The Basics of Stock Options (Paulin, 1999)

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The Basics of Stock Options(Paulin, 1999)

• What are Stock Options?
• Stock options are rights to purchase shares at a
  specified price during a specified period of
  time.
• Stock options are the most popular long-term
  incentive compensation approach used in U.S.
  companies.

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The Basics of Stock Options(Paulin, 1999)

• Goals of Stock Options
• Reward Stock price growth
• Provide opportunities for Managers or Employees
  to be Shareholders to improve incentive
  alignment.
• Retention of key Employees/Managers
• Reflect Competitive Compensation Trends

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The Basics of Stock Options(Paulin, 1999)

• Option Events
• 1. Grant date - time begins on an option at this
  date. Strike price is usually FMV set at this
  date.
• 2. Vesting date - when option recipient can
  first exercise option realize a profit.
• 3. Exercise date - when option recipient
  purchases the shares and takes control of the
  options.
• 4. Sale - when option recipients sells the
  shares and takes the option profit.
• 5. Expiration date - end of option term,
  normally about 10 years after grant date.

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The Basics of Stock Options(Paulin, 1999)

• Decision Area Common Practice Alternatives
• Type of Option NSOs ISOs
• Option Price FMV at grant
  discount/index/
• 
  premium
• Option term 10 years lt
  10 - any type
• 
  gt 10 - NSOs
• Vesting 2-5 years partial
  Cliff vesting
• vesting Ch.
  Control prov.
• Post-termination 0-90 days after quit gt 90
  days
• Payment cash, cashless or stock
  firm loans

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The Basics of Stock Options(Paulin, 1999)

• Option Types
• NQOs - Non qualified stock options
• related to market price of shares at grant date
• most popular option
• taxed at exercise and taxed at sale - less likely
  to hold
• no limit on dollar size of grant
• ISOs - Incentive stock options
• related to performance hurdles market price of
  shares
• capped at 100 K per year
• not taxed at exercise, taxed as capital gains at
  sale
• manager more likely to own stock after exercise

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The Basics of Stock Options(Paulin, 1999)

• Option Price
• Fair Market Value - determined on day of grant
• Strike Price - is the option price
• Alternatives
• Premium options Above FMV of grant date
• Discounted options Below FMV on grant date
• Indexed options tied to stock index such as S
  P 500 or industry average - these are variables
  and cannot be fixed in advance

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The Basics of Stock Options(Paulin, 1999)

• Vesting Schedules
• Partial Vesting ownership rights given over 2-5
  year period on 1/3 1/3/ 1/3 or 1/4 1/4 1/4 1/4
  basis
• Cliff Vesting 100 percent vesting given during a
  2-5 year period (all or nothing). Must wait full
  term.
• Performance vesting vested when a performance
  hurdle is fully or partially satisfied.
• Accelerated vesting change of management control
  such as merger/acquisition triggers full vesting
  rights automatically for key managers.

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The Basics of Stock Options(Paulin, 1999)

• Post Termination Exercise Events
• Retirement 2-5 years is standard
• Quit zero to 90 days is standard
• Death one year after death is standard (for
  survivors)
• Termination for cause specified in contract.
  Options may be accelerated or rights forfeited
  depending on situation.

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The Basics of Stock Options(Paulin, 1999)

• Payment at Exercise
• 1. Cash exercise - company takes cash and uses
  it to buy stock back and reduce dilution.
• 2. Stock for stock - lowers dilution buy
  exchanging stock for other stock (from earlier
  grant) as payment.
• 3. Cashless exercise - no investment or risk on
  part of recipient. Broker buys sells shares
  and delivers cash to recipient for option profits
  (could be paid in stock instead of cash). Often
  used with NSOs because income tax is due at
  exercise.