It’s estimated that more than 10 million people in the United States are granted employee stock options (ESOs) every year, with many millions globally. And those numbers are rising.
However, the landscape has changed in recent years. There has been a shift from options toward restricted stock in the United States ever since the Financial Accounting Standards Board (FASB) in 2006 required companies to theoretically value ESOs when granted and expense the value of the grants against earnings. Prior to 2006 companies did not deduct the grants from earnings, but they did deduct the intrinsic value of the ESOs from taxable income when a grantee exercised the options. Despite this change, ESOs and a hybrid instrument called Stock Appreciation Rights (SARs) are still the dominant type of equity compensation to executives, managers and employees.
There are often concerns in connection with ESOs’ long-term effectiveness in aligning the interests of employee and employer with the resulting hoped for increases in earnings and stock prices. Claims of executive compensation abuses also are being debated. On the other hand, there are virtually no discussions about how grantees (whether executives, managers or secretaries) can manage those equity grants maximally to reduce the inherent speculative risk of holding ESOs and get the highest expected returns from those holdings. Here, we’ll illustrate how to best manage those ESO holdings to accomplish both goals.
The cost of exercise
ESOs are contracts between the company and the grantee, whereby the company has the obligation to issue and deliver a certain number of shares to the grantee at a specified price if the grantee exercises the right to purchase those shares. The specific terms of the ESO contracts are outlined in two documents: The company stock plan document and the options grant agreement. The ESOs generally have a 10-year maximum life compared with the maximum of three years for exchange-traded calls. But the grantee’s rights in the ESOs have restrictions that exchange-traded call options do not have.
After the ESOs are granted, there is a period called the vesting period, which may last from one to five years. Until the vesting period expires, the grantee cannot exercise any rights in relation to the stock options and does not yet own the ESOs.
In addition, ESOs generally never can be sold, transferred or pledged as collateral, but there typically is no prohibition against selling calls or buying puts to hedge the risks. After the ESOs are exercised and the grantee holds stock, restrictions by company contracts generally no longer apply. However, grantees holding ESOs or stock who may have non-public material information may be restricted by various Securities & Exchange Commission (SEC) statutes and rules. Officers and directors also are subject to Sections 16b and 16c of the Securities Act of 1934 even if they have no inside information.
So, given the contractual terms that apply to ESOs and some additional restrictions that officers and directors have from SEC rules, managing the positions efficiently is not a simple matter. That said, the vast majority of the millions who have ESOs have no idea of the value of their holdings, the risks of losing that value or how to manage their options. They generally are advised by wealth managers and advisers who believe the only way to manage those positions is to make premature exercises after vesting, sell the stock and invest the residual proceeds into a mutual fund or some other structured investment.
But along with this strategy comes two major penalties to the exercising grantee: 1) A forfeiture of the remaining time value, or time premium, in the options, and 2) the penalty of an early tax payment. The consequences of these penalties can be significant (see "Costs of exercising," below).
Both graphs assume an "expected time to expiration" rather than maximum contractual expiration. Both illustrate the time premium, or time value, that is forfeited on premature exercise, the approximate tax that becomes due, and the residual proceeds available for re-investment. The essential difference in the two graphs is the assumed volatility that is necessary to calculate the time value of the options. The second graph assumes 0.60 vs. 0.30 in the first. This causes substantially different time premiums.
Both graphs show the same tax payable upon exercise. There is a cost associated with paying the early tax that can be calculated using an expected return on invested funds of perhaps 5% annually.
As can be seen, there is a large amount of lost ESO value and tax liability when premature exercises occur. If a stock has a 0.30 volatility and is 100% above the exercise price of the ESOs having 4.5 expected years to expiration, the forfeited time premium equals about 39% of the take-home amount. With the higher volatility of 0.60, the forfeited time premium equals 53% of the take-home amount. Those percentages substantially are larger when the stock is less than 100% above the exercise price when exercise occurs.
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.
Qualcomm President Steve Altman filing
Apple Computer Senior Vice President Jeffrey Williams’ filing
JP Morgan CEO Jamie Dimon’s filing
John Olagues is the author of "Getting Started in Employee Stock Options" (Wiley, 2010). Email him at firstname.lastname@example.org.