Employee Stock Option is a contract between an employee and an employer in which employee is given the right to exercise stock option and to buy company’s stock at a predetermined price when that option becomes vested. While exercising employee stock option, employee can use one of the three strategies to buy the stock. These three strategies are Cash Exercise, Cashless Exercise and Cash Swap. Under Cashless Exercise employee buys company’s stock without involving any cash on hand. Employee buys stocks by borrowing money from brokerage which is called borrowing on margin and at the same time sells some of the stocks at market price to cover the cost of buying stocks which also includes taxes and commissions.
Consider the following assumptions for the explanation of cashless exercise.
Options granted – 50
Option Price – ₹20
Current price of share – ₹50
No of shares already owned – 50
While exercising stock option, employee buys 50 shares by borrowing money from brokerage firm and sells 20 shares to cover the cost (50*20=₹1000) of buying 50 shares under stock option plan. He also sells some extra shares to pay taxes and commission. So at the end of the exercise he ends up owning less than 80 (50+50-20) shares.