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New Design of Employee Stock Options


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This presentation shows a new design for employee stock options, which improves every element. It helps the company, the employee/grantee and makes the management of those concentrated positions easier for the Wealth Manager.

John Olagues

Published in: Business, Economy & Finance
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New Design of Employee Stock Options

  1. 1. A New Design of Employee Stock OptionsJohn Olagues504-875-4825 or 504-428-9912olagues@gmail.com
  2. 2. "Options were poorly structured, and, consequently, theyfailed to properly align the long-term interests ofshareholders and managers, the paradigm so essential foreffective corporate governance. The incentives they createdovercame the good judgment of too many corporatemanagers.” Alan Greenspan
  3. 3. The topic of this presentation is most relevant today as there arestructural problems with the traditional employee stock options.Traditional options by their nature prevent effective long term alliancesbetween employees and shareholders largely because of the risk-averse attitudes of the employees and their interest in reducing thatrisk.Unless the employees, managers or executives are willing to usehedging strategies involving selling exchange traded calls or buyingexchange traded puts on company stock, their only choice to reducerisk is by early exercises and sell stock, and perhaps diversify the netafter tax proceeds.This strategy of making early exercises is so highly penalized in mostcases of traditional ESOs that its unwise in all but rare cases to use thestrategy.
  4. 4. Is there a way to design employee stock options to makethem more effective in accomplishing the goals for whichthey were created?Before we can answer that question, we must state the goals.The goals are toA. Align the interests of the managers, officers and directors with theinterests of the shareholders by making the value of their equitycompensation dependent on an increase in value of the companyshares.B. Attract and Influence high quality employees to be loyal long termemployees.
  5. 5. C. Preserve and increase the cash position of the company.D. Encourage early cash flows to the company from the early payment ofthe exercise price and the tax credits upon exercises.E. Allow for the efficient management of the granted options by thegrantees.F. Maintain the theoretical costs of the plans to a modest level.
  6. 6. How well do Traditional ESOs accomplish those goals ?A. The traditional ESOs do align the employee/executive withshareholders during the vesting periods and after vesting as long asthe employee/executive holds the ESOs and the grantees understandthe values and risks of the ESOs.B. Company cash is preserved and indeed additional cash flows aregenerated by any early exercises (which are encouraged by thecompany and the options holders advisers through their promotion ofthe premature exercise, sell stock and diversify strategy).
  7. 7. C. The traditional ESOs because of vesting requirements, non-transferability and non-pledgability make it difficult for risk-adversegrantees to efficiently manage traditional ESO positions. Prematureexercises after vesting require penalties to the grantees in the form ofa) a forfeiture of the remaining "time value" which is quite high whenvolatility is reasonably high and b) an early payment of taxes.D. Early exercises, usually followed by sales of stock cause an earlytermination of 100% of the grantee/shareholders alignment and longterm incentives from those options.E. Theoretical expenses against earnings are moderate, given therestrictions, although "fair values" on the grant day are oftenunderstated by the company.
  8. 8. What are Dynamic Employee Stock Options?Dynamic Employee Stock Options are Options whereby thesettlement of the exercises consist of the purchase of less than 100%of stock (perhaps 75%) plus payments in the form of new ESOs withnew 10 year maximum expiration and current market prices as theexercise prices.The exact value and number of new ESOs is determined by a formulawhich includes a percentage (perhaps 25%) of the full intrinsic valueof the options upon exercise plus the recovery of the otherwiseforfeited remaining "time value" in 100% of the options. ExercisingDynamic ESOs results in the "fair value" of the resulting combinationof stock and options being equal to the "fair value" prior to theexercise. However, the exercise will cause a tax liability on 75% theintrinsic value of the options. No "time value" is forfeited although apartial penalty for an early tax payment is incurred.The following ESO plan goals are enhanced(see next slide).
  9. 9. A. A substantial alignment of interests is extended past the exerciseand sale of stock as the grantee still will hold substantial new ESOs.B. Company cash is preserved and earlier cash flows will come to thecompany since the employee will likely exercise earlier. The twopenalties of early exercises (i.e. forfeiture of "time value" and an earlytax payment) by the grantee are substantially eliminated. The grantee,understanding the minor penalties, will likely exercise much earliercausing more and earlier cash flows to the company.C. Efficient risk management of the grants by the grantee is facilitatedsince most of the penalties of early exercises of traditional ESOsare eliminated. The stock can be sold and hedging will not benecessary.D. The theoretical costs to the company of the Dynamic ESOs areabout 3.5% greater than traditional ESOs.
  10. 10. The terms of the settlement of the exercise could bethe following.For example: Upon exercise, grantee receives 75% (rather than 100%)of the stock at the exercise price plus new ESOs with new 10 yearexpiration dates and market value 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 havebeen gained on a traditional ESO exercise, plusb) the amount of the remaining "time value" otherwise forfeited to thecompany upon early exercise of 100% of the employee stock options.
  11. 11. The receipt of 75% of the stock could be changed by thecompany to receipt of 60% or 80% of the stock at the exerciseprice, which will change the 25% of new options to 40% or20%.The grantee would receive, in total, new options equal to 40%,25%, or 20% of the full "intrinsic value" plus the return of theotherwise forfeited "time value" in new options. Thepercentages would depend on how much continued alignmentis sought after exercise.The plan could give choices of the percentages of stockreceived to the grantee or pre-determined by the company.
  12. 12. The following two slides are familiar graphs. They illustrate amongother things, the value of the "time premiums" (i.e. time value) and"intrinsic values" and how they change with different volatilities anddifferent prices of the stock at different times.The slides also show the net take home amounts after tax fortraditional ESOs exercised, assuming a total tax of 40%.The companies will take the "intrinsic value" as a tax deduction uponthe exercise.Dynamic ESOs will have different results. The grantee gets lessstock upon exercise than with the TESOs but the grantee gets a newload of new DESOs. The tax deduction to the company will bereduced.
  13. 13. Let us assume that the 1000 vested ESOs in the slides were DynamicESOs with a 75/25 split upon exercise with the stock at various pricesand various times remaining.First we use the .30 volatility graph.A. Employee exercises when the stock is trading at $30 with 5.5 yearsexpected time to expiration. The results are: the employee receives750 shares for a purchase price of $20 and receives new ESOs withan exercise price of $30 with 10 years to expiration. The new ESOshave a value of $2500 from 25% of the "intrinsic value" plus $6114 of"time value" = $8614.He would receive 720 new ESOs, which are valued at $8614. The "fairvalue" of the package upon exercise, that the employee receives is$7500 in intrinsic value + $8614 in new options value. Which equalsthe exact value the employee had prior to exercise.
  14. 14. B. If the employee waited until the stock increased to $50 to exerciseand there were 3.5 expected years to expiration, he would againreceive 750 shares at $20 and new DESOs as follows. The newoptions value is $7500 (i.e. $30 x 250) plus $3368 of "time value" =$10,868, giving 530 new ESOs with an exercise price of $50 with 10years maximum life.The full value that the employee receives is $22,500 in "intrinsicvalue" plus $10,868 in new ESOs, which equals exactly the valueprior to exercise ($33,368).
  15. 15. If the assumptions in the block of the second graph (slide 14) where a.60 volatility was used, then the "fair value" after exercise would be thesame 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 .60volatility when the DESOs were exercised and the split was 75/25.The grantee would receive 750 shares purchased at $20, plus newoptions with an exercise price of $40 with 10 years maximum life and6.3 years expected life. The grantees value is $15,000 in receiving750 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 newoptions.The only penalty for early exercise is that there is an early tax requiredon the "intrinsic value" (i.e. $15,000) received in stock.
  16. 16. 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. Intr. Val. Price….Price…….....Time to exp...Remain...Intrin.Val… 5+6 ….Option. Rec..of 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
  17. 17. To further reduce the gaming of the timing of the sales ofthe stock received from the exercise of the DESOs, thecompany would compare the sales price with the averageclosing prices of the stock for the 30 business daysfollowing the sales. If the sales price is greater than theaverage, then the difference is returned to the company.To reduce the gaming of the grant day exercise prices, thecompany would take the average closing prices of the 21business days following the grant day and make theexercise price equal to the higher of the two.
  18. 18. A fuller explanation of Dynamic Employee Stock Options can be found at the following link ---------------------------------------------------------------