Equity Compensation Advisor

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.

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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.

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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.

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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.

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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