How Important Are the Tax and Accounting Determinants of Corporate ESO Strategy?

An employee share option (ESO) is a complex financial instrument, characterized by high leverage and risk-sensitivity, features usually reserved for highly professional investors, which is used for employee compensation. Many accounting, taxation, agency, valuation and financial management aspects make it even more difficult to analyze. As a result, both firms willing to grant them and their potential recipients face intricate decision problems. On the corporate side, the advantages of the time management of cash flow, possible tax benefits and the prospect of attracting talented employees must be weighed against their accounting cost, a need for dilution management, costs of a potential non-exercisability and the nature of agency problems. On the recipient side, the exercise probability and stock appreciation prospects, the payoff size, the amount of tax on exercise and capital gains taxation must be evaluated in the context of individual time and risk preferences. More broadly, both firms and their employees face multiple choices in their share-based compensation decisions. First, there is a choice over the extent of share-based compensation relative to cash. Second, the decision must be taken over the form of such payment as more techniques are possible in addition to ESO, e.g. share purchase plans, stock awards or convertible bond grants. Third, a decision over the details of the ESO contract, including exercise price, market and/or performance-based conditions, vesting schedule, expiry time etc. must be made. Fourth, following the grant date some decisions may have to be taken in the event of possible inadequate realization of option payoff, including option repricing, exchange for cash etc. Finally, management of the EPS dilution must be frequently adopted, linking corporate compensation and payout policies.