MBAO 6600 - Executive Compensation The Basics of Stock Options (Paulin, 1999) What are Stock Options? Stock options are rights to purchase shares at a.

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MBAO Executive Compensation The Basics of Stock Options (Paulin, 1999) What are Stock Options? Stock options are rights to purchase shares at a specified price during a specified period of time. Stock options are the most popular long-term incentive compensation approach used in U.S. companies.

MBAO Executive Compensation The Basics of Stock Options (Paulin, 1999) Goals of Stock Options Reward Stock price growth Provide opportunities for Managers or Employees to be Shareholders to improve incentive alignment. Retention of key Employees/Managers Reflect Competitive Compensation Trends

MBAO Executive Compensation The Basics of Stock Options (Paulin, 1999) Option Events 1. Grant date - time begins on an option at this date. Strike price is usually FMV & set at this date. 2. Vesting date - when option recipient can first exercise option & realize a profit. 3. Exercise date - when option recipient purchases the shares and takes control of the options. 4. Sale - when option recipients sells the shares and takes the option profit. 5. Expiration date - end of option term, normally about 10 years after grant date.

MBAO Executive Compensation The Basics of Stock Options (Paulin, 1999) Decision Area Common Practice Alternatives Type of Option NSOs ISOs Option Price FMV at grant discount/index/ premium Option term 10 years < 10 - any type > 10 - NSOs Vesting 2-5 years partial Cliff vesting vesting; Ch. Control prov. Post-termination 0-90 days after quit > 90 days Payment cash, cashless or stock firm loans

MBAO Executive Compensation The Basics of Stock Options (Paulin, 1999) Option Types NQOs - Non qualified stock options –related to market price of shares at grant date –most popular option –taxed at exercise and taxed at sale - less likely to hold –no limit on dollar size of grant ISOs - Incentive stock options –related to performance hurdles & market price of shares –capped at $100 K per year –not taxed at exercise, taxed as capital gains at sale –manager more likely to own stock after exercise

MBAO Executive Compensation The Basics of Stock Options (Paulin, 1999) Option Price Fair Market Value - determined on day of grant Strike Price - is the option price Alternatives: –Premium options: Above FMV of grant date –Discounted options: Below FMV on grant date –Indexed options: tied to stock index such as S & P 500 or industry average - these are variables and cannot be fixed in advance

MBAO Executive Compensation The Basics of Stock Options (Paulin, 1999) Vesting Schedules: Partial Vesting: ownership rights given over 2-5 year period on 1/3 1/3/ 1/3 or 1/4 1/4 1/4 1/4 basis Cliff Vesting: 100 percent vesting given during a 2-5 year period (all or nothing). Must wait full term. Performance vesting: vested when a performance hurdle is fully or partially satisfied. Accelerated vesting: change of management control such as merger/acquisition triggers full vesting rights automatically for key managers.

MBAO Executive Compensation The Basics of Stock Options (Paulin, 1999) Post Termination Exercise: Events Retirement: 2-5 years is standard Quit: zero to 90 days is standard Death: one year after death is standard (for survivors) Termination for cause: specified in contract. Options may be accelerated or rights forfeited depending on situation.

MBAO Executive Compensation The Basics of Stock Options (Paulin, 1999) Payment at Exercise 1. Cash exercise - company takes cash and uses it to buy stock back and reduce dilution. 2. Stock for stock - lowers dilution buy exchanging stock for other stock (from earlier grant) as payment. 3. Cashless exercise - no investment or risk on part of recipient. Broker buys & sells shares and delivers cash to recipient for option profits (could be paid in stock instead of cash). Often used with NSOs because income tax is due at exercise.