Since ESOs are basically call options, we have already covered most of the important aspects. However, ESOs have a few features that make them different from regular stock options. The details differ from company to company, but a typical ESO has a 10-year life, which is much longer than most ordinary options. Unlike traded options, ESOs cannot be sold. They also have what is known as a "vesting" period. Often, for up to three years or so, an ESO cannot be exercised and also must be forfeited if an employee leaves the company. After this period, the options "vest," which means they can be exercised.
employee stock option (ESO)
An option granted to an employee by a company giving the employee the right to buy shares of stock in the company at a fixed price for a fixed time.
Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition
V. Risk and Return
14. Options and Corporate Finance
© The McGraw-Hill Companies, 2002
PART FIVE Risk and Return
www.esopassociation.org for a site devoted to , employee stock options.
Sometimes, employees who resign with vested options are given a limited time to exercise their options.
Why are ESOs granted? There are basically two reasons. First, going back to Chapter 1, the owners of a corporation (the shareholders) face the basic problem of aligning shareholder and management interests and also of providing incentives for employees to focus on corporate goals. ESOs are a powerful motivator because, as we have seen, the payoffs on options can be very large. High-level executives in particular stand to gain enormous wealth if they are successful in creating value for stockholders.
The second reason some companies rely heavily on ESOs is that an ESO has no immediate, upfront, out-of-pocket cost to the corporation. In smaller, possibly cash-strapped, companies, ESOs are simply a substitute for ordinary wages. Employees are willing to accept them instead of cash, hoping for big payoffs in the future. In fact, ESOs are a major recruiting tool, allowing businesses to attract talent that they otherwise could not afford.
For an employee stock option calculator, visit . www.stock-options.com.
For more information on ESOs, try the National Center for Employee Ownership at , www.nceo.org.
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