What Is an Employee Stock Option Plan in the Context of Fringe Benefits?

One of the fringe benefits you might have offered to you in some companies is an employee stock ownership plan, or an ESOP. Depending on the company, it can be a promising investment opportunity. These plans confer on employees the right, but not the obligation, to purchase company stock at an attractive price. ESOPs have made a great deal of money over the years for many employees in very successful companies.

Stock Options

A stock option gives the holder the right to buy or sell a specific quantity of a particular stock on a particular date and at a fixed price, called the "strike price." A call option gives the holder the right, but not the obligation, to buy a stock, while a put option allows the option holder to sell. In an employee stock ownership plan, employees are always granted call options. For example, a call option on 1,000 shares of AT&T; stock may have a strike price of $20 and an expiration date of March 1, 2015. This means that the option holder can purchase 1,000 AT&T; shares on March 1, 2015, for $20 per share, or a total of $20,000.

Profitiing from Option

Options are leveraged financial instruments. In a call option, if the stock appreciates, the option holder profits far more than the shareholder selling the stock to the option holder. If, for example, AT&T; stock is trading at $22 on March 1, 2015, the option holder can purchase the shares for $20 and sell them on the open market for $22, profiting $2 per share, or $2,000 in total. If AT&T; is trading at only $20 on the option's expiration date, the option is worthless, because anyone can buy the shares in the stock market at the same price. In this example, a mere 10-percent variation in the stock price wipes out the entire potential profits of the investor.

ESOPS

The call options offered in employee stock ownership plans come with one limitation: employees cannot take options with them if they leave the company. For example, an employee plan may grant the worker the right to buy company stock in two years, and stipulate that the individual must still be employed by the company in two years to exercise the options. Some plans allow the descendants to inherit the options if the employee passes away. These options provide a strong incentive for the workers to stay with the company if the stock is performing well.

Rationale

Corporations have numerous reasons to institute ESOPs. First, they help retain good talent. In addition, employees who hold company stock tend to work harder, since the more profitable the company, the higher the stock price tends to go and the more valuable their options will be. ESOPs are also a financially attractive form of compensation for the issuing company. If business is bad and the stock price is low, the options are not exercised. During tough times, the company does not have to print and distribute new stock to option holders at all. If the stock price is high and employees exercise the options, the company will issue new shares and lose some money by selling them to workers at below-market prices. If the stock price is sufficiently high to warrant the exercise of options, the company can probably afford this burden.

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About the Author

Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.

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