Employee stock options plan is a company wide incentives plan whereby the company contributes shares of its own stock or cash to be used to purchase such stock to a trust established to purchase shares of the firm’s stock for employees. The firm generally makes these contributions annually in proportion to total employee compensation, with a limit of 15% of compensation. The trust holds the stock in individual employee accounts, and distributes it to employees upon retirement, assuming the person has worked long enough to earn ownership of the stock. Many companies use employee stock options plans to retain and attract employees, the objective being to give employees an incentive to behave in ways that will boost the company’s stock price.
By issuing employee stock options as compensation, organizations can preserve and generate cash flow. The cash flow comes when the organizations issues new shares and receives the exercise price and receives a tax deduction equal to the fair market value of the shares that are transfer to the trustee, and can also claim an tax deduction for dividends paid on ESO-owned stock. Employees aren’t taxed until they receive a distribution from the trust, usually at retirement when their rate is lower. The Employee Retirement Income Security Act (ERISA) allows a firm to borrow against employee stock held in trust and then repay the loan in pretax rather than after-tax dollars, another tax incentive for using such plans.
Employees will have an incentive to work hard for the company as they become the owner of the share, so there is a good chance for the employee to take more responsibility and regarding performance they put up more effort to get the upper hand. They will want to put the goals of the company ahead of their own and will be willing to work harder to make their stock options become more valuable. This puts employees in an ownership position, and they will treat the business as if it were their own. This can also help the shareholders of closely held corporation to diversify their assets by placing some of the company’s stock into the ESO trust and purchasing other marketable securities for themselves in their place.
Many business owners find that offering stock options to employees improves morale. When employees are given a share of ownership in the company, they will enjoy coming to work. They know that their efforts will directly impact their financial situation and will be more willing to work together. Instead of looking at the situation as the employees against the employer, they will look at the situation as if everyone were working towards a common goal.
There are some drawbacks which may face by the company when using the employee stock options as a compensation strategy, such as lack of diversification. An employee stock option often leads employees to rely too heavily on them for their financial success. A wise approach to investing would involve diversifying your available resources over several different types of investments. Many employees who have access to stock options will put everything they have into them. This puts a lot of pressure on the company to succeed. When employees are relying on the company for their retirement, it changes the responsibilities for everyone.
Another disadvantage of offering the employee stock options is that employees may loss of focus. In some cases, when company offers stock options to employees before the company goes public, they could potentially lose focus on the job at hand. Sometimes, the price of a company’s stock goes up significantly during an IPO. When this happens, the employees that have the stock options might be more concerned with the value of the stock options than focusing on their job. This could potentially lead to lost profits shortly after the IPO is completed.
Moreover, the management encourages the employees to take high risk. As far as employees are concerned stock option in form of compensation is an undue risk. In case of unstable company, if large numbers of employees try to exercise the option to get profit in the market then there is a chance of collapse in the whole equity structure of a company. When company issues additionally new shares to the other investors, there is no chance for the other investors to get the upper hand as it increases the outstanding shares. In such case the company must either repurchase stock or increase its earnings which may help in forestalling the dilution of value.