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Understanding and Managing the Risks of Holding Employee Stock Options

John OlaguesTruth In Options504-875-4825 www.optionsforemployees.com/articles Olagues@gmail.com

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When employee stock options are granted, those ESOs have a value, although they never can be sold before vesting and generally can not be sold after vesting. Companies granting ESOs must calculate a theoretical value as required by FASB and the SEC for purposes of calculating the reportable expenses against earnings. That calculated value is then expensed against earnings when the options vest. The method of calculating the value and the timing of the expense against earnings results in an understating of the ESOs true expense. The calculated value is understated by the companies to be as low as possible, and is substantially understated especially for employees and executives who truly expect to remain at the company for longer periods and who understand proper management of the granted ESOs (like most CEOs advisers). On the other hand, for persons receiving grants with longer vesting periods, who have short expected time remaining with the company or who take the advice of wealth managers who promote the early exercise, sell and "diversify" strategy, the values at grant are substantially less.

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So if you are granted ESOs, the value at grant that you have is dependent upon "your" expectations of longevity at the company and your ability to manage those ESOs properly. The value of the ESOs at grant generally will range between 25% to 65% of the underlying stock. So if you are grated ESOs to buy 1000 shares at $20, the value of the ESOs at grant may be anywhere between $5000 and $13,000. See the following two slides for a clear conception of the Employee Stock Options values. That value that you have been granted is at risk from the day of grant until they expire or are exercised or forfeited. That value can be diminished by movements of the stock downward (i.e. the delta risk) and the passage of time (i.e.theta risk) and early exercises of the ESOs (i.e.forfeiture of remaining time premium and the penalty of paying an early tax). The probability of the stock being above the exercise price at a specific time in the future may range from 30% with high volatility stock to 70% for a low volatility stock. If the stock is below the exercise price immediately before expiration, the ESOs are worthless unless the company has repriced the exercise price.

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So, as anyone can see from the two slides above there is a lot of risk to holders of employee stock options of losing the value that is granted. Along with that risk comes potential gains of much more than the value at grant. If the value at grant is just a small portion of your total assets, then there is probably little that you should be concerned with as far as reducing risk. However, if the stock advances substantially (perhaps 50% over the exercise price), and the ESOs are vested and the present value of the ESOs becomes more than an incidental part of your total assets, you may very well be looking for efficient ways to reduce the risk and preserve the value.

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The only efficient way to reduce risk under the circumstances in the above paragraph is to predominantly sell slightly out-of-the-money exchange traded calls and to a much lesser degree to buy puts. However, that strategy is not what the company or the wealth managers want you to do. They want you to not sell calls or buy puts to reduce risk. If you want to reduce risk, the companies and the wealth managers would prefer you make premature exercise, sell the stock received and "diversify". This is true even though the sales of calls (at or out-of-the-money) or buys of puts maintains part of the employee/company alignment and premature exercise, sell stock and "diversify" eliminates 100% of the alignment.

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The premature exercise strategy eliminates none of the market risk other than the risk on the amounts paid in compensation tax upon exercise. The reasons that the companies want early exercise is that the remaining time premium is returned to the companies and the companies get early cash flows from the issuance and sales of new shares and early tax credits. The wealth managers want early exercises and sales to get early Assets Under Management.

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In order to make it hard to efficiently reduce risk, the companies sometimes will prohibit the sales of calls and buy of puts in the Incentive Plan documents or the grant agreements, although this is rare. Some companies, that have not made that prohibition a part of the contract documents and knowing that the documents can not be changed without the consent of the grantees, try a different tact to stop the executives and employees from selling calls or buying puts. They insert the prohibition into their Insider Trading Policy under the deliberate misrepresentation that prohibiting the sales of calls and purchases of puts at all times is necessary to prevent violations of SEC Rule 10 b-5.

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However it is impossible that sales of calls or the purchases of puts will violate 10 b-5 at times when the sale of stock is permitted and consistent with 10 b-5. Therefore the prohibition on selling calls or buying puts, when the sales of stocks are permitted under an Insider Trading Policy has another objective other than avoiding a violation of 10 b-5. That objective is to try to prevent risk reduction other than by premature exercise, sale and "diversify". But the companies justify the insertion of that provision into the Insider Trading Policy by misrepresenting the necessity of the insertion. That act, being in connection with the subsequent exercise and sale of stock and "diversify" is in fact a violation of 10 b-5, thereby exposing the company and those responsible for the insertion to criminal prosecution and civil suit.

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