A type of call option used as incentive compensation where an employee is granted a right to purchase the shares of company stock at a predetermined price for a specified period of time, subject to a vesting period.

Just like with any other call option, the holder has the right, but not an obligation, to purchase the shares of company stock.

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Employee stock options have a number of features that set them apart from ordinary stock options. Qualified stock options receive a very attractive tax treatment as long as they adhere to certain legal requirements:.

If the option grant satisifies these conditions, no taxes are due either upon the executive option grant or option exercise date. Such qualified stock options are covered by the incentive stock option plan under the Economic Recovery Tax Act of If the employee exercises the stock options at least two years after the grant date, the profits are taxed at a lower capital gains tax rate.

To provide further incentive to the employees, the company may reprice stock options to make them more attractive should the stock price fall below the option strike price. Note that ESO s priced below the fair market value of company stock may be deemed deferred compensation under the US Internal Revenue Code Section A.

This has important tax consequences for both the employee and the company.

Failure to price the ESO s correctly may also result in significant penalties and interest charges. In many cases, the employee stock options may represent a significant part of the personal net worth.

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Hence, it is important to determine the value of such options. The American Financial Accounting Standards Board FASB Statement No R endorses the Binomial Model as an established way to value the employee stock options.

This methodology is also recommended under the International Financial Reporting Standards IFRS. The volatility of company stock is a key input into the option valuation.

For a privately owned company that does not offer its stock to the public, establishing the share price requires that you perform business valuation of the entire firm first. This is repeated for a number of dates over a year or two.

The stock volatility can then be calculated as the variance of historic stock returns. For a public company, you can use the market prices of stock directly to calculate the stock price volatility.

Once you know this key measure of stock price behavior, you can use the Binomial Model to calculate the value of the stock options.

Factors affecting the employee stock option value include:. Each of these parameters has an impact on the value of employee stock options. You can use the Binomial Model to run sensitivity analysis in order to see how much each parameter affects the value of stock options. All other trademarks are property of their respective owners.

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