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All you need to know about Employee Stock Options

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Most comprehensive Paper ever written on Employee Stock Options by the foremost expert in the world.


www.truthinoptions.net
olagues@gmail.com
504-875-4825

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All you need to know about Employee Stock Options

  1. 1. .an analysis ofEmployee Stock Options not for dummiesAuthor John Olagues
  2. 2. .Table of Contents 1) What are Employee Stock Options... Contract terms and restrictions 2) Purposes of the Employee Stock Options grants 3) Values of the Employee Stock Options grants 4) Risks of losing the Employee Stock Options value 5) Fiduciary Duties of advisers to reduce risks 6) Premature Exercises, Selling and Diversifying of ESOs and the consequences 7) Insider Trading Policies used to force early exercises 8) Probabilities of increased values 9) Early Exercises and consequences to the employee and the company10) Taxes to the employee and the company11) Dynamic Employee Stock Options..a new superior options design that works 1
  3. 3. .What are Employee Stock Options?Employee Stock Options are contracts between an employee or executive and thecompany which grants the options. Most often these grants are substitutes for part ofthe grantees compensation.These contracts give the employee/grantee rights to buy a certain number of sharesof company stock from the company. The company assumes certain liabilities toissue and deliver the shares to the grantee if and when the employee stock optionsare exercised. These employee stock options contracts usually have the grant daymarket price as the exercise price, have maximum time to expiration of 10 years andcan not be exercised until the options vest (perhaps 1 to 4 years after the grant).The term of these contracts are outlined in the Employee Stock Plan and the GrantAgreements.The options are generally not transferable and not pledgeable.Generally, there areno prohibitions in those contract documents against selling exchange traded calls orbuying puts to manage the employee stock options efficiently. The contract termscannot be changed if the change is detrimental to the employee, unless theemployee agrees to the change. 2
  4. 4. .Google, Cisco and Apple Plan DocumentsBelow are links to the Google Stock Plan Document, the Cisco Incentive StockPlan document and to Apples Stock Plan Document.Googlehttp://www.secinfo.com/d14D5a.r3mD3.d.htm#1stPageCiscohttp://www.secinfo.com/d14D5a.v5RKa.d.htmApplehttps://mail-attachment.googleusercontent.com/attachment/?ui=2&ik=53fbb1432b&view=att&th=13737f47396603d2&attid=0.1&disp=inline&safe=1&zw&saduie=AG9B_P-A3YBdVyb5dP27bKQ7mICC&sadet=1336839257456&sads=YngX7kheBqgErOKAMKEUXwfA0BQNone have prohibitions against selling calls and buying puts. 3
  5. 5. Although all of the Stock Plan documents prohibit transferring or pledging theemployee stock options (Google allows a limited form of selling to selected banksand under some circumstances the Cisco Employee Stock Options can betransferred to family members).Nor is there any prohibition against hedging in the Options Award Agreements.Options Award Agreements generally outline the specific terms of a particularaward. For example: the Award Agreement states the number of shares that canbe bought, the exercise price, the vesting period(s), and the expiration date.The Stock Plan and Award Agreements are the documents that constitute the fullcontract between the company and the grantee regarding the granted equitycompensation.Since there is no prohibition against hedging in the contract documents, why domany companies discourage the strategy? Some even tell their employees thathedging is prohibited by the plan.If holders of employee stock options are prohibited from hedging ESOs, then whyis it not clearly written in those contract documents? 4
  6. 6. The answer is that the company officials know that there is generally noprohibition in the company documents but they know that premature exercisesbenefits the company in three ways as explained below. Therefore the companyencourages premature exercises.1. On premature exercise, the employee forfeits the remaining "time premium",which the company recaptures. In effect the companys remaining liability to theemployee is eliminated.2. The employee pays an early tax, and the company gets an early deductionfrom income tax, equal to the difference between what the exercise price is andwhat the stock could be sold for in the market.3.The employee pays the exercise price early and that adds to the cash flow tothe company also.See the following slide for a better understanding of the consequences of earlyexercises to the employee. 5
  7. 7. When most of the plans were established, there was no prohibition againsthedging. And the plans require that if there is a change to the plan which may beadverse to the grantee, the company needs the approval of the grantee.So the companies can not just insert a prohibition against hedging into theirpresent plans, because that diminishes the value of the ESOs to the existinggrantees and those who relied on there being no prohibition. 7
  8. 8. So the companies try to make employees think that there is a prohibition whenthere is none. But there is a drawback to that strategy and that is if the companyadviser tells the employee he cannot hedge and the stock goes down after he istold that he cannot hedge, the company would be liable for damages.Also, in my opinion, the advisers who tell their clients that they cannot hedgewhen the documents clearly allow hedging, open themselves up to a liabilitysimilar to the companys liability.The difference in value that the grantee will receive is on average about 40%more from selling calls and buying puts compared with a premature exercisestrategy with the stock 90% above the exercise price after vesting. So the liabilityis not incidental. 8
  9. 9. In summary, Google, Cisco and Apple have no prohibitions against selling calls orbuying puts in the plan documents. Holders of ESOs are free to manage theirequity compensation as they see fit as long as it is consistent with the PlanDocuments and Options Agreements, without further approval from anyone.However, it does appear that Apple has in January 2012 modified its InsiderTrading Policy to try to prohibit all trading in puts and calls even when selling thestock is allowed under 10 b-5 and their Insider Trading Policy. Similarly Googleapparently changed its Insider Trading Policy to prohibit "hedging"There has never been and will never be a prosecution of a civil complaint orcriminal complaint under 10 b-5 for selling calls or buying puts when the sale ofstock is permitted by 10 b-5 at the same time in the same account. So why doesApple and perhaps Google prohibit trading in calls and puts when trading thestock is permitted under 10 b-5?The answer is that they want to use the Insider Trading Policy to try to stop themost efficient way of managing the grants by the owners of employee stockoptions. They do this because efficient management by the employee raises thecost to the company and delays the cash flows to the company. Selling callsversus ESOs actually extends the alignment of employee /shareholders whereasall alignment is lost upon early exercise and sale. 9
  10. 10. .Purposes of the Employee Stock Options GrantsThese options are granted to align the interests of the grantee with the shareholders.They are granted as cashless compensation for past and future performances withthe company and to attract and retain long term high quality employees. But it isundecided as to how effective they are in that objective. In addition, the companiesuse the grants of employee stock options to preserve present cash. Options grantsare also made to generate future cash flows when the company issues and sellsnew shares pursuant to the exercise of the employee stock options. New cash isalso generated when the companies deduct from taxable income the "intrinsic value"of the employee stock options when exercised. A major portion of the entire cashflows for some companies come as a result of exercises of employee stock options. 10
  11. 11. .See the links below for how valuable those cash flows are to the companies.http://www.slideshare.net/OLAslideshare/employee-stock-options-and-investmentshttp://www.slideshare.net/OLAslideshare/ssrn-id1101271Effectively, the grant and exercise of the employee stock options become a form of"money creation" for companies which have liquid markets for their stock. However,this "money creation" that comes as a result of the issuance of and exercise of theemployee stock options, will come faster if premature exercises of the options aremade. Therein lies the reason behind the promotion of the early exercise, sell anddiversify strategy to the great mass of grantees other than some top executives whounderstand the true "nature of the game" and hold their ESOs to near expiration. 11
  12. 12. .Value of Employee Stock OptionsValues of Employee Stock Options can be calculated using standard theoreticalmodels. The assumptions of "expected time" to expiration can be input into thecalculation instead of the maximum time to expiration in consideration of theprobability that the grantee will terminate employment early or prematurelyexercise the employee stock options.The matrix on the following page illustrates the values of the employee stockoptions on the grant day to buy 1000 shares when the stock is trading at $40. 12
  13. 13. Illustration of the values of the employee stock options on grant day usingdifferent volatilities with the stock trading at $40, with an expected time toexpiration of 6.5 years.# of ESOs.........Assumed.........Assumed........Expected time........Theoretical Value ofGranted..........Interest rate........Volatility........to Expiration..........1000 ESOs at grant..1000.....................3%..................25..................6.5 yrs....................$12,600..1000.....................3%..................40..................6.5 yrs....................$17,400..1000.....................3%..................50..................6.5 yrs....................$20,470.SSo the "fair 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 employeemay be more or less that the amounts stated depending on his expectationsof 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. 13
  14. 14. . Risks of Losing those ESO values What are the risks of losing the value of those employee stock options and what are the fiduciarys duties to understand and advise reduction of that risk efficiently. See the next two slides for an illustration of where the risk is the highest when holding employee stock options. The illustrations show that the best time to reduce risk is when the ESOs are moderately in-the-money. That can be done efficiently only by selling calls and buying puts. The following slides illustrate the risk of loss of the value granted and why holding vested moderately in-the-money employee stock options unhedged is more risky than holding deep in-the-money employee stock options. The fourth slide addresses how to reduce that risk. 14
  15. 15. Illustration of the risks of losing the granted values with differentexpected times to expiration and different volatilities.Expected time........Expected Volatilities.......Probabilities of ESOsto Expiration...........of the Underlying.............being Worthless.......................................Stock.........................at Expiration5 yrs..................................30..................................403 yrs..................................30..................................441 yr....................................30..................................47------------------------------------------------------------------------5 yrs..................................50..................................603 yrs..................................50..................................571 yr....................................50..................................54------------------------------------------------------------------------ So with 5 expected years to expiration with a .30 volatility, the chance is 40%that you will receive nothing for your ESOs. With higher volatilities, the chancesare higher that you will receive nothing. 15
  16. 16. 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. Thisallows 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...............Value50………50.00.............35.............1400............14.01...............14.01 …......The color equations below show the % drops in the50………56.25.............35.............1400............18.38...............12.13…........ESOs "fair value" with 25% drops in the stock.50………75.00.............35.............1400............33.07 ………....8.07…........The largest % drops in the ESOs are with the options50………93.75 ............35..............1400............49.48................5.75…........that are moderately in-the-money compared to the50…..…100.00.............35..............1400........... 55.21...............5.21 ...........% drops in the deep in-the-money ESOs.50….…. 125.00............35..............1400............78.73............... 3.7350……..50.00..............35..............1000..............11.76...............11.76……......This is proof that when the stock is trading50……..56.25..............35..............1000..............15.92................9.67……...... at $100 with an exercise price of $50, the risk50……..75.00..............35..............1000..............30.58................5.58 ……..... is less than when the stock was trading at $75.50……..93.75..............35..............1000..............47.22................3.47….....….The higher risk is from the higher volatility of the50……100.00..............35..............1000............. 53.03................3.03….......…options values and the much larger erosion of50……125.00..............35..............1000..............76.93................1.93…....…. higher “time values” when the stock is moderately above the exercise price50……..50.00..............35...............500................8.31................8.3150……..56.25..............35...............500...............12.35................6.13............33.07 to 12.35 = 20.72 = 63% drop50……..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 16.
  17. 17. Exercise...Stock.....Volatility.....Days to..........Fair…............Time. .Price.........Price.......................Expiration......Value..............Value50……......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 with lower "intrinsic values" as shown in the color graphs shown below 50.............50.00..............35...........100..............3.68...................3.6850……... ..56.25.............35............100..............7.82.................. 1.57............ 27.42 to 7.82 = 71.5% drop50……... ..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........ ..... ....0.05If different percentage drops of the stock were examined, (for example 30 35, or 40% drops), the results of the percentage dropsof the options would show greater percentage drops. If the stock drops occurred over longer periods, the percentage drops in theoptions 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 aremost risky. And that occurs when the ESOs are moderately in-the-money. The strategy of early exercise, sell and diversify ishighly inappropriate when the ESOs are moderately in-the- money and that strategy is inappropriate except in rare situations. Theinappropriateness results from the required forfeiture of "time value" and the payment of an early tax and the questionablebenefits and costs of "diversifying". That leaves only one choice to efficiently manage ESOs that are significant parts of theemployees assets. That is to sell calls or do other efficient risk reduction trades in the exchange traded options markets.When the stock is trading at 50% above the exercise price shortly after vesting, the only efficient way to reduce the risk is to sellexchange traded calls. This means that promoting the strategy of early exercises, selling and diversifying under thesecircumstances makes the advisers liable for violation of their fiduciary duties and in violation of SEC Rule 10 b-5. The followingslides will explain how to generally handle your options grants. 17
  18. 18. .So, in view of the information in the slides above, how does a holder of moderatelyin-the-money ESOs, (i.e. the stock is trading at $75 with a $50 exercise price)efficiently reduce the risk?The employee simply opens a brokerage account and sells some calls (perhaps 5or 6 calls for every 1000 ESOs that he has that are vested). Perhaps the ones withthe exercise price of $80 or $85 with 9 months to 2 years time remaining are themost appropriate. That would reduce his risk by about 35 % and he still has asubstantial alignment with the shareholders. If the employee sold more calls, therisks and alignment would both be reduced further.If he wanted protection against extreme downward moves, he could purchase asmall number of puts, perhaps in his IRA, and sell less calls.This strategy assumesthat there is no prohibition by the company and that the ESO holder has sufficientcollateral to finance the call sales or the put purchases and that there is areasonably liquid market to make the options trades.On the other hand if the company wanted to facilitate the reduction of risk to holdersof moderately in-the-money ESOs without hedging, they could design the options tobetter achieve all the objectives of the ESO grants. Check out the link below for amuch improved type of employee stock option which is illustrated at the end of thisbook.http://www.slideshare.net/OLAslideshare/new-dynamicemployeestockoptionspresentati-4-12038997 18
  19. 19. .Fiduciary DutiesFiduciaries Relationships“Fiduciary” relationships are those relationships existing between parties to atransaction wherein one party is duty bound to act with the utmost good faith for thebenefit of the other; such a relationship ordinarily arises when one party reposes aconfidence in the integrity of the other, and the other voluntarily accepts thatconfidenceBrokers General Fiduciary duties to client. A brokers fiduciary duties to aprincipal may include an obligation not to advance the brokers own interests ormake a secret profit, a duty to account for all funds or property rightfully belongingto the principal,and a duty of disclosure. A broker also owes a principal a of duty ofgood faith. 19
  20. 20. .Fiduciary’s duty to advise risk reduction. A broker, as an agent, has a duty to usereasonable efforts to give his or her principal information relevant to the affairs thathave been entrusted to the broker.The rule requiring a broker to act with the utmostgood faith towards his or her principal places the broker under a legal obligation tomake a full, fair, and prompt disclosure to the principal of all facts within the brokersknowledge which are or may be material to the matter in connection with which thebroker is employed, which might affect the principals rights and interests or theprincipals action in relation to the subject matter of the employment, or which in anyway pertain to the discharge of the agency which the broker has undertaken. NewEngland Retail Properties, Inc. v. Maturo, 102 Conn. App. 476, 925 A.2d 1151(2007), certification denied, 284 Conn. 912, 931 A.2d 932 (2007).The duty to disclose could also include informing the the principle of varying risksinvolved in a particular transaction, strategy or course of action. 20
  21. 21. Is a stock broker, wealth manager or broker-dealer a fiduciary to a customer?The ordinary relationship of a stockbroker to the customer is that of principal andagent. In some respects a stockbroker is a trustee. A stockbroker, like any otherbroker, is under a duty to act in good faith toward his or her customer,and,generally, the relationship between a stockbroker and a customer is a fiduciaryone.First Union Discount Brokerage Services, Inc. v. Milos, 744 F. Supp. 1145 (S.D.Fla. 1990), affd, 997 F.2d 835 (11th Cir. 1993);Saboundjian v. Bank Audi (USA),157 A.D.2d 278, 556 N.Y.S.2d 258, 11 U.C.C. Rep. Serv. 2d 1165 (1st Dept1990); Byrley v. Nationwide Life Ins. Co., 94 Ohio App. 3d 1, 640 N.E.2d 187 (6thDist. Erie County 1994).- State common-law action for breach of fiduciary duty against a stockbroker basedon the handling of a stock brokerage account on behalf of a profit-sharing plan wasnot preempted by ERISA; the state law involved was one of general application,which imposed duty on all stockbrokers regardless of the identity of theircustomers, and ran in favor of all customers, including employee benefit plans.Duffy v. Cavalier, 215 Cal. App. 3d 1517, 264 Cal. Rptr. 740 (1st Dist. 1989). 21
  22. 22. .So fiduciaries are obligated to identify and advise efficiently risk reductions totheir client.However, if the fiduciary does so and the employee/client efficiently reducesrisk, it raises the costs to the company and delays cash flows to the company.Indeed, it also delays the fiduciaries from getting "Assets Under Management".So Craig McCann and Kaye Thomas in 2005, created a paper called "OptimalExercise of Employee Stock Options and Securities Arbitrations" for thepurpose of giving some alleged authority for the early exercise, sell anddiversify strategy. The paper overstates the merits of diversifying andunderstates the penalties of premature exercises. It also avoids addressingsituations where the risks are greatest.A further analysis of the paper is on the following two slides or can be found athttp://www.slideshare.net/OLAslideshare/debunking-of-mccann-thomas-paper 22
  23. 23. .Summary of Craig McCann, Kaye Thomas paper promoting Early Exercise, Selland Diversify.The strategy of early exercise, sell stock, and diversify rarely has any merit even inthe circumstance that McCann and Thomas artificially chose in their paper "OptimalExercise of Employee Stock Options and Securities Arbitrations", because the earlyexercise penalties of forfeiture of the remaining “time value” and the payment of anearly tax, outweigh any advantage “diversification” may have.So the promoters of that strategy minimize the penalties of early exercise andexaggerate the merits of “diversifying” in order to help the companies, themselvesand the wealth managers at the expense of their clients/grantees.They do not mention that the stock trading at their "Optimal Exercise Price" or higherafter three years of vesting has a 1 chance in 11 nor do they mention that highestand most probable risks occur when the stock is trading substantially lower than theiroptimal exercise price. Effectively, the alleged authoritative paper says to ignore thehighest risks, and wait for the risks to drop and then make early exercises, sell anddiversify. That strategy has been proven to be worthless. 23
  24. 24. .However, if selling calls and/or buying puts, to reduce the risk of holding in-the-money calls is prohibited by the company, which is rare, or if the employee has nocollateral to support the sales of calls or the buying of puts, then this efficient strategyof selling calls is not available.The best strategy then is probably to assume the riskand do as Steve Jobs, Ron Johnson, Paul Otellini, Larry Ellison, John Chambers,James Dimon, and 135 Goldman Sachs executives and others did. See below. Nonebelieved that early exercise, sell and diversify, as promoted by McCann and Thomas,has any merit and held their employee stock options practically to expiration beforeexercising and immediately selling the stock.Steve Jobs exercised 120,000 on 8/12/07, ESOs expiring 8/13/07Apples R. Johnson exercised 200,000 on 12/1/ 09 ESOs expiring 12/14/09Paul Otellini of Intel exercised 800,000 11/9/07, ESOs expiring 11/12/07Larry Ellison of Oracle exercised 10,000,000 on 4/3/09, ESOs expiring 6/4/09John Chambers of Cisco exercised 2,000,000 on 2/8/10, ESOs expiring 5/14/10John Chambers of Cisco exercised 1,350,000 on 2/13/07, ESOs expiring 5/1/07James Dimon of J.P. M. exercised 1,261,000 on 7/17/09, ESOs expiring 8/15/09 24
  25. 25. .Insider Trading Policies and Equity Compensation:Some Insider Trading Policies prohibit (or claim to prohibit) selling calls and buyingputs at all times, whether the covered person possesses non-public materialinformation or not. Those Insider Trading Policies even disallow selling "qualifiedcovered calls" in blind trusts and pursuant to 10 b-5-1 plans. Some of those InsiderTrading Policies prohibit trading calls and puts when selling long stock is 100%consistent with 10 b-5. Under these conditions the possibility of a civil or criminalproceeding being brought against the "qualified covered call seller" or covered putbuyer or his employer for a Rule 10 b -5 violation is zero. There never has been aRule 10 b-5 proceeding under such or similar conditions.So why do they make such prohibitions in the Insider Trading Policy if the probabilityof a 10 b-5 violation is zero? 25
  26. 26. .The answer is that most Stock Plan Documents and Grant Agreements do notprohibit selling calls or buying puts and the plans cannot be changed by the whim ofthe companies to diminish the values of the equity compensation to the grantee.If company changes the plan documents directly and the changes are harmful to thegrantee/employee, the company has breached its contract with the employee/grantees. If they use the Insider Trading Policies to indirectly change the plans,when the change is completely un-necessary to comply with Rule 10 b-5, thecontracts that the employee has with the company are similarly breached by thecompanies.So why do the companies risk litigation for breach of contract by diminishing thevalue of employee stock options through prohibitions inserted in Insider TradingPolicies that have no value as far as protection against possible violations of 10 b-5? 26
  27. 27. . "Qui Bene" Cicero asked? The Company and the Wealth Managers benefit but the employee/grantee loses, because the most efficient strategy to manage the grants of employee stock options is to sell calls and to a lesser degree to buy puts versus substantially in-the-money vested employee stock options. And that strategy becomes unavailable if a prohibition is legally inserted in the Insider Trading Policy. The employee is required to assume very big risks of loss because of a violation of his/her contract with the company. Perhaps the designers have no idea of what the consequences of these Insider Trading Policies are. Or perhaps they do fully understand the consequences of their policies. 27
  28. 28. .Just recently Apple Computer inserted a provision into its Insider Trading Policythat appears to prohibit selling exchange traded calls or buying puts versus longun-restricted stock or at any other time, even when there is zero chance of aviolation of 10 b-5.This prohibition eliminates the only efficient way to manage an employees Appleequity holdings and as a result will transfer billions to the company from theemployees, while also benefitting the wealth managers as they now have anexcuse for not using an efficient management method. 28
  29. 29. .But the Apple Employee Stock Plan and the grant agreements allow for sellingcalls and buying puts to efficiently manage their equity compensation grants.So this insertion into the Insider Trading Policy of a prohibition of selling calls andbuying puts constitutes a breach of the Employee Stock Options contract. If youare an employee of Apple holding shares, or equity compensation grants, you areaffected by this breach, which interferes with your ability to manage those assetsefficiently. You should bring this matter to the attention of Apple and consider a suitif you are damaged as a result of the breach 29..
  30. 30. Probabilities of Stock being HigherIt is estimated that 90% of the time, the stock which was at $20 on the grant day, willbe below $40 after 3 years from the day of grant for stocks with .30 volatility. And forthe stock which is presently $20, the probability is 70% that it will be less than $30after 3 years after the grant day.Wealth managers have a fiduciary duty to advise risk reduction in concentratedpositions. And, most of the time, their advice should come when the stock is less than100% above the exercise price.So how is it possible for wealth managers to advise efficient risk reduction most of thetime (i.e. 90% of the time) when their only tool is to make premature exercises, sellstock and diversify?Even if the "time value" is near zero, the early tax payment penalty makes itinefficient. But they advise premature exercises anyway because of the benefits tothe company and themselves. 30
  31. 31. Early Exercises and the Consequences to the Employee andthe Company.Slides 33 and 34 show the results of early exercises.The penalties to the employeefor early exercises of traditional ESOs are illustrated in red in slide 35 below. Thebenefits to the employer are also illustrated in red in slide 36 below. 31
  32. 32. This slide shows the total penalties (red) for early exercises.Exer... Market....Vol...Expected..TimeVal..Ear.Tax...Total....Net After TaxPrice.....Price............Time.Ex.. .Forfited...Penalty. Penalty...Proceeds20...........30........30.... 5.5 yrs....$6114....$1200.....$7314......$600020...........40........30.....4.5 yrs....$4528....$1918.....$6418.....$12,00020...........50........30 ....3.5 yrs....$3368.. .$2100.....$5578.....$18,00020...........60........30.....2.5 yrs....$2372....$2000.....$4372.....$24,0001000 ESOs exercised .30 Vol, 5% risk free Interest rate, "0" dividend--------------------------------------------------------------------------------------20..........30.........60.....5.3 yrs....$9300....$1200....$10,500.....$600020..........40.........60.....4.3 yrs....$6460....$1918.....$8378.....$12,00020..........50.........60.....3.3 yrs....$4740....$2100.....$6840.....$18,00020..........60.........60.....2.3 yrs....$2870....$2000.....$4870.....$24,0001000 ESOs exercised .60 vol, 3% risk free interest rate, "0" dividend 34
  33. 33. This slide shows the benefits to the company of early exercises.Exer....Market..Vol...Expected.Time.Val.....Cash Flows.........Early TaxPrice....Price............Time.Ex.. Received..Ex.pr. tax cred...Credit Benefit20.........30.......30.... 5.5 yrs......$6114.... ..$20K......$4K ...........$120020.........40.......30.....4.5 yrs......$4528.... . $20K......$8K........... $191820.........50.......30 ....3.5 yrs......$3368.... . $20K....$12K............$210020.........60.......30.....2.5 yrs......$2372.... ..$20K....$16K............$20001000 ESOs exercised. 30 Vol, 5% risk free Interest rate, "0" dividend--------------------------------------------------------------------------------------20.........30......60......5.3yrs......$9300.......$20K......$4K...........$120020.........40......60......4.3 yrs......$6460... ..$20K......$8K...........$191820.........50......60......3.3 yrs......$4740......$20K....$12K...........$210020.........60......60......2.3 yrs......$2870......$20K....$16K...........$20001000 ESOs exercised .60 vol, 3% risk free interest rate, "0" dividend 35
  34. 34. Taxes.Taxes upon Grant. There is no tax liability to the grantee upon the grant ofemployee stock options and no tax deduction to the company.Taxes upon Vesting. There is no tax liability to the grantee upon the vesting ofemployee stock options and no tax deduction to the company.Taxes upon Exercise. There is a tax liability to the grantee and a tax deductionavailable to the company upon the exercise of employee stock options. That taxliability and tax deduction equals a percentage of the "intrinsic value" of theoptions.Taxes upon Sales after exercising. Any gains or losses that are achievedsubsequent to the exercise of employee stock options are capital gains orlosses. 36
  35. 35. .Taxes upon exercise of employee stock options by certain officers and directorsmay be delayed until the stock received is sold. This possibility is pursuant toIRC Section 83(c)(3) and is very interesting. It says(3) Sales which may give rise to suit under section 16(b) of the SecuritiesExchange Act of 1934 So long as the sale of property at a profit could subject a person to suit under section 16(b) of the Securities Exchange Act of 1934, such person’s rights in such property are— (A) subject to a substantial risk of forfeiture, and (B) not transferable. (4) For purposes of determining an individual’s basis in property transferred in connection with the performance of services, rules similar to the rules of section 72 (w)shall apply. This means that for officers and directors, tax liability on stock received from the exercise of employee stock options occurs when the stock is sold. 37
  36. 36. .How are the gains and losses treated for tax purpose if aperson sells calls or buys puts while holding recently vestedESOs with an exercise price of $50 while the stock is tradingat $75?We give the answer by using an example:Assume that on April 18, 2012, you are not an officer or director and hold 10,000vested ESOs to buy your company stock at $50 per share which is now trading at$75. The value of the ESOs would be equal to about $350,000 (i.e. $250,000 in"intrinsic value" and $100,000 in "time value"). Assume you then sell 60 calls withan exercise price of $80 that expire Jan 2014 or 21 months from the day of sale.Assume that the value is about $1350 per call making the 60 calls sell for $81,000.You have reduced the delta risk by about 35% and reduced the daily erosion riskabout 100%. The calls will trade for higher prices than the "fair value" of theEmployee Stock Options with the same exercise price and expected time toexpiration including the "time value" and the "intrinsic value". 38
  37. 37. .There is no tax on the opening position. My view is that the two positions, (i.e. thesale of the 60 calls and the 10,000 Employee Stock Options) are not offsetting asdefined in Section 1092. Even if the positions were offsetting as defined in Section1092, any losses liquidated from buy back of calls, or expiration and assignment ofcalls are deductible currently as short term capital losses since ESOs never have a"fair market value" and never have an "unrecognized gain" which otherwise mightbe used to delay the liquidated losses on the call selling transactions. My view isthat any liquidated gains on the sale of the calls are short term capital gains whenclosed and reportable currently.This treatment provides a manner in which the income taxes from the ESOs can bedelayed to near expiration day, and any gains on the calls can be delayed toexpiration day of the calls. But liquidated losses from the call sales (if there arelosses) can be deducted currently as short term capital losses.If the employee wanted protection from extreme moves of the stock, he/she couldbuy puts in an IRA and reduce the number of calls sold and achieve additional taxadvantages. 39
  38. 38. Dynamic Employee Stock Options A New Design for Employee Stock Options 40
  39. 39. "Options were poorly structured, and, consequently, they failed toproperly align the long-term interests of shareholders and managers,the paradigm so essential for effective corporate governance. Theincentives they created overcame the good judgment of too manycorporate managers.” Alan Greenspan 41
  40. 40. The topic of this presentation is most relevant today as there are structuralproblems with the traditional employee stock options. Traditional options by theirnature prevent effective long term alliances between employees and shareholderslargely because of the risk-averse attitudes of the employees and their interest inreducing that risk.Unless the employees, managers or executives are willing to use hedging strategiesinvolving selling exchange traded calls or buying exchange traded puts on companystock, their only choice to reduce risk is by early exercises and sell stock, andperhaps diversify the net after tax proceeds.This strategy of making early exercises is so highly penalized in most cases oftraditional ESOs that it is unwise in all but rare cases to use the strategy. 42
  41. 41. Is there a way to design employee stock options to make themmore effective in accomplishing the goals for which they werecreated?Before we can answer that question, we must state the goals. The goals are to:A. Align the interests of the managers, officers and directors with the interests of theshareholders by making the value of their equity compensation dependent on anincrease in value of the company shares.B. Attract and Influence high quality employees to be loyal long term employees.C. Preserve and increase the cash position of the company.D. Encourage early cash flows to the company from the early payment of theexercise price and the tax credits upon exercises.E. Allow for the efficient management of the granted options by the grantees.F. Maintain the theoretical costs of the plans to a modest level. 43
  42. 42. How well do Traditional ESOs accomplish those goals ?A. The traditional ESOs do align the employee/executive with shareholders duringthe vesting periods and after vesting as long as the employee/executive holds theESOs and they understand the values and risks of the ESOs.B. Company cash is preserved and indeed additional cash flows are generated byany early exercises (which are encouraged by the company and the options holdersadvisers through their promotion of the premature exercise, sell stock and diversifystrategy).C. The traditional ESOs because of vesting requirements, non-transferrability andnon-pledgeability make it difficult for risk-averse grantees to efficiently managetraditional ESO positions. Premature exercises after vesting require penalties to thegrantees in the form ofa) a forfeiture of the remaining "time value" which is quite high when volatility isreasonably high and b) an early payment of taxes.D. Early exercises, usually followed by sales of stock cause an early termination of100% of the grantee/company alignment and long term incentives from those ESOs.E. Theoretical expenses against earnings are moderate, given the restrictions,although "fair values" on the grant day are often understated by the company. 44
  43. 43. What are Dynamic Employee Stock Options?Dynamic Employee Stock Options are Options whereby the settlement of theexercises consist of the purchase of less than 100% of stock (perhaps 75%) pluspayments in the form of new ESOs with new 10 year maximum expiration andcurrent market prices as the exercise prices.The exact value and number of new ESOs is determined by a formula whichincludes a percentage (perhaps 25%) of the full intrinsic value of the options uponexercise plus the recovery of the otherwise forfeited remaining "time value" in100% of the options. Exercising Dynamic ESOs results in the "fair value" of theresulting combination of stock and options being equal to the "fair value" prior tothe exercise. However, the exercise will cause a tax liability on 75% the intrinsicvalue of the options. No "time value" is forfeited although a partial penalty for anearly tax payment is incurred.The following ESO plan goals are enhanced(see next slide) 45.
  44. 44. A. A substantial alignment of interests is extended past the exercise and sale ofstock as the grantee still will hold substantial new ESOs.B. Company cash is preserved and earlier cash flows will come to the companysince the employee will likely exercise earlier. The two penalties of early exercises (i.e. forfeiture of "time value" and an early tax payment) by the grantee aresubstantially eliminated. The grantee, therefore will likely exercise much earliercausing more and earlier cash flows to the company.C. Efficient risk management of the grants by the grantee is facilitated since most ofthe penalties of early exercises of traditional ESOs are eliminated. The stock can besold and hedging will not be necessary.D. The theoretical costs to the company of the Dynamic ESOs are about 3.5%greater than traditional ESOs.E. Even the job of the wealth manager becomes much easier as he can not beaccused of mismanaging the ESOs. 46
  45. 45. The terms of the settlement of the exercise could be thefollowing.For example: Upon exercise, grantee receives 75% (rather than 100%) of the stockat the exercise price plus new ESOs with new 10 year expiration dates and marketvalue exercise prices.The "fair value" of the new ESOs would equal the sum of a) + b):a) 25% of the "intrinsic value" of the exercised ESOs that would have beengained on a traditional ESO exercise, plusb) the amount of the remaining "time value" otherwise forfeited to the companyupon early exercise of 100% of the employee stock options.The receipt of 75% of the stock could be changed by the company to receipt of 60%or 80% of the stock at the exercise price, which will change the 25% of new optionsto 40% or 20%.The grantee would receive new options equal to 40%, 25%, or 20% of the full"intrinsic value" plus the return of the otherwise forfeited "time value" in new options.The plan could give the choices of the percentages of stock received tothe grantee or pre-determined by the company. 47
  46. 46. The following two slides are familiar graphs. They illustrate among other things,the value of the "time premiums" (i.e. time value) and "intrinsic values" and howthey change with different volatilities and different prices of the stock at differenttimes.The slides also show the net take home amounts after tax for traditional ESOsexercised, assuming a total tax of 40%.The companies will take the "intrinsic value" as a tax deduction upon theexercise.Dynamic ESOs will have different results. The grantee gets less stock uponexercise than with the TESOs but the grantee gets a new load of new DESOs.The tax deduction to the company will be reduced. 48
  47. 47. Let us assume that the 1000 vested ESOs in the slides were Dynamic ESOs witha 75/25 split upon exercise with the stock at various prices and various timesremaining. First we use the .30 volatility graphsA. Employee exercises when the stock is trading at $30 with 5.5 years expectedtime to expiration. The results are: the employee receives 750 shares for apurchase price of $20 and receives new ESOs with an exercise price of $30 with 10years to expiration. The new ESOs have a value of $2500 from 25% of the "intrinsicvalue" plus $6114 of "time value" = $8614.He would receive 720 new ESOs, which are valued at $8614. The "fair value" of thepackage upon exercise, that the employee receives is $7500 in intrinsic value +$8614 in new options value. Which equals the exact value the employee had priorto exercise.B. If the employee waited until the stock increased to $50 to exercise and therewere 3.5 expected years to expiration, he would again receive 750 shares at $20and new DESOs as follows. The new options value is $7500 (i.e. $30 x 2500) plus$3368 of "time value" = $10,868, giving 530 new ESOs with an exercise price of $50with 10 years maximum life.The full value that the employee receives is $22,500 in "intrinsic value" plus $10,868in new ESOs, which equals exactly the value prior to exercise ($33,368). 51
  48. 48. If the assumptions in the block of the second graph (slide 11) where a .60 volatilitywas used, then the "fair value" after exercise would be the same as the "fair value"prior to exercise, which are greater than the "fair values" when we assumed the .30 volatility.For example. Assume that the stock was trading at $40 with a .60 volatility whenthe DESOs were exercised and the split was 75/25. The grantee would receive750 shares purchased at $20, plus new options with an exercise price of $40 with10 years maximum life and 6.3 years expected life. The grantees value is $15,000in receiving 750 shares 20 points below market, plus $5000 in new options value,plus the "time value" of $6460 returned in the form of new options. The total is$26,464 in value. The $11,460 would equal 521 new options.The only penalty for early exercise is that there is an early tax required on the"intrinsic value" (i.e. $15,000) received in stock. 52
  49. 49. Exercise of Vested 1,000 DESOs with 75/25 Split 1 2 3 4 5 6 7 8 9 Stock ….Ex ..…Vol.....Expected...Time value...25% of…Colum….Total New...Tot. Intri. Val. Price….Price…….......Time to exp...Remain...Intrin.Val… 5+6.....Options. Rec...Stock Rec.-----------------------------------------------------------------------------------------------------------------------------$30.….. $20…....30…....5.5 years……$6114...…$2500......$8614….....700...........$7500$40…....$20…....30……4.5 years…….$4526…..$5000…..$9526….….580........$15,000$50…….$20……30……3.5 years……$3368…..$7500.....$10,868 …...530.........$22,500$60…….$20……30……2.5 years……$2372…$10,000…$12,372……503........$30,000$30. …..$20…....60....…5.3 years…….$9300…..$2500….$11,800……715...........$7500$40.…...$20…....60……4.3 years…….$6460…..$5000….$11,464……521.........$15,000$50...….$20…….60……3.3 years…....$4740…..$7500….$12,240……445.........$22,500$60...….$20…....60……2.3 years…….$2670...$10,000….$12,670…...384.........$30,000The options with a .30 volatility assume an interest rate of 5%The options with a .60 volatility assume an interest rate of 3%The amount of stock received upon exercise is 750 shares for a cost of $20 per share.All new ESOs have an exercise price equal to the market price and 10 years maximum life.Column 7 equals the total value of the new ESOs in each case. Column 9 shows the amount before tax 53
  50. 50. To further reduce the gaming of the timing of the sales of the stockreceived from the exercise of the DESOs, the company wouldcompare the sales price with the average closing prices of the stockfor the 30 business days following the sales. If the sales price isgreater than the average, then the difference is returned to thecompany. The difference can never be greater than the intrinsicvalue received from the exercised optionsTo reduce the gaming of the grant day exercise prices, the companywould take the average closing prices of the 21 business daysfollowing the grant day and make the exercise price equal to thehigher of the two. 54
  51. 51. ConclusionIt has been estimated that there are 10 million employees in the U.S whoreceive employee stock options yearly and millions more worldwide.Very few of those employees, executives or their advisers understand thenature of, the value of, the risk of losing that value or the proper ways tomaximize that value, reduce risk and delay taxesIt is hoped that this short book will increase those numbers. 55

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