Shows what you lose when you make premature exercises of employee stock options. Thet loss from the penalties far outweigh any advantages of diversification John Olagues www.truthinoptions.net olagues@gmail.com 504-875-4825 http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470471921.html

1. Premature Exercise of Employee Stock Options What are the Penalties

2. The two slides below illustrate what amounts of "time premium" are forfeited upon early exercise of ESOs. The slides also illustrate the approximate compensation tax that becomes due upon early exercise. The first slide assumes a stock has a .30 volatility and the second slide assumes a .60 volatility. Therefore the "time premiums" are different. The intrinsic values are identical in the two slides as is the tax.

5. Some will disagree with my calculations of "time premiums" claiming they are overstated. My view is that they are accurate, because I assume that the grantees understands the nature of, and the value of the ESOs. But none will argue that the remaining "time premium", whatever it is, is not forfeited upon early exercises.

6. 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.

7. For Example: 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.

8. 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 years to expiration. Those are quite high penalties, when the small amount of net after tax proceeds is considered. Simple Hedging Strategies, which are available to most grantees, will capture the $6444 or the $8169 mentioned above. So it's your choice. Pay the penalties or not?