10 questions and answers on employee stock options

Employee Stock Options

10 Questions and Answers for Employee Stock Options Holders

This presentation asks 10 essential questions and gives the 10 essential answers about handling your Employee Stock Options.

Those 10 questions are on the next two pages

1. Which strategy of managing vested in-the-money employee stock options, terminates the alignment the earliest between the grantee and the shareholders, thereby defeating the purpose of the grants?

2. Which strategy forfeits part of the employee stock options value (called "time value") back to the company and causes an early payment of income tax?

3. Which strategy reduces risk the least?

4. Which strategy is useless most of the time in the life of the employee stock options?

5. Which strategy has the best expected after tax returns to the employee/ grantee with the least risk?

6. What strategy generates early cash flows to the company through the company issuing new shares to the employee and taking a tax deduction as the employee exercises and pays cash to the company and to the government.?

7. What strategy benefits the Wealth Managers by getting early Assets Under Management?

8. Which strategy is most prone to violations of SEC Rule 10 b-5?

9. Which strategy is rarely prohibited by the company in the stock plan and grant documents, but is highly discouraged by the "Insider Trading Policies"?

10. Which strategy is most prone to implicate the Wealth Managers in violations of fiduciary duties to their clients and violations of 10 b-5?

Three strategy choices are presented . Those area) Hold to near expiration (without early exercise or hedging) and exercise if in-the-money right before expiration.

b) Make early exercises, sell stock and "diversify".

c) Reduce risk, and generate income by selling exchange traded calls and sometimes buying puts.

Question #1

Which strategy of managing vested in-the-money employee stock options, terminates the alignment the earliest between the grantee and the shareholders, thereby defeating the purpose of the grants?

a) Hold to near expiration (without early exercise or hedging) and exercise if in-the-money right before expiration.


c) Reduce risk, and generate income by selling exchange traded calls and sometimes buying puts.

Answer #1

Strategy b) All alignment is eliminated when the stock is sold. Full alignment continues in a) and partial alignment continues in c)

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Selling Calls against Employee Stock Options Extends Alignments Does selling exchange traded calls to generate income and Reduce the highest risks of holding Employee Stock Options enhance and extend the purpose of the options grant?

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Whenever I speak with a person who has some experience withemployee stock options, I generally get the comment thathedging by selling calls defeats the object of the options grant.The person claims that the purpose of granting ESOs isto align the interest of the company with theinterests of the executives. The claim is that hedgingthe ESOs essentially reduces the equity position of theexecutive and that defeats the object of the grantand it should be discouraged or prohibited by the employer.That idea is just another myth that pervades the EmployeeStock Options industry.

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Let's look at the idea closely:

We will do so by way of an example.Many executives these days own stock along with theiremployee stock options. Assume that an executive owns4000 shares and ESOs to buy 10,000 shares with an expected expiration date of five years from today. The options are exercisable at $50 with the stock trading at $75 (a highly risk position).

In traders lingo, the two combined positions may have a deltaof long 12,700 shares (i.e. +4000 from the stock and +8700from the options).

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So here the executive could be perceived as owning the stock equivalent of 12,700 shares.If he were to a) sell the 4000 shares(which is not discouraged by the company) he would reduce hisdeltas (the equivalent stock position) by 4000 shares and thereby reduce his alignment by 4000 shares.

If he were to b) prematurely exercise ESOs to purchase 4000shares and sell the stock received, his deltas would be reducedby perhaps 3480.

This of course is not discouraged by the company aftervesting even though it will have reduced the executivesalignment with the company by 3480 stock equivalents.If he were to c) sell his 4000 ESOs on some new transferableoptions plan, his delta would be reduced by 3480, thereby reducing his alignment accordingly.

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This type of transferable option was introduced by Google at the encouragement of Morgan Stanley.

If he were to d) sell (write) listed LEAP calls on 4000 shares ofstock with an exercise price of 80 against the 4000 shares, this would reduce his deltas by perhaps 2400. His alignment would be lessened by the 2400 deltas.

So why would the company discourage or prohibit d) and notdiscourage a), b) or c), since a), b), and c) all reduce the alignment more that d).

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Some companies actually try to use their Insider Trading Policy to prohibit the sale of calls, when there is no prohibition in the Stock Plan contract document or the Grant Agreement contract. They do so in order to make early exercises of ESOs the only way to reduce the risk of holding substantially in-the-money Employee Stock Options.

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Their true purpose is to create the early cash flows and reduce the company’s liability to their employees, and thereby creatingearlier Assets Under Management for the wealth managers.

In fact, discouraging d) reduces the value of the options in theeyes of the informed executive/grantees. This reduction of valuerequires a larger grant to executives to create the sameincentive. If the call selling was not discouraged, the executiveswould perceive the ESOs to have more value, thereby requiring less total options granted.

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In fact, if companies were to encourage a gradual call selling ofthe ESOs from the date of vesting to expiration day, this would create more value in the eyes of the executives and require fewer grants and less expenses against earnings. This wouldalso provide the executive an efficient way to exit his options positions, reduce risks and delay taxes.

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Question #2

Which strategy forfeits part of the employee stock options value (called "time value") back to the company and causes an early payment of income tax?

a) Hold to near expiration (without early exercise or hedging) and exercise if in-the-money.


c) Reduce risk, generate income by selling exchange traded calls and sometimes buy puts.

Answer #2

Strategy b) The penalties are quite high with b).There are no penalties with a) and c)

Premature Exercise

of

Employee Stock Options

What are the Penalties?

The two slides below illustrate what amounts of "time premium" are forfeited upon early exercise of employee stock options. The slides also illustrate the approximate compensation tax that becomes due upon early exercise. Of course in the case of incentive stock options, the tax results are different.The first slide assumes a stock has a .30 volatility and the second slide assumes a .60 volatility. The "time premiums" therefore in the graph with the .30 volatility are much lower than with the assumed volatility of .60. The intrinsic values are identical in the two slides as is the tax.

Some pundits who wish to promote the "premature exercise, sell and diversify" strategy will disagree with my calculations of "time premiums" claiming they are overstated. My view is that the calculations are accurate, because I assume that the grantees understand the nature of, the value of the ESOs and the benefits of avoiding "premature exercises". But none will refute the fact that the remaining "time premium", whatever it is, is forfeited upon early exercises.

Let's now analyze the value of the penalty of the early compensation tax. I will merely multiply the total intrinsic value upon exercise by .40 and get the tax payable.

We then assume that the expected rate of return over the remaining expected life of the options is 5% compounded annually and can be achieved by holding the employee stock options.

For Example: Assume a grantee owns vested options to buy 1000 shares of stock at $20, which is now trading at $40 and there are 4.5 years to expiration. The volatility is assumed to be .30. He exercises his ESOs and sells his stock.The forfeited "time premium" is equal to $4526 and the penalty for the early tax is $1918. Therefore the total penalty is $6444.

If we calculate the "time premium" using a .60 volatility the penalty is $6460 + $1918 or $8169 in total.

So in summary, the lower volatility stock gets you a $6444 penalty and the higher volatility stock get a higher penalty of $8169 when you exercise with the stock 100% above the exercise price with 4.5 expected years to expiration.Those are quite high penalties, when the small amount of net after tax proceeds is considered ($12,000).

Simple Hedging Strategies, which are available to most grantees, will on average capture the $6444 or the $8169 mentioned above.

So it's your choice. Pay the penalties or hedge?

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Question #3

Which strategy reduces risk the least?




Answer #3

Strategy a) does not reduce the risk of a concentrated position at all. Strategy b) eliminates the concentrated position but exposes the employee to market risk on the residual amounts after forfeiture of "time value" and paying an early tax. Strategyc) Reduces risk of the concentrated position and incurs no exposure to market risk

Illustration of the values of the employee stock options on grant day using different volatilities. Assume that the stock is trading at $40

# of ESOs........Assumed.........Assumed.............Theoretical Value ofGranted.........Interest rate........Volatility..............1000 ESOs at grant

..1000.....................3....................25..........................$12,600

..1000.....................3....................40..........................$17,400

..1000.....................3....................50..........................$20,470

..1000.....................3....................60..........................$23,300

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..1000.....................3....................70..........................$25,890

..1000.....................3....................90..........................$30,290

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So the true value of 1000 ESOs or SARs granted with an exercise price of 40, and with 10 years of maximum contractual life with a 50 volatility is $20,470on the day granted. The perceived values of the options by the employee may be more or less that the amounts stated depending on his expectations of longevity with the company and the quality of advice received to managesuch grants. The values in the right hand column are the values at risk on the day of grant.These values erode everyday unless the stock increases in market value.

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Illustration of the risks of losing the granted values with different expected times to expiration and different volatilities. Stock is assumed to be trading at the exercise price

Expected time........Expected Volatilities.......Probabilities of ESOsto Expiration...........of the Underlying.............being Worthless.......................................Stock..........................at Expiration

7 yrs..................................30..................................40 5 yrs.................................30..................................40 3 yrs..................................30..................................44 1 yr....................................30..................................47------------------------------------------------------------------ 7 yrs..................................50..................................625 yrs..................................50..................................603 yrs..................................50..................................571 yr...................................50..................................54------------------------------------------------------------------- 7 yrs.................................70..................................72 5 yrs.................................70..................................69 3 yrs.................................70..................................65 1 yr ..................................70..................................59--------------------------------------------------------------------

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. Where is the Highest Risk when holding Employee Stock Options?The Matrix below shows the “fair value” of employee stock options at various stock prices at different times to expiration. This allows an examination of the changes in the ESOs value over times and the risks of holding the ESOs under different conditions. Exer.......Stock.......Volatility......Days to..........Fair.......…......Time.Price......Price..........................Expiration......Value...............Value.50………50.00.............35.............1400............14.01...............14.01 …......The color equations below show the % drops in the ESOs50………56.25.............35.............1400............18.38...............12.13…........"fair value" with 25% drops in the stock after 900 days. 50………75.00.............35.............1400............33.07 ………....8.07….........The largest % drops in the ESOs are with the options 50………93.75 ............35.............1400............49.48...............5.75…..........that are moderately in-the-money compared to the 50…..…100.00.............35.............1400........... 55.21...............5.21 .............% drops in the deep in-the-money ESOs. 50….…. 125.00............35.............1400............78.73.............. 3.73

50……..50.00..............35...............500................8.31................8.31 50……..56.25..............35...............500...............12.35................6.11…..…...33.07 to 12.35 = 20.72 = 63% drop 50……..75.00..............35...............500...............27.42............... 2.47 …..…..55.21 to 27.42 = 27.79 = 50% drop50……..93.75..............35...............500...............44.83................1.18….....…78.73 to 44.83 = 33.90 = 43% drop50…….100.00.............35...............500...............50.97................0.9750…….125.00.............35...............500...............75.61................0.61

This is proof that when the stock is trading at $100 with an exercise price of $50, the risk is less than when the stock was trading at $75. The higher risk is from the higher volatility of the options values and the much larger erosion of higher “time values” when the stock is moderately above the exercise price .

.Exercise...Stock.....Volatility.....Days to..........Fair…............Time.Price.........Price.......................Expiration......Value..............Value

50……......50.00.............35............500..............8.31................8.31……… 50……......56.25.............35............500............ 12.35...............6.11……… 50…..…....75.00.............35............500.............27.42............... 2.47 ……… 50…..…....93.75.............35............500.............44.83................1.18………. 50…….....100.00............35............500.............50.97................0.97……… 50…....….125.00............35............500.............75.61................0.61.... ......25 % stock drops over 400 days show greater percentage losses for the ESOs that are moderately in-the-money as shown in the color graphs below 50…..…. .50.00.............35............100.............3.68...................3.68........50……... ..56.25.............35............100..............7.82.................. 1.57...... ..... 27.42 to 7.82 = 71.5% drop 50……... ..75.00.............35............100............25.12........... .......0.12 .... ........50.97 to 25.12 = 50.7% drop50……... ..93.75.............35............100............43.83.......... ........0.07..... ........75.61 to 43.83 = 43.0% drop50……....125.00.............35......... ..100............75.05........ ..... ....0.05

If different percentage drops of the stock were examined, (for example 30 35, or 40% drops), the results of the percentage drops of the options would show greater percentage drops. If the stock drops occurred over longer periods, the percentage drops in the options would be even greater because of the greater erosion of the "time value" over longer periods.This means that if fiduciaries are concerned with risk reduction, they are required to advise reducing risk when the ESOs are most risky. And that occurs when the ESOs are moderately in-the-money. The strategy of early exercise, sell and diversify is highly inappropriate when the ESOs are moderately in-the- money and that strategy is inappropriate except in rare situations. The inappropriateness results from the required forfeiture of "time value" and the payment of an early tax and the questionable benefits and costs of "diversifying". That leaves only one choice to efficiently manage ESOs that are significant parts of the employees assets. That is to sell calls or do other efficient risk reduction trades in the exchange traded options markets.

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Question #4

Which strategy is useless most of the time in the life of the employee stock options?




Answer #4

The answer is strategy b): the probability of the stock increasing to levels when even the promoters of b) advise using it, is very small (i.e. about one chance in 10 after vesting), whereas strategy c) allows risk reduction immediately after vesting in many situations, which are much more probable.

.The promoters of the early exercise sell and "diversify" strategy say essentially the following.1. After vesting of perhaps 3-4 years, if the employee stock options are deep-in-the-money and trading about 110 % above the exercise price, that is the optimal time to exercise, sell and "diversify".2. They say that if the stock is below that price, the employee should wait and hope it goes higher, notwithstanding that when the stock is 50% above the exercise price, the risk is greater than when it is 110% above the exercise price.3. But the chance of the stock being 110% above the exercise price after 3.5 years from the grant day is about 1 chance in 10 with a reasonably volatile stock So their strategy is not even useful at all 90% of the time after vesting in 3.5 years from the grant day.

But the strategy of selling calls and sometimes buying puts has application when the stock is 40 % above the exercise price or higher than , which will occurs 5 to 6 times more often than the stock being 110% above the exercise price.

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Question #5:

Which strategy has the best expected after tax returns to the employee/ grantee with the least risk?




Answer #5

Strategy a) has the greatest potential with the greatest riskStrategy c) has less potential than a) but less riskStrategy b) has the least potential for gain and more risk than c)

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It can be demonstrated that selling calls and buying puts while holding substantially in-the- money ESOs is by far the best strategy. The expected advantage of selling calls versus early exercise, selling stock and diversify is between 40% to 70% depending on the volatility, the expected time to expiration and the relationship of the stock to the exercise price.

The next slide shows three Graphs which compare the results of selling 30 listed calls with a strike price of $450 versus Employee Stock Options to buy 3000 shares of Google stock at $350 with the stock at $416 to the results of holding the ESOs to expiration un-hedged without any early exercises.

The vertical axis shows the value of the combined positions at expiration.

The blue graph shows the result of holding the Employee Stock Options un-hedged to expiration.

The green graph shows the results at expiration of hedging by selling 30 calls (for $8300 each) with a strike price of $450. Both the ESOs and the calls expire in 20 months after the sale The red graph shows the results of selling the same 30 calls versus ESOs to buy 3000 shares where the ESOs expire 2 years after the calls expire. The difference between the red and green graphs represents the remaining time premium in the ESOs with two years to expiration. Although the graphs assume a sale of 30 calls versus 3000 ESOs, we seldom hedge beyond 60-70% No taxes were considered in these graphs

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Question #6

What strategy generates early cash flows to the company through the company issuing new shares to the employee and taking a tax deduction as the employee exercises and pays cash to the company and to the government.




Answer #6

Only strategy b) generates early cash flow to the company, which is one of the main reasons why it is promoted by the industry.

How do early exercises affect the employee holding Employee Stock Options?

1. The ESOs have substantial amounts of remaining "time value" in their ESOs which is forfeited back to the company when early exercises are made. That amount is a relatively large percentage of the ESOs total value if the stock is not trading far above the exercise or if the expected volatility is high.

For example, lets take a situation where the ESOs vest after 3 years. Assume the ESOs have an exercise price of $20 with the stock trading at $30 and a .40 volatility with 5 years expected time to expiration with no expected dividend and an interest rate of 2%. The full value of the ESOs is approximately $15.00 (i.e. $10 of intrinsic value and $5 of "time value"). So under the above circumstances, the employee nets approximately $6.00 after tax for ESOs that are worth $15 prior to exercise.

Now what is the probability of the stock with an expected volatility of .40 advancing from $20 to $30 or higher after three years? The probability is about 28%. So 72% of the time the stock will be less than $30 after three years when they vest. The probability is about 15% that the stock will be above $40 after the three years. So most of the time after 3 years, the ESOs will have large percentages of their value in the form of "time value", which will go back to the company if the ESOs are exercised early.

The question arises as to how should the employee manage the ESOs most of the time. Certainly he should not make the early exercises which forfeits a large part of the value back to the company. If he/she wishes to reduce the risk because the value of the ESOs and company stock held is a substantial part of his/her assets, there is only one choice. That choice is to efficiently sell calls and buy puts. If an adviser tells an employee otherwise and advises early exercise and sell strategies, he/she may be violating SEC Rule 10 b-5 and subjecting himself/herself to penalties under 10 b-5.

How do companies benefit from early exercises of ESOs by employees?

Early exercises benefit the company in three ways:

1. Their liability to the employee is reduced by the value of the "time value" forfeited.

2. The company receives a cash flow from the exercise of the ESOs equal to the exercise price paid when they issue new shares to the employee.

3. The company receives a tax credit because they can deduct the "intrinsic value" on the date of exercise as an expense against income tax. These two cash flows are received at more favorable prices of the stock than would be received if the company had a new issue of stock to the public.

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Question #7

What strategy benefits the Wealth Managers by getting early Assets Under Management?




Answer #7

Strategy b) The Wealth Managers use the net after tax proceeds from early exercise and selling the stock to buy mutual funds, which generally underperform the market because of commissions, fees and transactions costs.

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If the options have an exercise price of $50 and the stock is trading at $80 after three years of vesting, the risk to the holder of the ESOs is greater than if the stock were $110. So, Wealth Managers will often advise exercising the ESOs and selling the stock and then buying mutual funds.

If the holder of the ESOs sold calls to generate income prior to exercise or bought puts to protect against extreme down moves, the wealth managers will not get any current Assets Under Management and can not sell mutual funds with the residual amounts from the ESOs.

If the stock went down later and the stock was below the exercise price at expiration( perhaps five years later), the only money the wealth managers would be able to use to buy mutual funds is the income from the call selling and the profits from the put buys.

So that is why the wealth managers want early exercises.

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Question # 8

Which strategy is most prone to violations of SEC Rule 10 b-5




Answer # 8

Strategy c) There has never been a 10b-5 prosecution for selling calls or buying puts to reduce risk and there has never has been a prosecution for holding to near expiration, exercising and selling. All prosecutions have been from early exercises, sell and diversify. Many violations for early exercises and sell are never prosecuted civilly or criminally.

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Some companies insert complete prohibitions of selling calls into the Insider Trading Policies in order to force early exercises to the benefit of the companies and to the advantage of the wealth managers. This assertion is merely a deception upon the employees to diminish the values of the options grants. The insertion has absolutely no value in connections with prevention of 10 b-5 violations and those making the insertion can not even find a justification for it. In fact the insertions themselves violate 10 b-5.

The employees should just ignore the alleged prohibitions and sell the calls or buy the puts, because the insertion violates their employee stock options contract.

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Question #9

Which strategy is rarely prohibited by the company in the stock plan and grant documents, but is highly discouraged by the "Insider Trading Policies".




Answer #9

Strategy c) There is an attempt to stop the most beneficial strategy to the grantees by the company fraudulently using the Insider Trading Policy to try to stop selling calls and or buying puts. Those fraudulent Insider Trading Policies promote strategy b), which is the strategy most prone to Rule 10 b-5 violations. There has never been a civil or criminal complaint under Rule 10 b-5 for c).

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§ 240.10b-5

Employment of manipulative and deceptive devices.

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

]

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Question #10

Which strategy is most prone to implicate the Wealth Managers in violations of fiduciary duties to their clients and violations of 10 b-5.

a) Hold to near expiration without early exercise or hedging and exercise if in-the-money.b) Make early exercises, sell stock and "diversify".c) Reduce risk, generate income by selling exchange traded calls and sometimes buy puts.

Answer #10

Strategy b) The companies and the wealth managers ally together to promote the strategy that best helps themselves but most diminish the value to the grantees. And the employees are intimidated from pressing the issues for fear of losing their jobs.

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Wealth Managers are required to advise their clients in a manner which is expected to get the best results for their clients. If they have conflicts of interests whereby they advise what is best for the company or themselves, then they are violating their Fiduciary duties and are probably violating SEC Rule 10 b-5.

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None of the major illegal insider trading was done by insiders selling calls or buying puts to reduce risk of holdings in their equity. Everyone of the insider trading frauds whether by Terry Semel of Yahoo, Angelo Mozillo of Countrywide, Richard Fuld of Lehman Brothers and scores of others were done through early exercises, sells and "diversifying".

Isn't it a bit ridiculous to ban trading in calls and puts, when the object is to reduce risk and extend alignment, when the chance is zero of a violation of SEC Rule 10 b-5. And isn't it a bit ridiculous to permit and promote premature exercises, sales and diversify, when that strategy is the only one that executives have been prosecuted for using.

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John Olagues Truth In [email protected]://www.wiley.com/WileyCDA/WileyTitle/productCd-0470471921.html

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