Equity Compensation Advisor

I recently met with a client of mine to review their overall equity awards.   It had been a while since we looked at the overall asset allocation as we have been more focused on the equity awards.

Interestingly, because of the recent rise in the stock market and specifically this executive’s company stock, I was shocked when I discovered this executive had over 50% of their net worth in company stock and options. This concentration has increased the executive’s net worth substantially, but comes with added risk.

Weighing in on the risk:  As I discussed several years ago in a white paper titled “Understanding the Risks Associated with  Concentrated Stock” the additional risk the executive is taking on is uncompensated.  In other words, holding a large percentage of one stock will not necessarily increase the shareholder’s return, but subjects them too much greater risk.  Measured by volatility, a single concentrated position can have more risk than the most aggressive diversified portfolio.

Dan’s Moral:  By holding a concentrated position in company stock, the executive is not rewarded compensation for the additional risk.

The Ups and Downs:

As discussed in last weeks blog, the new 3.8% surtax only applies to shares sold with a capital gain does not apply to the income from the exercise of non qualified stock options.  However, the federal tax rates for those in the highest tax bracket did go up and there also was an increase in the Medicare tax rates for those in the highest bracket.

TAXES… For individuals with income over $200,000 or $250,000 for joint filers the Medicare tax rate went from 1.45% to 2.35%.  This increase only applies to the income over the threshold, but due to the recent run up in the stock market executives that are exercising a lot of stock options, this may cause their income to exceed the threshold and pay more in Medicare tax.

Dan’s Moral:  Even though the Medicare care tax increase is only .9% for incomes over the threshold, it is over a 60% increase.

Each blog includes the special feature,  “Dan’s Moral”,  as a wrap-up commentary, direct from blog author, Dan Langworthy.   Check “Dan’s Moral” in other blogs on Equity Compensation Advisor by category of interest.  We hope you find what you are looking for, however, Dan welcomes your requests for new equity reward topics that may interest you.  Contact Dan Langworthy by commenting below.

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Effect of the new Surtax on investment income from exercising stock options

Fact:   Beginning January 1st of this year (2013), an additional 3.8% tax is added to the capital gains tax for couples with an adjusted gross income of more than $250,000. 

For stock options, this 3.8% surtax only applies to the shares that have been exercised and held and later sold for a capital gain.  Therefore, the surtax does not apply to the income from exercising stock options, restricted stock or restricted units.  However, the additional income that may be reported as a result of exercising options or restricted stock may potentially increase the executives compensation above the threshold that other gains would then be subject to the 3.8% surtax.

Example:   If a married couple has an adjusted gross income of $240,000 this year, of which $30,000 is from dividends and capital gains, that $30,000 in dividends and capital gains would not be subject to the 3.8% surtax because their income is below the $250,000 threshold.  However, if one of the spouses had exercised some non-qualified stock options with a bargain element of $40,000 in addition to their adjusted gross income of $240,000, their total adjusted gross income would be $280,000, subjecting the $30,000 of dividends and capital gains to the new 3.8% surtax, as a result of exercising the options.

This is a hypothetical example and is not representative of any specific investment.  This information is not intended to be a substitute for specific individualized tax advice.  We suggest that you discuss your specific tax issues with a qualified tax advisor.

Dan’s moral:  Even though stock options are not subject to the new surtax, the additional income from the exercise may increase the adjusted gross income that includes other dividends and capital gains to the surtax.

Coming up:   My next blog I will discuss the effect of exercising stock options on the new Medicare tax increase.

Each blog includes the special feature,  “Dan’s Moral”,  as a wrap-up commentary, direct from blog author, Dan Langworthy.   Check “Dan’s Moral” in other blogs on Equity Compensation Advisor by category of interest.  We hope you find what you are looking for, however, Dan welcomes your requests for new equity reward topics that may interest you.  Contact Dan Langworthy by commenting below.

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I recently read an article in Bloomberg’s BusinessWeek that discussed the SEC and executive’s selling through automatic trading plans.  The article indicated executives are using inside information to boost returns when they are selling stock through automatic trading plans i.e.10b5-1 plans.??

How does this work?  10b5-1 plans were created as an automatic trading platform that allows executives to sell company shares without triggering insider-trading charges.

In order to qualify as 10b5-1 plan the executive must meet three requirements:
• They can not initiate the plan when they have significant non-public knowledge about the company,
• They need to indicate specific dates or prices when they will sell their shares.
• They must give up the control of the shares to a broker.

How does the SEC feel??  By giving the executives of flexibility to end the plans before they are fully executed or to set up multiple short-term plans it may question the SEC’s original intent to sell shares without triggering insider-trading charges. These recent findings have prompted the SEC to undertake a more detailed analysis of the 10b5-1plans with potentially making them more strict without the level of flexibility that is currently offered in 10b5-1 plans.??Dan’s moral: Adhering to a strict 10b5-1 plan may allow the executive to continue to sell the shares without scrutiny by the SEC.

Dan’s moral: Adhering to a strict 10b5-1 plan will allow the executive to continue to sell the shares without scrutiny by the SEC.

Each blog includes the special feature,  “Dan’s Moral”,  as a wrap-up commentary, direct from blog author, Dan Langworthy.   Check “Dan’s Moral” in other blogs on Equity Compensation Advisor by category of interest.  We hope you find what you are looking for, however, Dan welcomes your requests for new equity reward topics that may interest you.  Contact Dan Langworthy by commenting below.

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Normally, when an option is granted to an executive, the exercise price is the same as the stock price on the date of grant.  However, with the downturn in the market in the previous years, some companies have issued options that are below the current market value of the stock.

Example:  An executive receives an option to buy 5000 shares of stock at $25/share.  At the time the option was issued the stock price was $40/share.

While this is rare, it occasionally does happen.

The Question is:   What are the tax implications to the executive upon issue date?

The Answer is:  Surprisingly, in this example there is no taxable event at the time the option is granted, even though there is a built-in bargain element of $75,000.

What does this mean for taxes?  The tax law does allow for the executive to receive the option that is in the money without reporting any income, assuming the option is not too deep in the money.  There is no specific tax rules on what definition of how “deep” in the money and option can be without triggering a tax implication when the option is granted.  Ultimately it is up to the accountant to determine when the option  is so deep in the money that it needs to be reported for tax purposes.  In my opinion  an  option that has an exercise price at least 50% of the current stock valuable should not be taxable at the time the option is granted.

This is a hypothetical example and is not representative of any specific investment.  This information is not intended to be a substitute for specific individualized tax advice.  We suggest that you discuss your specific tax issues with a qualified tax advisor.

Dan’s Moral:  If the option agreement indicates that the grant of an option may be a taxable event when granted, more research is needed.

Each blog includes the special feature,  “Dan’s Moral”,  as a wrap-up commentary, direct from blog author, Dan Langworthy.   Check “Dan’s Moral” in other blogs on Equity Compensation Advisor by category of interest.  We hope you find what you are looking for, however, Dan welcomes your requests for new equity reward topics that may interest you.  Contact Dan Langworthy by commenting below.

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As I had indicated in my last Blog (Part 3),  in this, our final blog of the Series “Is it Time” I would like to discuss intrinsic value and time value, by using a specific example from an executive that I have recently worked with.

Lets talk Intrinsic Value and Time Value! 

As I had mentioned in the past, the intrinsic value of an option is the amount that exceeds the exercise price of the option.  For example:   If the exercise price of an option is $25/share and the stock is trading at $40/share the intrinsic value is $15/share, times the number of shares being exercised.

The time value of an option is the theoretical upside potential of the option going up in value due to the price of the stock going up. As I have mentioned in past blogs,  the further away and option is from expiration the greater the time value.
These two values combined, make up what is referred to as the Black Scholes value or the total value of an option.

In my previous blog, I had used an example using the profit percentage which only factors in the intrinsic value. While the time value is not a value that can be cashed out, it needs to be factored in when deciding “is it time” to exercise.

Example:

In a recent analysis of a company executive, we determined he had  several different options that were issued over the past 10 years, of which most of them had a high intrinsic value because the current stock price was much higher than the grant price.  However, the options that were closest to expiration had the lowest time value.

In this executive’s case, the company was trading at 36.25/share and he had options that were issued in September 2003, that will expire in September 2013, with an exercise price of 12.60/share.  The time value was less than 1% of the total Black Scholes value, indicating that it was time to exercise these options.  In addition, he had some options that were issued in July 2007, with an exercise price of 20.50/share, due to expire in July 2017.  Because the options do not expire for another four years, the time value was about 15% of the Black Scholes value, indicating the executive may not need to take immediate action in exercising these options.

This is a hypothetical example and is not representative of any specific investment.  This information is not intended to be a substitute for specific individualized tax advice.  We suggest that you discuss your specific tax issues with a qualified tax advisor.

Dan’s Moral:  It is important to determine both the intrinsic value and time value in determining “is it time “when exercising options.

Each blog includes the special feature,  “Dan’s Moral”,  as a wrap-up commentary, direct from blog author, Dan Langworthy.   Check “Dan’s Moral” in other blogs on Equity Compensation Advisor by category of interest.  We hope you find what you are looking for, however, Dan welcomes your requests for new equity reward topics that may interest you.  Contact Dan Langworthy by commenting below.

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Continuing our series on “Is It Time” –  I discussed last week the time value and intrinsic value of options and  this week I will spend some time discussing “profit percentage” as a tool to help in determining if it is time to exercise options.

The profit percentage method of determining options value focuses exclusively on the intrinsic value and not the time value. The profit percentage of an option is the dollar amount of the profit/share from exercising the option, divided by the value of the stock/share.

Example:

This is a hypothetical example and is not representative of any specific investment.

As shown in the chart above, a stock with low exercise price versus the current stock price will have a high profit percentage.  The higher the profit percentage is the more attractive the option is for exercising.  An option with a profit percentage of 60% or higher may be a good candidate for exercising, even if the the option does not expire for 5+ years.  When the profit percentage of an option reaches 90% or more, the remaining time value of the option is very low regardless of when the option expires.  On the other hand, an option with less then a 20% profit percentage may be better left unexercised until closer to expiration.

Coming up:  In next week’s blog I will finish up this series by discussing both time value and intrinsic value using actual client scenarios.

Dan’s Moral: the profit percentage method is a good initial tool in evaluating the question “is it time?”

Each blog includes the special feature,  “Dan’s Moral”,  as a wrap-up commentary, direct from blog author, Dan Langworthy.   Check “Dan’s Moral” in other blogs on Equity Compensation Advisor by category of interest.  We hope you find what you are looking for, however, Dan welcomes your requests for new equity reward topics that may interest you.  Contact Dan Langworthy by commenting below.

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Continuing from last week’s blog “Is it Time to Exercise ” I think it is important to first understand the components that go into determining the value of an option.

Determining the value:  Before determining which options to exercise, it is important to understand if the options have met the necessary vesting schedule before any decision is made to exercise the options.  Vesting schedules vary from company to company but it is fairly common to see a 3 or 4 year vesting schedule.  Options issued in 2013 with a four year vesting schedule usually will have 1/4 of the options vest every year.

Once it is determined that the options have met the necessary vesting schedule, we then look at the two components that make up the total value of the options, (intrinsic value and time value).

The intrinsic value of an option is the difference between the exercise price and the current stock price multiplied times the number of shares available to exercise.

Example:  If the stock is trading at $40/share and the exercise price is $15/ share, the intrinsic value is $25 per share($40-$15).  In general, the more the  is trading above its exercise price, the more appealing it is to exercise the option.

     This is a hypothetical example and is not representative of any specific investment.

The second component in determining  the option value is the time value.  Time value, is the value that is placed on the option’s potential for future appreciation.  In other words, it is the theoretical upside potential of the options increasing in value as the stock continues to appreciate.  The more time remaining before the options expire, the greater the time value.

Also, the volatility of the underlying stock is also factor in to the time value. The greater the volatility is the greater the time value of the options.

In the next week’s blog I will give an example of using the “profit percentage” method to help in determining when to exercise stock options.

Dan’s Moral:  In evaluating stock options, it is first important to know when the shares have vested and then an  understanding both the intrinsic value and time value will aid in the decision process.

Each blog includes the special feature,  “Dan’s Moral”,  as a wrap-up commentary, direct from blog author, Dan Langworthy.   Check “Dan’s Moral” in other blogs on Equity Compensation Advisor by category of interest.  We hope you find what you are looking for, however, Dan welcomes your requests for new equity reward topics that may interest you.  Contact Dan Langworthy by commenting below.

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I recently had a detailed discussion with a human resource employee at a Fortune 500 company that revolved around educating executives about their stock options.  He shared with  me that the number one question executives ask is “When do I know when to exercise my options?”. This question is not only asked by personnel in human resources but it’s also the number one question I am asked as well. 

Is It Time?  Certainly no one can predict the future price of a company stock but understanding some of the basics that go into valuing stock options will help answer the question “Is it time?”.   I use  various types of software to help analyze stock options that help us determine the timing of when to exercise stock specific stock options.  However, the fundamentals that go into some of the sophisticated software programs can also be understood with a general understanding of how stock-option valuation works.

Coming up:  The next several blogs in this series will specifically discuss how to evaluate stock options and the factors that go into determining when is it a good time to exercise.

Dan’s Moral:  A basic understanding of stock option valuation will help in determining, “Is it time to exercise?”

Each blog includes the special feature,  “Dan’s Moral”,  as a wrap-up commentary, direct from blog author, Dan Langworthy.   Check “Dan’s Moral” in other blogs on Equity Compensation Advisor by category of interest.  We hope you find what you are looking for, however, Dan welcomes your requests for new equity reward topics that may interest you.  Contact Dan Langworthy by commenting below.

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The other day I met with an executive that had been granted various types of equity awards over the past five years. The executive organized all of the equity award agreements with the stock options and restricted stock in one large folder.  I asked him, “Tell me, do what’s know what the approximate value of all of your options and restricted stock are?”  He replied, “I have no idea.”

To this point, I proceeded to put together an overall equity award profile and organize them, first,  by the type of award and second, by maturity date.  Once we could clearly take inventory, he was shocked to realize how much the value of the options and restricted stock were.  This ultimately led him to make a decision that it was time to reduce his exposure in company stock, but more importantly, the end result will allow him to retire several years earlier than he had anticipated.

Certainly, there are many different types of strategies for tax and cash flow planning as it relates to the various types of equity awards, but at the very core is to organize all of the awards to see what the current value is.  Once the value of the awards are calculated, it is important to see when the options expire.  Finally, once the value and expiration is determined. then it is important to look at which awards to exercise/sell based on the grant price and the current Price of the stock.

Dan’s Moral: With the rapid increase in the stock market, it is important to look at the value of all of the equity awards in an organized way.

Each blog includes the special feature,  “Dan’s Moral”,  as a wrap-up commentary, direct from blog author, Dan Langworthy.   Check “Dan’s Moral” in other blogs on Equity Compensation Advisor by category of interest.  We hope you find what you are looking for, however, Dan welcomes your requests for new equity reward topics that may interest you.  Contact Dan Langworthy by commenting below.

• Please be sure to Subscribe to be automatically notified of  future published blogs.