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Employee stock options are stock options for the company's own stock that are often offered to upper-level employees as part of the executive compensation package, especially by American corporations. An employee stock option is identical to a call option on the company's stock, with some extra restrictions.

Mechanics
The company gives a stock option grant to the employee which specifies:
 * The number of options granted to the employee
 * The options' exercise price
 * The options' expiration date
 * The options' vesting schedule, specifying when options may first be exercised
 * A list of restrictions on what can and can't be done with the options

For example, when employed by company XYZ, Alex might receive a stock option grant of 1000 XYZ shares, with an exercise price of $7.50, an expiration date of 10 years after the grant, and a schedule of equal vesting over four years.

As with an ordinary call option, Alex can make money if the price of XYZ stock rises above his exercise price of $7.50 before the options expire. Suppose that 5 years after the option grant, the price of XYZ has risen to $16.00. Alex decides to exercise all 1000 options. The stockbroker managing Alex's option account pays company XYZ $7,500 ($7.50 per option times 1000 shares) and receives the 1000 shares. (In doing this, the stockbroker is extending Alex a very short-term loan of $7,500.) The stockbroker immediately sells the 1000 shares on the stock market and receives $16,000. The stockbroker then deducts the $7,500 he advanced for the options exercise, and the remaining $8,500 belongs to Alex, after the stockbroker deducts his commission and fees.

The vesting schedule controls when Alex may exercise his options. In this example, his 1000 options vest equally over four years, so Alex could exercise 250 of his options one year after the option grant, an additional 250 options after one additional year, and so on. Unvested options are not available to exercise.

Rationale for stock option grants
The usual rationale given for stock option grants to employees is to "align employees' interests with the interests of stockholders". If the company's stock rises, its employees with stock options experience a direct financial benefit; this, the argument goes, will incentivize employees to always behave in a way that will boost the company's stock. This is supposed to increase behaviors like curbing corporate waste.

Simply granting stock, rather than options, would achieve this same effect, but this would cause a more immediate dilution of

Conversely, a company may offer stock options to employees to help reduce staff turnover, if the job in question is in great demand. This happened frequently in the so-called dot-com boom of the late 1990s.

Employee stock options differ from the options that are traded on exchanges as securities primarily in the time frame under which they can be exercised. Employee stock options typically allow an exercise timeframe of up to ten years, whereas the longest time to expiry for exchange traded options is typically 2 years. Thus employee stock options are similar to warrants.

Stock options are sometimes jokingly referred to as "golden handcuffs" (in the same vein as golden handshakes or golden hellos), especially in a strongly rising market - the employee may feel compelled to work out the time until they are able to liquidate the stock even if they might otherwise prefer to leave the company.

Types of Employee Stock Options
Stock options granted to employees are of two forms, that differ primarily on their tax treatment. They may be either:
 * Incentive stock options (ISO's)
 * Non qualified stock options

Expensing of Employee Stock Options
According to current US generally accepted accounting principles, stock options granted to employees do not need to be charged as an expense on the income statement when granted, although the cost is disclosed in the notes to the accounts. This allows a potentially large form of employee compensation to not show up as an expense in the current year, and therefore, currently overstate income. Many assert that over-reporting of income by methods such as this by American corporations was one contributing factor in the Stock Market Downturn of 2002.

Many people argue that stock options should not be treated as an expense. Every other expense decreases the net worth of the corporation, whereas stock options, when exercised, actually increase it. Exercised stock options do not lower the income of the corporation, but "cut more slices into the pie" of earnings per share. Those who are against stock option expensing say that the diluted earnings per share metric (the amount of income divided by all outstanding shares and all shares that would theoretically exist if all the stock options were used) clearly shows the economic effect of stock options. For example, Martin J. Whitman argues that while stock options may dilute the value held by each of a company's existing shareholders, they are of little concern to creditors, and that "GAAP... ought to be geared toward meeting the needs and desires of creditors rather than the needs and desires of short-term stock market speculators."  Under International Accounting Standards, an estimate of the cost of stock options granted to employees is charged against profit as an expense in the accounts.