or the average of the high and low stock prices on the offering date. Calculating the fair value of an ESPP share requires the examination of several inputs, similar to stock options, including grant date stock price, expected life, volatility, risk-free interest rate, and dividend yield.

The assumptions are determined as of the grant date, which usually coincides with the first day of the offering period. The accounting rules specify how to estimate the fair value for this type of ESPP as a sum of four components, outlined below. Depending on the design features of the ESPP, you could include different combinations of the above components when calculating the fair value. For example, another common ESPP design is to offer a discount but no look-back feature. That fair value is based on the first and fourth components, which are the discount and the interest foregone.

Additionally, some companies include a sales restriction after purchase, which means participants cannot sell their shares for a specified amount of time usually from three months to one year. The primary reason a company includes this feature is to promote longer-term share ownership, as opposed to the ability to sell shares immediately upon purchase. However, employees perceive holding periods as riskier and tend to participate less frequently and contribute at lower levels.

A mandatory holding period may be considered in the fair value estimation for an ESPP, which will lower the compensation expense. A private company will have to set the fair market value of the shares in order to set a price for exercise. Without a traded market in the shares, it can be difficult to determine fair market value.

The Section A provides detailed guidelines to determine fair market value. This directly impacts the employees and the employers who could be liable for failing to withhold proper taxes When a company repurchases stock shares from employees at a premium employer pays more than the fair market value of the shares , the gain is generally taxed as compensation income and not as capital gain.

Further, the use of cashless exercise increases the risk that all the gain could be treated as compensation. There is also the risk that a repurchase may be treated as a dividend. A repurchase of stock from an employee will generally be treated as a sale of stock and qualify for capital gain treatment if the sale is a substantially disproportionate redemption of stock, meaning that both:. Typically, ESOs are issued by the company and cannot be sold, unlike standard listed or exchange-traded options.

The holder may choose to immediately sell the stock in the open market for a profit or hold onto the stock over time. Stock options are a benefit often associated with startup companies, which may issue them in order to reward early employees when and if the company goes public. They are awarded by some fast-growing companies as an incentive for employees to work towards growing the value of the company's shares. Stock options can also serve as an incentive for employees to stay with the company.

The options are canceled if the employee leaves the company before they vest. ESOs do not include any dividend or voting rights. Corporate benefits for some or all employees may include equity compensation plans. These plans are known for providing financial compensation in the form of stock equity. ESOs are just one type of equity compensation a company may offer. Other types of equity compensation may include:. In broad terms, the commonality between all these equity compensation plans is that they give employees and stakeholders an equity incentive to build the company and share in its growth and success.

For employees, the key benefits of any type of equity compensation plan are:. The benefits of an equity compensation plan to employers are:. In terms of stock options, there are two main types:.

• Stock Options – easleyLAW.
• The Basics of Valuing ESPPs.
• What does my Exercise or Strike Price Mean?.
• How you can make the most of your employee stock options;

There are two key parties in the ESO, the grantee employee and grantor employer. The grantee—also known as the optionee—can be an executive or an employee, while the grantor is the company that employs the grantee. The grantee is given equity compensation in the form of ESOs, usually with certain restrictions, one of the most important of which is the vesting period. The vesting period is the length of time that an employee must wait in order to be able to exercise their ESOs.

Why does the employee need to wait? Because it gives the employee an incentive to perform well and stay with the company. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant. Note that the stock may not be fully vested when purchased with an option in certain cases, despite exercise of the stock options, as the company may not want to run the risk of employees making a quick gain by exercising their options and immediately selling their shares and subsequently leaving the company.

If you have received an options grant, you must carefully go through your company's stock options plan, as well as the options agreement, to determine the rights available and restrictions applied to employees. The options agreement will provide the key details of your option grant such as the vesting schedule, how the ESOs will vest, shares represented by the grant, and the strike price.

If you are a key employee or executive, it may be possible to negotiate certain aspects of the options agreement, such as a vesting schedule where the shares vest faster, or a lower exercise price. It may also be worthwhile to discuss the options agreement with your financial planner or wealth manager before you sign on the dotted line. ESOs typically vest in chunks over time at predetermined dates, as set out in the vesting schedule.

As mentioned earlier, we had assumed that the ESOs have a term of 10 years.

This means that after 10 years, you would no longer have the right to buy shares. Therefore, the ESOs must be exercised before the year period counting from the date of the option grant is up. It should be emphasized that the record price for the shares is the exercise price or strike price specified in the options agreement, regardless of the actual market price of the stock. In some ESO agreements, a company may offer a reload option. A reload option is a nice provision to take advantage of. We now arrive at the ESO spread. As will be seen later, this triggers a tax event whereby ordinary income tax is applied to the spread.

The following points need to be borne in mind with regard to ESO taxation:.

Technology

This spread is taxed as ordinary income in your hands in the year of exercise, even if you do not sell the shares. This aspect can give rise to the risk of a huge tax liability, if you continue to hold the stock and it plummets in value. The ability to buy shares at a significant discount to the current market price a bargain price, in other words is viewed by the IRS as part of the total compensation package provided to you by your employer, and is therefore taxed at your income tax rate. Thus, even if you do not sell the shares acquired pursuant to your ESO exercise, you trigger a tax liability at the time of exercise.

The value of an option consists of intrinsic value and time value. Time value depends on the amount of time remaining until expiration the date when the ESOs expire and several other variables. Given that most ESOs have a stated expiration date of up to 10 years from the date of option grant, their time value can be quite significant.

While time value can be easily calculated for exchange-traded options, it is more challenging to calculate time value for non-traded options like ESOs, since a market price is not available for them. To calculate the time value for your ESOs, you would have to use a theoretical pricing model like the well-known Black-Scholes option pricing model to compute the fair value of your ESOs. You will need to plug inputs such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility into the Model in order to get an estimate of the fair value of the ESO.

From there, it is a simple exercise to calculate time value, as can be seen below. The exercise of an ESO will capture intrinsic value but usually gives up time value assuming there is any left , resulting in a potentially large hidden opportunity cost. The value of your ESOs is not static, but will fluctuate over time based on movements in key inputs such as the price of the underlying stock, time to expiration, and above all, volatility.

Consider a situation where your ESOs are out of the money i. It would be illogical to exercise your ESOs in this scenario for two reasons. The biggest and most obvious difference between ESOs and listed options is that ESOs are not traded on an exchange, and hence do not have the many benefits of exchange-traded options.

Exchange-traded options, especially on the biggest stock, have a great deal of liquidity and trade frequently, so it is easy to estimate the value of an option portfolio. Not so with your ESOs, whose value is not as easy to ascertain, because there is no market price reference point. Many ESOs are granted with a term of 10 years, but there are virtually no options that trade for that length of time.

LEAPs long-term equity anticipation securities are among the longest-dated options available, but even they only go two years out, which would only help if your ESOs have two years or less to expiration. Option pricing models are therefore crucial for you to know the value of your ESOs. Your employer is required—on the options grant date—to specify a theoretical price of your ESOs in your options agreement. Be sure to request this information from your company, and also find out how the value of your ESOs has been determined. Option prices can vary widely, depending on the assumptions made in the input variables.

For example, your employer may make certain assumptions about expected length of employment and estimated holding period before exercise, which could shorten the time to expiration. With listed options, on the other hand, the time to expiration is specified and cannot be arbitrarily changed. Assumptions about volatility can also have a significant impact on option prices.

If your company assumes lower than normal levels of volatility, your ESOs would be priced lower. Listed options have standardized contract terms with regard to number of shares underlying an option contract, expiration date, etc. This uniformity makes it easy to trade options on any optionable stock, whether it is Apple or Google or Qualcomm. If you trade a call option contract, for instance, you have the right to buy shares of the underlying stock at the specified strike price until expiration.

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Similarly, a put option contract gives you the right to sell shares of the underlying stock until expiration. While ESOs do have similar rights to listed options, the right to buy stock is not standardized and is spelled out in the options agreement. For all listed options in the U. If the third Friday happens to fall on an exchange holiday, the expiration date moves up by a day to that Thursday.