Compensatory stock option definition
/What is a Compensatory Stock Option?
A compensatory stock option is an option given to an employee, giving the person the ability to buy a certain number of company shares at a predetermined price, and within a predetermined date range. The option is intended to be part of an employee’s compensation package. By issuing stock options to an employee, an employer gives the person an incentive to improve the entity’s performance, thereby driving up its stock price.
Accounting for Compensatory Stock Options
The employer charges the amount of compensation inherent in this arrangement to expense over the periods during which the recipient is providing related services to the employer. For example, if an employer has offered compensatory stock options to an employee that span a period of three years of related service, and the total compensation related to this arrangement is $36,000, then the employer would record the following journal entry in each of the 36 months:
By the end of the service period, the employer will have recognized a total of $36,000 in compensation expense.
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Example of a Compensatory Stock Option Arrangement
A company hires a new software engineer, Emily, and includes stock options as part of her compensation package to incentivize long-term performance and retention. As part of her employment offer, Emily is granted 10,000 nonqualified stock options with an exercise price of $15 per share, which is the fair market value of the company's stock on the date of the grant.
The options are subject to a four-year vesting schedule with a one-year cliff, meaning Emily must stay employed for at least one year before any options vest. After the first year, 25% of the options (2,500 shares) vest, and the remaining 7,500 options vest in equal monthly installments over the next 36 months.
By the end of her third year, if the company's stock price has risen to $30 per share, Emily will have vested in 7,500 options. She can choose to exercise her options at the original $15 price, purchasing shares at half their current market value. If she exercises all 7,500 options, her out-of-pocket cost would be $112,500 (7,500 × $15), and the market value of the shares would be $225,000 (7,500 × $30), giving her a paper gain of $112,500, subject to taxation depending on the type of option and how long she holds the shares after exercising.
This arrangement aligns Emily’s financial interests with those of the company’s shareholders and encourages her to contribute to the company's success while offering a potentially lucrative long-term reward.