A share option is a financial instrument offered primarily as a benefit to employees. It provides the right, but not the obligation, to buy shares in the company at a pre-determined price or at a discount to the market price. Share options can serve as an incentive to align employees’ interests with those of shareholders.
Historical Context
Share options have roots going back to the early 20th century, with significant usage seen during the rise of technology companies in the 1980s and 1990s. They became a popular form of compensation during the dot-com boom when companies sought to retain talent without immediate cash expenditures.
Types of Share Options
1. Non-Qualified Stock Options (NSOs)
These are options that do not qualify for special tax treatments and are subject to ordinary income tax.
2. Incentive Stock Options (ISOs)
These are qualified for favorable tax treatment and are typically offered to employees. Gains are taxed at capital gains rates if certain conditions are met.
3. Enterprise Management Incentives (EMIs)
A scheme used primarily in the UK, aimed at smaller companies to offer tax-advantaged share options.
4. Savings Related Share Options Scheme (SAYE)
A scheme allowing employees to save regularly, and at the end of the period, use the savings to buy shares at a discounted price.
Key Events
- 1981: Introduction of ISOs in the United States
- 1999: Dot-com boom popularizes share options
- 2002: Sarbanes-Oxley Act tightens the regulations around stock options
Detailed Explanation
Share options typically involve a “vesting period,” which is the time an employee must wait before they can exercise the option to buy shares. Once vested, the employee can purchase shares at the exercise price, which is often lower than the market price. Upon selling these shares, any profit made is subject to income tax.
Example of Share Option Calculation
An employee is granted options to buy 100 shares at $10 each. The current market price is $30 per share.
Total profit = \( $20 \times 100 \) shares = $2,000
Mathematical Models
Black-Scholes Model
The Black-Scholes formula is often used to estimate the fair value of share options:
Where:
- \( S_0 \) = current stock price
- \( X \) = exercise price
- \( t \) = time to maturity
- \( r \) = risk-free interest rate
- \( N(d) \) = cumulative distribution function of the standard normal distribution
Importance and Applicability
Importance
- Employee Motivation: Aligns the interests of employees with those of shareholders.
- Retention: Helps in retaining key talent, particularly in tech and startup companies.
- Cash Flow Management: Allows companies to offer competitive compensation without immediate cash outflow.
Applicability
- Startups: Often used as a tool to attract and retain talent.
- Large Corporations: Used to reward employees and senior management.
- SMEs: Beneficial under schemes like EMIs.
Considerations
- Tax Implications: Understanding different tax treatments (NSOs vs. ISOs).
- Market Conditions: Share options can become worthless if stock prices fall below the exercise price.
- Employee Awareness: Employees must understand how and when to exercise their options.
Related Terms
- Option: A financial derivative representing a contract sold by one party (option writer) to another party (option holder).
- Strike Price: The fixed price at which an option can be exercised.
- Vesting Period: The period during which the employee cannot exercise the options.
- Stock Appreciation Rights (SARs): Gives employees the right to the monetary equivalent of the appreciation in the value of a specified number of shares.
Comparisons
- Share Option vs. Stock Grant: A stock grant offers actual shares, whereas a share option offers the right to buy shares.
- Share Option vs. SARs: Share options involve buying shares, whereas SARs involve cash equivalent of the stock’s appreciation.
Interesting Facts
- Google’s IPO in 2004 resulted in significant wealth creation for its employees through share options.
- Steve Jobs famously received stock options in the 1990s to return as Apple’s CEO.
Inspirational Stories
- Sheryl Sandberg’s journey at Facebook, where her stock options turned her into one of Silicon Valley’s wealthiest executives.
Famous Quotes
“Ownership in the company aligns the interests of employees and shareholders, leading to better company performance.” - Peter Drucker
Proverbs and Clichés
- “Don’t count your chickens before they hatch.”
- “Strike while the iron is hot.”
Expressions
- “In the money”: When the market price is above the exercise price.
- “Underwater”: When the exercise price is above the market price.
Jargon and Slang
- “Vesting cliff”: The point at which the first portion of share options become exercisable.
- [“Golden handcuffs”](https://financedictionarypro.com/definitions/g/golden-handcuffs/ ““Golden handcuffs””): Lucrative share options designed to keep key employees from leaving.
FAQs
What is the vesting period?
Are share options taxable?
What happens to my share options if I leave the company?
References
- Black, F., & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy.
- “Understanding Employee Stock Options,” Investopedia.
- “Enterprise Management Incentive,” UK Government HMRC Website.
Summary
Share options are powerful tools in employee compensation, offering benefits to both the employee and the employer. They have a rich historical context and are embedded with various models and schemes designed to motivate and retain talent. With their impact on personal and company finances, understanding share options is essential for anyone involved in corporate finance, investments, and human resource management.
