A cardinal rule for ESO management is to avoid the penalties of early exercise and hold the ESOs to near expiration. Thankfully, a better approach exists. To reduce risk and take profits if the stock moves up, sell long-dated exchange-traded calls or buy puts or put verticals. Buying puts and put verticals can be done in individual retirement accounts with interesting tax consequences. In short, gains are deferred or tax free and any losses are deductible.
The grantee should execute partial hedges shortly after the grants and increase the totals over time, especially if the stock runs up. The grantee will have expected returns from 40% to 80% greater than the strategy of premature exercise.
Although there are some SEC rule restraints, especially for officers and directors, those restraints can be managed effectively. That doesn’t mean even some of the best-advised executives don’t make mistakes. Examples of both the wrong and right way to manage ESOs are available in public SEC filings.
For example, this past summer, Qualcomm President Steve Altman exercised ESOs to buy 200,000 shares and immediately sold the shares (filing online). The date of the exercise was June 2, 2011. The exercise prices ranged between $34.83 and $37.29. The prices of the stock sales were $58.06 on the day of exercise. The expiration dates of the ESOs were between 2016 and 2018.
Altman’s premature exercises were made with five, six and seven years to expiration day with the stock approximately 63% above the exercise price. Let’s examine the penalties he incurred from the early exercises in the form of forfeited remaining time premium and the costs of the early tax payments. The average time value forfeited was $7.10 x 200,000 and the average cost of the early taxes was 30% of the taxes paid (that is, 40% of $22.00 x 200,000). So the penalties are $1.42 million in forfeited time premium and $264,000 for the early tax payment. The $1,684,000 in penalties are a substantial percentage of the total intrinsic value received with an exercise and immediate sale. It’s an even larger percentage of the net proceeds after paying the tax: (0.60 x 200,000 x $22) = $2,640,000.
Altman is not alone, however. Many Qualcomm executives made similar early exercises and sales with similar penalties.
On the other hand, Jeffrey Williams, a senior vice president at Apple Computer, made most of his exercises and sales when the stock was about 600% above the exercise price and with only one year to expiration (filing online).
Many other well known executives waited to the last moment to exercise and sell. Here are a few examples:
- Steve Jobs exercised 120,000 ESOs that expired on Aug. 13, 2007, on Aug. 12.
- Apple’s R. Johnson exercised 200,000 ESOs that expired Dec. 14, on Dec. 1, 2009.
- Intel’s Paul Otellini exercised 800,000 ESOs that expired on Nov. 12 on Nov. 9, 2007.
- Oracle’s Larry Ellison exercised 10 million ESOs that expired on June 4, 2009, on April 3.
- John Chambers exercised 2 million ESOs that expired on May 14, on Feb. 8, 2007. Then, on Feb. 13, Chambers exercised 1.35 million ESOs that expired on May 1.
- James Dimon exercised 1,864,400 ESOs that expired on March 27, 2010 on March 3 (filing online).
The reason these executives waited until near expiration is because they had good advice and understood that making premature exercises reduces the value of the options. Premature exercises in effect cause the remaining time premium to be forfeited back to the company and an early compensation tax occurs.
Anyone who owns employee stock options can imitate these executives and even manage the options better by reducing some of the risks inherent in holding the options by hedging the risks using exchange-traded calls and puts.
Using sales of calls and purchases of puts to reduce risk and maximize net after-tax returns for holders of ESOs is far superior to the premature exercise, sell and diversify strategy. If so, then why doesn’t everyone do it?
The reason is that the issuing company gets significant benefit from early exercises. Those benefits are:
- Premature exercises reduce the company liability to the grantee when the company receives back the forfeited time value.
- The company receives an early cash flow equal to the exercise price.
- The company receives an early cash flow that comes from the tax deduction and tax credit because the intrinsic value is a deduction upon exercise. These flows generally offer the companies better terms than would be had by new issues of stock.
Reducing risk by selling calls and buying puts denies those benefits to the company because it delays the exercises and the cash flows. So the company — and allied investment bankers — advises a strategy that benefits the company. The advisors, especially those large wealth managers with conflicts of interests, choose the route that benefits themselves and their clients.
The best way to manage your ESOs is to sell long-dated, exchange-traded, generally slightly out-of-the-money calls. Or you may wish to buy puts or put vertical spreads inside an IRA vs. your equity compensation holdings held in your own name. Establish smaller hedges early after the grants and increase the size if the stock appreciates. Last, monitor the trading activities of the chief executive officer and sell calls or buy puts when he or she is selling stock. You will achieve greater net after tax returns with less risk.