UPDATES! Stock Option Terms: What You Can Expect
Podcast included: In addition to reading this article, you can listen to our interview of the author. For more interviews with our expert contributors, see our podcasts page.
After reading this article, test your knowledge with a fun, interactive quiz on stock options
Despite volatile equity markets and the move to performance shares for executive compensation, options are still among the best tools that employers have to attract and keep employees and executives. Whether stock options are a reward, an incentive, or both, they align the interests of workers and shareholders.
In 2018, my company (Ayco) informally surveyed the stock option plans of the 350 large US companies for which we provide financial counseling, updating our survey of 2016 (we have conducted similar surveys about every two years since 1997). The results give a sense of what you may or may not see in your stock option grant.
Use Of Stock Options Has Decreased
Since the start of mandatory expensing of stock option grants under FAS 123(R) (now called ASC Topic 718), some companies have changed their stock option grants and begun to use more restricted stock, restricted stock units (RSUs), and performance shares. Very few companies still make option grants broadly to employees.
Just under half of Ayco's survey group still uses stock options or stock appreciation rights, but this figure has dropped from about 75% in 2008. Almost 10% of the responding companies have stopped using stock options altogether since 2015. The overall percentage of companies that do not grant stock options has jumped from 24% in 2008 to 51% in 2018. Meanwhile, at companies that still do grant stock options, the options are becoming an ever smaller portion of total long-term incentive (LTI) compensation. At most of the option-granting companies in the 2015–2016 survey, options make up less than 50% of LTI awards.
|Percentage of options/SARs in LTI awards||Companies in 2007–2008 survey (250)||Companies in 2012–2013 survey (325)||Companies in 2017–2018 survey (350)|
Term Of Option
Options have been traditionally granted with a term of 10 years. A few companies have had terms of 15 and even 20 years. However, in response to option expensing, some companies are shortening the length of nonqualified stock option (NQSO) grants. In 2017–2018, Ayco found that almost 10% of the surveyed companies are now granting NQSOs with terms of less than 10 years. Among these, the range varies from five to eight years, but seven years is the most term at companies that grant options with terms of less than 10 years. This trend may widen as companies seek ways to reduce the "cost" of options when they list stock option grants as an expense on their financial reports. However, a couple of companies in the survey group that had previously used a seven-year option term have switched back to a 10-year term.
Interestingly, you are most likely to receive a grant of stock options in January, February, or March: 67% of the companies in Ayco's survey granted options during the first quarter of the year in 2017 and/or 2018 (11% in January, 38% in February, and 18% in March).
A vesting schedule determines when you may exercise your stock options. Overwhelmingly, companies impose time-based vesting schedules (the famous "golden handcuff"). The following table shows when the surveyed 350 companies first make options exercisable.
|Vesting schedule||Percentage of companies|
|33% per year over 3 years||47%|
|25% per year over 4 years||32%|
|20% per year over 5 years||3%|
|Unequal pattern over 3 to 5 years||7%|
|100% vesting at end of 1st or 2nd year||2%|
|100% vesting at end of 3rd year||6%|
|100% vesting at end of 5th year||1%|
Performance vesting has become more popular for grants of restricted stock and restricted stock units than for grants of stock options. Just over 5% of the companies in Ayco's survey group have provided for performance-based vesting in option grants made during the past five years. In some cases, only the CEO or the most senior executives have options with performance targets. Typical goals include share-price appreciation, total shareholder return, or hitting designated financial targets. (For details about these types of grants, see the FAQ about stock options with performance-based features.)
Acceleration Of Vesting
For qualified retirement, at death, or upon disability, many plans now accelerate vesting, continue the normal vesting schedule, or give this decision to the committee that administers the plan. We found that just under 10% of the companies continue vesting and nearly 40% of the companies provide for automatic or discretionary acceleration of vesting in the event of retirement. Upon the death of an optionholder, this percentage rises to 62% of companies.
Acceleration Of Vesting For Changes In Control
A significant majority of plans accelerate vesting upon a change in control, and many companies have added a double-trigger requirement. Note, however, that accelerating the vesting of ISOs will probably cause the $100,000 limit to be exceeded for executives. For holders of ISOs at companies that grant the maximum number of ISOs each year, this means that some or all of the newly vesting ISOs will become NQSOs.
Exercise Periods Upon Termination of Employment
As defined in the stock option plan, retirement typically allows a longer post-separation exercise period than termination of employment for other reasons. The most common definition of retirement allowing an extended post-termination exercise period tends to be age 55 with 10 years of service, though over half of the companies apply different measures. We counted 10 companies that provide a longer period to exercise vested options after normal retirement than after early retirement.
|% of companies|
|Remainder of term||37%|
|One or two years||10%|
|Less than a year||9%|
The following table shows how much time the surveyed companies give an estate or a designated beneficiary to exercise vested options after the death of an optionholder.
|% of companies|
|Remainder of term||18%|
|Three or four years||20%|
|Less than a year||4%|
Voluntary Termination Before Retirement
Most companies allow executives who quit before they are eligible for retirement to exercise vested options for a limited period.
|Longer than one year||6%||0%|
|One month or two||14%||13%|
|Forfeited at termination||7%||39%|
Almost all companies immediately cancel options if an employee is terminated for cause. On the other hand, companies are likely to allow a relatively long period to exercise vested options when involuntary termination occurs at the request of an employer.
About 5% of the surveyed companies require senior executives to retain company shares for a specified length of time or until retirement.
Stock option plans increasingly have added enhancements and variations that make options more flexible, but also more difficult to master. Some of these features include the following, with interesting long-term shifts since our survey of 2003–2004:
|Feature||% of companies
|% of companies
|Incentive stock options||10%||22%|
|Stock appreciation rights||10%||1%|
|Market stock units||2%||0%|
|Transferable for estate planning||40%||50%|
|Net exercise procedure||10%||0%|
|Vesting accelerated by double trigger upon change in control||72%||5%|
Note that the deferral of option gains is now nonexistent because this would subject stock options to the onerous rules of Internal Revenue Code Section 409A, introduced in 2005 by the American Jobs Creation Act. Other design-related findings of interest, from a small percentage of companies, include a cap on the maximum gain under the option (e.g. 150% or 200% of the exercise price) and an automatic exercise provision which provides that all "in the money" options will be exercised on the last trading day of the term.
Know Your Terms
Whether the terms of your grant are aligned with the majority or with the minority of what other companies do, you should study your stock option plan and grant agreement to understand the provisions, definitions, and special features. This is the first and most important step that you can take to maximize the value of your stock options, prevent mistakes, and feel personally invested in the life of your company.
Before his retirement, Richard Friedman was the Vice President of the Benefits & Compensation Group at The Ayco Company, a leading provider of financial-planning services for executives at public companies. This article was published solely for its content and quality. Neither the author nor his firm compensated us in exchange for its publication.