Equity Compensation Advisor

In evaluating employee stock options, the Black-Scholes formula is the most widely used method. It calculates the total value of an option, which includes both intrinsic value and time value.

Intrinsic value is simply the difference between the exercise price of the option and the current stock price.  Time value is the theoretical upside potential gained by continuing to hold the option.

There are six factors used to determine the Black-Scholes value:

1. Exercise price of the option
2. Current price of the stock
3. Maturity date
4. Risk-free interest rates
5. Dividend yield of the stock
6. Volatility of the stock

There is software designed to perform the complex calculation of the Black-Scholes value involving these six factors.

Dan’s Moral: There’s more than meets the eye when it comes to calculating the value of options, so executives need to look beyond intrinsic value.

Often I am and asked, is it better to cash in my options at the time they are exercised (a cashless exercise) or to exercise and hold the stock?  To arrive at an answer, we first need to know whether the options are non-qualified or Incentive Stock Options (ISOs).  Since ISOs require a much more detailed analysis (and another blog post) to determine if it makes sense to take advantage of the special tax treatment available only to ISOs, let’s look at non-qualified options.

In the case of non-qualified options, a cashless exercise usually makes the most sense.  There’s only one economic benefit to exercise and hold shares, and that is to receive dividends.

The drawbacks to exercising and holding shares include:

• Paying the exercise price of the option requires additional capital to control the same number of shares.
• Greater risk of loss if the stock falls below the exercise price of the option.

Unless the stock is paying a large dividend or if the option has a low time value, it is generally more attractive to do a cashless exercise for non-qualified options.

Dan’s Moral: The inherent benefits of options provide an incentive to delay exercising until the executive is ready to sell the stock.

Securities offered through LPL Financial Member FINRA/SIPC