Employee stock options plan (ESOP): Should you opt?– 1

Now-a-days, offering Employee stock options plan (ESOP) is a common way for companies to try and make lucrative offers to hire and retain employees. The simple reasoning that is given behind offering ESOP is that “You perform better, so the company does well, hence you get better salary and the return on stock options is also improved. Hence, Employees drive their own productivity and take their own share from it .” All sounds well and good, but are ESOP really worth buying?

Now, I’m not going to get into the controversial issues on calculation of taxes like Fringe benefit tax and other stuff. Let us look at ESOP from an investment perspective. I will attempt to answer the questions like:

How employee stock option plan works?
Should I invest in employee stock option plan?
What are the risks in employee stock option plan?

So you work for a reputed company listed on the world renowned stock exchange like NASDAQ or NYSE. As a part of your job offer, you are given the option to buy “Employee stock option” at a specified price and the option maturity can be anything from 1 year to 5 year – meaning that it will take that much time before you could reap the benefits of your employee stock option plan.

Let’s say that on certain parameters like salary and designation, you are offered an option to buy 100 shares of your organization, 2 years down the line, at a price of $ 24 each.

You look at the offer, and you decide to opt for it. What happens next?

For next 2 years, each month some portion of your money will be deducted from your salary in the name of “purchase of stock options”. In the above example, you decide to buy 100 shares at price of $24 each, so the total cost will be $2400. So, over the next 2 years, or 24 months, an amount of $100 will be deducted from your salary and be credited towards your “Employee stock option plan”. This process will go on for 2 years or 24 months, making it a total of 24 months * $ 100 = $2400. In case your company is listed in USA and you are working in India, and equivalent of $100 will be deducted based upon the $-Re forex conversion.

So what happens after the maturity duration of 24 months?

At the end of maturity, the market price is looked at.

If the market price of your company stock is equal to or less than $ 24 (your offer price of employee stock option plan), then nothing happens in terms of returns. You get back your $2400 without any returns on it.

If the market price of your company stock is more than $ 24 (your offer price of employee stock option plan), then you get the returns. Suppose the stock price has reached $30, so you get back your $2400 plus ($30-$24 = $6) per share as profit, totaling to $600 as net profit in this two years time.

Hence, overall, you don’t loose anything. It’s either you get back your principle amount back without any returns OR you get back your principle as well as returns – based upon what is the market price of stock at the end of maturity with respect to the offer price of the stock option.

The working of “Employee stock option” can be displayed in the following graph (RED line):

If the market price of stock goes above the offer price of $24, you make a positive profit – which grows linearly as the stock price moves ahead (the slanted red line above $24).
If it remains below $24, you make ZERO profit, i.e. you don’t loose anything (the flat Red line below $24)

Hence, it is a safe bet. If the price is higher than offer price, you get the profit as the difference between the current market price and your offer price. Otherwise, you get your money back.

But is it so really safe to buy Employee stock option?
Continue to Part II