Many community banks are periodically approached to repurchase outstanding shares due to a variety of reasons that often have nothing to do with the bank, but rather reflect the personal situation of the stockholder, who often lives out of the bank’s market area. As the stock is probably thinly traded, management will often accommodate the request and buy the shares. The stock is then generally maintained as Treasury Stock. Over time, the Treasury Stock may accumulate to a level that is not consistent with the strategic goals of the bank.
Another issue that financial institutions commonly face, particularly recently, is turnover at employee levels. This issue is occurring throughout the country in all industries.
One creative way to address both issues is to offer employees stock through stock options. Not only does this create more stockholders that are local and in your market area, but it also provides buy-in from employees to continue to build your brand and loyalty.
Stock options are a form of compensation. These options, which are contracts, give an employee the right to buy or exercise a set number of shares of the financial institution’s stock at a preset price, also known as the grant price. This offer does not last forever. Employees have a set amount of time to exercise options before they expire.
The number of options financial institutions grant employees varies, depending on the factors and/or conditions established in the plan as formally adopted by the financial institution, and the individual stock option agreement with the employee.
To help understand how stock options work, let’s walk through a simple example. Suppose a financial institution grants stock options as part of an employee’s compensation. The financial institution grants stock options for 20,000 shares of the stock to an employee. The employee and the financial institution will need to sign a contract outlining the stock options terms; this could be included in an employment contract.
The contract will specify the grant date and the day the options begin to vest. When a stock option vests, it is available for the employee to exercise or buy. The employee usually will not receive all of their options right at the beginning of the agreement; instead, the options are earned over a vesting period. The granting of the options is not a taxable event to the employee. Taxation is triggered by the exercising of the options.
In this case, let’s assume the options have a four-year vesting period with a one year waiting period before the vesting period begins, and an expiration date of ten years. Under this example, it will take five years before the employee has the right to exercise all 20,000 options. Assuming the options vest gradually over the course of this vesting period, the employee will be able to access some of the stock options before those five years are up. Let’s assume that one-quarter (5,000) of the options vest each year over the four-year vesting period. So, by year three, the employee will have the right to exercise 10,000 options (one year waiting period and two of the four vesting years at 5,000 options per year).
Once the options vest, the employee can exercise them, allowing the employee to buy shares of company stock at the price(s) specified in the contract. This price may be referred to as the grant price, strike price, or exercise price. No matter how well (or poorly) the financial institution does, this price will not change.
Let’s now assume that the five years have elapsed, and the employee has not yet exercised any of the options. Thus the employee now has 20,000 stock options. Let’s also assume an exercise price of $1. To exercise all of their options, they would need to pay $20,000 (20,000 x $1) to purchase the stock. They could exercise their options and purchase all of the stock any time after the five year vesting period, but prior to the ten year expiration date. The employee will be taxed at ordinary income tax rates on the difference between the exercise price and the market price on the date the option is exercised. A second taxable event would be triggered for the employee when the employee sells the stock they purchased.
A stock option plan is just one way to use stock as a way to provide additional compensation to employees. Another option would be stock grants, in which case shares of stock are simply granted to employees. This would be considered a form of compensation to the employee at the time the stock is granted to the employee, resulting in a taxable event, including applicable payroll taxes. Another option would be an employee stock purchase plan, such as an Employee Stock Ownership Plans (ESOP). While not all plans work well for all financial institutions, we hope this gives you a sense of some of the possibilities to consider.