Employee stock options (ESOs) are used by companies to reward and retain key employees. (Note that employee option plans are not regulated by ERISA.)
An option is a contract giving the option owner the right to purchase shares of stock at a preset price for a specified period of time.
The company permits the employee to buy (exercise) a specified number of shares of the company's stock for a preset price during a specific time period. The preset price is the strike price.
An employee who has been granted an option must wait until the option vests before it can be converted into shares of company stock.
The time period in which the option can be exercised is the option's duration or exercise period. Most options have a duration of 10 years -- the option holder has 10 years after the option has been granted in which to buy the stock.
ESOs vest in accord with the employee stock-option plan. Most ESOs vest on a staggered schedule (ramp vesting). A new employee may be granted the right to purchase 1,000 shares of company stock at a set price (usually, but not always, the market price of the stock on the day the stock is granted). Of these 1000 shares, 200 might vest after one year, another 300 after two years and 500 after three years. (Options that vest all at one time are said to be on a cliff vesting schedule.)
The benefit of options to the employee is the difference between the market price of the stock at the time the option is exercised and the option's strike price. If the strike price is greater than the current market price, the option is "out of the money" or "under water."
Companies may adjust strike prices of out-of-the-money option grants by canceling the original option grant and granting new options. This is perfectly legal.
Typically, if the employee leaves the company, options that have not yet vested are canceled. The terminated employee may have a limited amount of time (normally a month) in which to exercise vested options.
Privately held companies may have employee stock-option plans. The strike price may be based on a future public offering or an internal determination of value (usually decided by the board of directors). In this case, the company buys the shares from the employee who is exercising the options.
Types of Employee Stock Options
There are two main types of ESOs:
1) Non-qualified Stock Options (NSOs)
Under most non-qualified plans, employees owe no tax when the options are granted, but they are required to pay income tax on the difference between the strike price and the market value of the stock when the option is exercised.
2) Incentive Stock Options (ISOs)
Under this type of plan, tax is deferred. The employee (usually an officer of the corporation or a higher-ranking executive) pays no tax when the options are granted or exercised -- taxes are owed only when the stock is sold (although in certain situations the alternative minimum tax might be triggered on exercising). Stock sold at least one year after the options are exercised and at least two years from the date the ISO was granted is taxed at the long-term capital gains rate. If the stock is sold before this holding period, the gains are taxed as ordinary income.
Possibilities on Vesting
Once the option vests, the employee has several choices.
- If the strike price is less than the price of the company's stock on the open market, the employee may make an immediate profit by buying the stock at the strike price and then selling it at the current market price.
- The employee may choose to hold the option, not buying the stock, hoping that the market price of the stock will rise before exercising the option.
- If the strike price is greater than the market price at the time of vesting (the option is under water), the employee would probably choose to hold the option, at least until the market price exceeds the strike price.
- The employee may choose to exercise the option and keep the stock shares, rather than selling them for an immediate profit. Or, the employee may exercise the option and sell enough shares to cover taxes and keep the remaining shares.
One thing that the employee cannot do is sell the ESO directly in the open market. Unlike marketable options, which are traded daily in a market similar to the stock market, corporate options are not negotiable or transferable (although some plans transfer options to the estate on the death of the employee).
- Lost future options. The employee claims that the termination (or failure to promote) caused him or her to miss out on options grants.
- Forced early exercise of options. The employee claims that the termination forced him or her to exercise options prematurely.
- Fraudulent inducement. An employee may claim he or she was induced to work for the defendant employer by the offer of options that were either not granted or that did not vest under the agreed-upon schedule.
Damages-claim valuation issues:
- The plaintiff claims as damages the price per share (minus the strike price) on the option's vesting date. Would have plaintiff have exercised the option and sold the shares on that day?
- The plaintiff claims the price per share (minus the strike price) on a date or time when the stock was at its highest price. This claim implies that the plaintiff has an amazing prescience. Accurate market timing is extremely rare. Is the plaintiff that prescient?
- The plaintiff claims that he or she was forced to exercise the option prematurely and thus has lost out on future price-per-share growth. However, the plaintiff could have held onto the stock after exercising the option to enjoy future appreciation.
Courts generally look at damages involving corporate securities such as stock and options under two theories: conversion (wrongful taking of the security) or breach of contract.
In Galigher v. Jones, 129 U.S. 193, 9 S.Ct. 335 (1889), the U.S. Supreme Court determined conversion damages to be the "highest intermediate value of the stock between the time of conversion and a reasonable time after the owner has received notice to enable him to replace the stock.
Under the breach of contract theory, damages are determined to be the value of the security at the time of the breach. Hermanowski v. Action Corporation, 580 F. Supp. 140, 146 (E.D.N.Y. 1983).
Scully v. U.S. WATS
In cases involving the valuation of employee stock options, courts have stressed that the individual circumstances of each case should be considered. The Third Circuit has held that neither the conversion theory nor the breach theory "could properly value stock options in all situations." Scully v. U.S. WATS, Inc., 238 F.3d 497 (2001).
The Scully court exhaustively reviewed the various methods of assessing damages involving employee stock options. The court held that in the present instance damages should be measured as the difference between the exercise price of the options and the market price of the stock as of the date of the breach.
The plaintiff had sought to have the shares valued at the time they would have vested, one year later, when the stock was substantially higher than at the time of the breach. The Scully court held that there was no evidence that the plaintiff would have sold the stock "at a time that, in hindsight, would have been particularly advantageous." (Id. at 513)
Because a large portion of the options had not vested, the defendant corporation asked that the stock be discounted by 30% to reflect its non-marketability as of the date of the breach. The appellate court agreed that the stock was not marketable at the time of the breach but declined to order the lower court to apply the discount.
Commenting on the choice of damages theories, the court noted: "Depending on the circumstances of the case the blurring between the conversion and breach of contract remedies may be justified." (Id. at 512).
Even though ESOs cannot be traded, they have value. Since 2006, U.S. corporations have been required to report options grants to employees as expenses on balance sheets, and, typically, their accountants use one of two methods to value the options: Black Scholes or the binomial model. These are both highly technical mathematical models that only estimate an option's value, since the future price of the underlying stock cannot be known with certainty. These methods are at present the best tools available for valuing damages involving employees stock options.
The Black-Scholes Model
The Black-Scholes options-pricing model was devised in 1973 by Fischer Black and Myron Scholes, two finance professors. Scholes was later awarded the Nobel Prize for the model and other work. (Black had passed away). The Black-Scholes option pricing model is the method of options valuation required by the Financial Accounting Standards Board in filings seeking approval for employee stock options plans.
Black-Scholes employs a complex formula that considers the current price of the stock, the strike price, the risk-free interest rate (e.g., the current rate on Treasury securities), the amount of time until the option expires, the company's dividend on the stock, if any, and the volatility of the stock. All of these variables are known with certainty except the volatility of the stock, which must be estimated. Usually, volatility is calculated as the historical standard deviation in the stock's price. Black-Scholes strictly applies to negotiable options, yet company-issued employee stock options are not negotiable. When determining damages in an employment matter, a "lack-of-marketability" discount should be applied.
The Binomial Model
The binomial model of options pricing model is considered better than Black-Scholes in estimating the value of options on a stock over short periods of time. The binomial model can take into account more variables (yet depends on more assumptions) than does Black-Scholes. However, it is not clearly superior to Black-Scholes when valuing options for litigation purposes. Critics maintain that under the binomial model, small changes in assumptions as to volatility can produce an unacceptably wide range of values.
An employee terminated in October of 2004 claims as part of his damages 4,000 unexercised company options granted in February 2004 that were forfeited when he was terminated.
The Black-Scholes options pricing model considers these variables: 1) the market price of company stock on the date of termination, 2) the risk-free interest rate, 3) the strike price, 4) the duration of the options, 5) the stock's current dividend yield and 5) the stock's volatility.
The company's 2004 annual report includes a statement of options expenses based on the Black-Scholes model. The annual report lists the values used as the risk-free rate of interest, dividend yield, volatility and duration.
Since the Black-Scholes model predicts prices for traded options and the plaintiff's options were not transferable, a discount has to be made to reflect this non-marketability. The non-marketability discount is assumed to be the difference between the value of call options and put options on the company stock, both valued using Black-Scholes.
Here is a summary of the damages valuation:
- Number of options: 4,000
- Strike price: $35.26
- Market price of stock on date of termination: $36.27
- Risk free rate: 3.69%
- Volatility: 34.85%
- Dividend rate: 0.7%
- Duration: 5.3 years
- Value of call: $13.19
- Value of put: $7.24
- Value per option, discounted for non-marketability: $5.95
- Loss: $23,800 (4,000 x $5.95)
Anyone needing more information on the valuation of employee stock options in litigation may contact David Adams, senior analyst at the Center for Forensic Economic Studies. Phone (800) 966-6099, e-mail email@example.com
Employee stock options (ESOs) can represent a significant portion of damages claims in wrongful-termination litigation and other types of employment actions.