Equity Compensation Advisor

Leverage is generally associated with some sort of debt against an asset: when the asset goes up in value, the investor is able to magnify their return, but when the investment goes down, it can obviously magnify the loss as well.  Executives of companies that have stock options may also be subject to leverage risk. They may have to borrow some or all of the money needed to exercise their options.  The executive may also need to borrow money to cover some or all of the tax liability for the exercise of their options.  Because of this hidden leverage, the executive may be exposed to substantially greater risk than just the high risk of their concentrated position in company stock.

Options themselves have built-in leverage that can magnify the price movement of the underlying stock.  In the last couple of years, we have seen a 30% drop in stock price result in a more than 50% drop in stock option value.

Equity Compensation Advisor’s Moral:  In evaluating a clients option portfolio, all of these factors must be taken in to account when assessing the executives overall risk exposure.

Securities offered through LPL Financial Member FINRA/SIPC

Stock Appreciation Rights (SARs) provide the holder with the right to receive cash compensation in an amount equal to the increase in value of a specified number of shares of stock. 

Although you may be thinking SARs sound like stock options, the difference is that SARs do not require the holder to come up with cash at the time of exercise.

For instance, your client receives a SAR for 5,000 shares when the stock is trading at $30/share.  Five years later when this client exercises their SAR, the stock is trading at $50/share, your client receives $100,000 (5,000 shares times the $20 increase per share).

Sometimes a company may pay a SAR in shares of stock instead of cash.  In this example, the client receives 2,000 shares of stock in lieu of $100,000. 

SARs are taxed the same as nonqualified stock options.  The holder does not report income at the time they receive the SAR or when it becomes exercisable.  They report compensation income on the amount of cash received.  If the holder is an employee, the income is subject to withholding and social security tax.  In the case of SARs that pay off in shares of stock, the holder reports compensation income equal to the value of the shares on the date the shares were transferred.

Not long ago I was working with a client who was looking to leave her current employer for another company.  She was rightfully concerned about restricted stock and stock options she had with her current employer. They had been worth significantly more the previous year and had lost value as the price of the stock dropped. 

We discussed what forfeiture value meant and how much she would be “leaving on the table” if she left the company.  The true forfeiture value is not the in-the-money value of the vested options, because she could exercise her options that had vested.  In fact, the real forfeiture value is the potential upside value (time-value) of the vested options over time and the Black-Scholes value of the unvested options.

My client’s vested in-the-money options were worth $126,000, and the forfeiture value of her options was $282,000.  This $282,000 is what she would be leaving on the table if she took the new job.  I ran an analysis that calculated the forfeiture values, which was advantageous in negotiating comparable equity awards with her new prospective employer. In this client’s case, despite the drop in stock prices over the last couple of years, all was not lost. It’s a great example of how leaving an employer doesn’t have to mean leaving value behind.

The $100,000 limitation rule for incentive stock options (ISOs) causes a lot of confusion for option holders and their advisors. Many option holders have had their ISOs disqualified for special tax treatment because they don’t understand this rule (More information about special tax treatment of ISOs can be found at http://www.executivecapitalmn/resources_andevents/white_papers.asp. Click on Avoiding nightmares when exercising ISOs).

The rule simply states that there is a $100,000 limit on the number of incentive stock options that can become exercisable in any calendar year. This limit is based on the value of the stock at the time the option is granted, not when the option is exercised. Therefore, as long as no more than $100,000 worth of granted ISOs vest in any one year, the $100,000 limit has been met.

It is helpful to set up a table for an ISO holder tracking when multiple ISO grants are issued and when they vest. Below is an example of multiple ISO grants for an ISO option holder.

Grant 1:  In 2008 $200,000 worth of ISO’s vesting 25%/year

Grant 2:  In 2009 $160,000 worth of ISO’s vesting 25%/year

Grant 3:  In 2010 $120,000 worth of ISO’s vesting 25%/year

The disqualified shares are a non-qualified option. In the above example, the executive has two different types of options in both 2010 and 2011 (an incentive stock option to buy $100,000 worth of shares and a non-qualified stock option to buy $20,000 worth of shares). Lastly, as to determining which options are disqualified, the tax law states that the options granted last are the first ones to be disqualified.

While this discussion clarifies the parameters of the $100,000 limit on ISOs, it usually leads to additional questions about tax treatment. I plan to make this the subject of many future blogs. In the meantime, feel free to email info@executivecapitalmn.com or call me at 952-886-7233.

Securities offered through LPL Financial Member FINRA/SIPC

One of my clients recently told me that another company in Minneapolis was recruiting her.  Although the courting company’s offer was quite attractive, she was rightfully concerned about walking away from a substantial number of stock options that were either underwater or had not vested.

 I explained that two components determine the value of her options– intrinsic value and time value.  Intrinsic value is the difference between the stock’s current value and the exercise price of the option.  This is sometimes referred to as the bargain element. 

Time value is the dollar value attached to potential profit derived from continuing to hold the option.  The farther away the option is from expiration, the greater the time value. 

Therefore, we calculated her forfeiture value by incorporating the time value of the vested options and the Black-Scholes value of her unvested options.  She presented her prospective employer with our calculation of what she would be leaving on the table and they offered her a similar equity package if she joined the new company. 

Equity Compensation Advisor’s Moral: Markets bounce around; all is not lost when your client leaves an employer and stock options behind.

Securities offered through LPL Financial Member FINRA/SIPC

I was curious about how executives of public companies decide to exercise their stock options?  Do they use financial logic, or do they base their decisions on the short-term price movement of the underlying stock?

A study I read examined how rational economic motives drive decisions to exercise stock options. *  Conducted by Professors Mark Lang (University of North Carolina Chapel Hill) and Steven Huddart (Penn State University), found that the majority of option holders make their exercise decisions based on the stock prices above or below their reference point (perceived value).

How are these reference points set?  The study found that they are a response to the average or extreme stock prices attained over a period of time.  For example, “I’m not going to exercise now because the stock is at $55 and last year it was at $65” or “when the stock gets to its high of $70, I’ll exercise.”

Other findings: When the stock price rose above a one year maximum, exercise activity doubled regardless of when the options expire; a 10% rise in stock price in a single week drove a 22% increase in exercise activity the following week.  The research concluded the past year’s stock price history has a strong effect on exercise behavior.  Individuals tend to focus on the one-year horizon, because the financial press typically reports the 12 month high. 

Instead of a rear view, I would encourage executives to consider the long-term prospects of their companies and base their decision to exercise options on financial logic.  After all, stock options have significant economic value that shouldn’t be sacrificed because of short-term price movement of the stock.  Yet, the NASPP’s (National Association for Stock Plan Professionals) 2007 survey revealed that 51% of participants exercise their stock options in less than 2 years even though most stock options have an expiration of 10 years.   

*The research examined 50,000 employees over a 10 year period. 

Equity Compensation Advisor’s Moral:  Basing decisions to exercise stock options on short-term stock price movement is short sighted.

Securities offered through LPL Financial Member FINRA/SIPC

With the Dow Jones Industrial now over 11,000, we have seen one of the greatest 12-month returns in stock market history.  The inherent leverage in stock options can cause tremendous valuation changes based on the movement of the underlying stock.

Below is an example of that illustrates the increase in value of a 3M executive’s options with a 20% change in the price of 3M stock, from the current price of 87.44.

Obviously the change in option value is based on several factors (exercise price, expiration, volatility of underlying stock, etc.).  As you can see, a 40% increase in the stock (87.44 to 125.91) creates over a 25% increase in the option values and a 40% decrease in the stock (87.44 to 55.96) creates over a 90% drop in option values.

With the Dow Jones Industrials up over 60% from March 2009 through March 2010, it may be time to protect one of the most leveraged investments, Stock Options.

Securities offered through LPL Financial Member FINRA/SIPC

After much prodding by a growing network of attorneys and CPAs, I’m diving into the blogosphere. My world—equity compensation and stock option awards—is wrought with complex issues that often require an uncommon depth of knowledge. As a result, I’m frequently consulted by legal and accounting professionals who want to help their clients make informed decisions about when to exercise and sell their stock option holdings. I’m always happy to share my 20 years of increasing expertise in stock option management.

The “Equity Compensation Advisor” blog will provide insights for helping public company executives optimize the value of their equity compensation portfolios (stock options, restricted stock and employee stock). However, in order to be as valuable a resource as possible, I want to address the issues you want more information about. So please feel free to ask about a specific blog post or suggest a topic. Comment below, email info@executivecapitalmn.com or call me at 952-886-7233.

To give you a flavor for the kinds of subjects I’ll be covering, here are a few:

• Payment methods for exercising options
• Minimizing tax liabilities                                                             
• Reducing concentration and overall market risks                                                
• Asset protection strategies                                                                
• Achieving independence from “golden handcuffs”
• Estate/legacy planning

Next entry: “Is it time to protect stock option gains?”

Securities offered through LPL Financial Member FINRA/SIPC