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Chapter 1
Introduction
If you are reading this book, it may be safe to assume you are a holder of ESOs, or advise others who hold them. As you will soon learn, there are choices available to ESO holders that go far beyond the traditional premature exercise plan offered by most financial advisers.
Consider for a moment an example where your ESOs have appreciated in value and you are faced with the choice to exercise them and then sell the stock, on the one hand, or hold on to the ESOs with all the associated risk in the form of possibly giving back gains resulting from the stock declining, on the other hand. Now imagine further that your financial adviserâand maybe you donât need to imagine thisâhas suggested the early exercise route, resulting in long stock positions that you will then liquidate, to lock in value, and then diversify through purchase of a basket of mutual funds. These are common choices made by many ESO holders and may be one faced by youânot surprising, given that most conventional wisdom dictates this route. Perhaps you are grappling with this question right now. There are, however, other choices available to you.
The central thesis of this book is based on the idea that ESOs have a substantial value on grant day, which is the day they are issued to the employee or executive, and that premature exercises of these ESOs should be avoided because it sacrifices that value, known as time premium or extrinsic value. Avoiding premature exercise is crucial if you plan to maximize the long-term potential value of ESOs.
When ESOs are exercised prematurely, a large portion of the value (in the form of time premium) is sacrificed to the company granting them, and another part is paid to Uncle Sam through an early tax burden. Time premium can be substantial, depending on how much time remains on the ESOs and what levels of volatility exist in the underlying stock at the time. This becomes clear in the example presented below, where the grantee, who prematurely exercised his ESOs, realized net proceeds (after taxes) of less than 50 percent of the theoretical value of the ESOs he was holding! The lost value came from two sourcesâfrom time premium forfeiture and the early exercise tax liability.
Grant Day
The day ESOs are issued to the employee or executive.
Assume that the exercise price is $20 on an ESO and that the stock price on the grant day was $20 with 4.5 years remaining until expiration. While we need to make some assumptions about volatility and interest rates, they will not alter the basic outcome. If the grantee exercises ESOs at 100 percent above the strike price (i.e., at $40), the net proceeds upon exercise of the ESOs and sale of the acquired stock (1,000 shares in this case) would be $12,000 after taxes. But the theoretical value of the options prior to exercise was $24,526. The lower value resulted from $8,000 in taxes due upon exercise and $4,526 in time premium that was forfeited, giving a total value lost of $12,526. Thus, over 50 percent of the ESOsâ value was lost due to early exercise. Yet strategies can be deployed for avoiding this, and more importantly producing a superior tax-adjusted outcome.
Clearly, delaying tax payments and capturing more of the time premium otherwise lost upon early exercise is going to make for better management of your portfolio. As you will see in this book, it is possible through use of hedging with listed calls and puts to set a floor for the expiration value price of your ESOs should they expire out-of-the-money, while at the same time you preserve potential for upside gain. This is as good as it gets with options.
Tip
Delaying tax payments and capturing more of the time premium otherwise lost upon early exercise allows you to better manage your portfolio. Through the use of hedging with listed calls and puts, it is possible to set a floor for the expiration value price of your ESOs should they expire out-of-the-money.
With the preceding example as the key objective to keep in mind, this book guides you through the steps needed to avoid the trap of early exercise. By offering the best available strategies to manage (and hedge) ESO grants, this book enables grantees to reduce risks while maximizing ESO value and keeping tax liability to a minimum.
To provide the proper background, we present a full explanation of all the essential ESO concepts, including definitions of technical terms. This is followed by contrasting ESOs with exchange-traded (i.e., listed) options, pointing out their differences and similarities. Since hedging of ESOs is done with listed options, it is necessary to get a solid feel for the basics of these often misunderstood trading vehicles.
With the necessary understanding of both ESOs and exchange traded options, youâll get introduced to the subject of ESO risk and reward scenarios, including the important issue of risk from premature exercise and early withdrawal from an IRA. This is followed by a detailed discussion of tax liability, including issues surrounding the so-called IRS Straddle Rule, the Constructive Sale Rule, the Wash Sale Rule, IRS Section 1221 and the tax implications of early exercise versus proper hedging of ESOs with exchange traded options.
The emphasis throughout this book is not on the design of the companyâs options plan or the options agreement, except to the extent that the plan impacts the grantees. That said, this is the only book that explains and promotes strategies involving the selling of exchange-traded calls and buying exchange-traded puts to manage ESO positions. Ample use of case studies using exchange-traded call and put options provides an accessible vehicle for understanding the hedging strategies that are aimed at efficiently achieving risk reduction while preserving ESO value. Whether a holder of ESOs or advisor to ESO holders, we trust you will find this book offers a valuable new way of thinking about ESOs and their potential value.
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Chapter 2
Preliminary Concepts and Definitions
Developing a plan to manage and properly hedge your ESOs requires a grounding in key concepts and terminology related to these assets. In this chapter, therefore, we begin by presenting a brief overview of the important company stock plan (CSP) and options award agreement (OAA), which form the legal framework between the options grantee and employer in terms of rights and obligations. We then provide extended definitions and explanations for related concepts, such as the grant price, expiration date, options vesting, and transferability, as well as a review of the basic components of options valuation.
The Company Stock Plan and the Options Award Agreement
The CSP is a document created by the company and generally approved by the shareholders. The CSP outlines the purposes of the plan, and is an essential part of the contract between the options grantee and the employer. The OAA, meanwhile, also is part of the options contract between the options grantee and the company granting the employee stock options. OAAs generally describe the number of options granted, the options expiration date, the exercise price, and the vesting periods and contain details of the specifics of each individual grant. We will address these concepts in more detail later in this chapter.
Did You Know?
The Company Stock Plan (CSP) is a document created by the company and generally approved by the shareholders. The CSP outlines the purposes of the plan and is an essential part of the contract between the options grantee and the employer.
For example, Googleâs 2004 CSP, among other things, describes how many common shares are subject to the plan, and sets out the nature of the options grants and the procedure for making the grants. The CSP, furthermore, sets forth who administers the plan and gives information that relates to all present and prospective participants in the CSP.
In Section 1 of Googleâs CSP, its purpose is stated, which is to âattract and retain the best available personnel for positions of substantial responsibilities by issuing various forms of equity compensation.â Section 2 of the CSP then gives a definition of an award as a general term that encompasses stock options, restricted stock, stock appreciation rights, restricted stock units, performance, and other forms of equity compensation.
Googleâs CSP refers to the related OAA, mentioning that the term (i.e., the time to expiration) of each option will be stated in the OAA and that the exercise price (i.e., the price at which the grantee has the right to buy the stock) and the waiting or vesting period will be determined by the administrator of the CSP, and refers to the form and mechanics of exercising the options and the payment of the exercise price.
Googleâs Options Award Agreement
The Google OAA gives all the detailed specifics that apply to the options granted by the company to the employees and executives. It covers the specific exercise price and other issues related to exercise rights, the total number of options granted, the vesting terms, the type of options, and the nominal expiration day. Key areas covered include early termination consequences, nontransferability, and tax obligations upon exercise. The OAA and the CSP constitute the sole contract between Google and the employee.
Grant Price
The grant price of the option is the price at which the employee or executive can purchase a specific number of shares of common stock from the company. The grant price is usually the closing market price of the stock on the day of the grant, unlike listed options, which have strike prices at standardized intervals (such as $10, $12.5, $15, $20, $25, etc.), the grant price by definition can be any price (i.e., whatever the closing price is on the day of the grant).
Sometimes if the stock declines substantially after the grant, companies may adjust the grant prices lower for executives. The grant prices of employee stock options (ESOs) have been subject to substantial controversy over the past several years as many executives have been accused of backdating grants to days when the stock was lower. There have also been claims that the stock prices have been artificially manipulated downward to accommodate grants to top executives. The grant price is also called the exercise or strike price; the latter term typically is used in reference to listed stock options.
Expiration Date
The expiration date of an option is the last day the holder of those options can exercise his or her options. For ESOs, the expiration date is often a maximum of 10 years from the date of the grant. Most ESO contracts provide a premature employment termination clause, specifying that the expiration date of options is accelerated to perhaps 60 days after termination. When making calculations of the value of the options at grant day for a companyâs cost purposes, the company will use an âexpectedâ expiration day, which is usually considerably earlier than the nominal day as specified in the OAA. There is a movement toward reducing the time to expiration used by companies because ESOs must now be expensed against earnings. A lower time to expiration assumed by the company means the ESOs have a lower theoretical value, and therefore the company shows a smaller expense. So we sometimes see companies using seven years instead of ten years to expiration. This expected time (used for cost calculations), instead of maximum contractual time to expiration, has significant valuation implications, which are explored later.
In some cases, companies such as Google assume that the expected time until expiration is three-and-a-half years when the maximum contractual time to expiration is ten years. The true value and actual costs to the company are indeed higher when 10 years is considered, and the actual ESO value to the employee/executive/grantees may be much greater than Googleâs expressed costs, in our view.
Vesting of Options
Most employee options contracts have provisions that require...
