Equity Compensation Advisor

The Uniqueness of Stock Options

Unlike any other type of investment, Stock Options have three unique characteristics that set them apart from the crowd.

1.   Rapid Appreciation
Stock Options have tremendous upside potential.  In general a stock option may appreciate more than the underlying stock it represents.  For example, a 25% increase in the value of the stock may result in a 40% or 50% (+) increase in the option value.  As the stock appreciates, the options will normally appreciate at a faster rate.

The main reason for this rapid appreciation is due to the inherent leverage that options have.  This leverage is not necessarily a bad thing but it does create more volatility.

2.  DownsidePotential                                                                                                                                                                                                                       Just as important to realize that options have rapid appreciation, it is important to remember that the opposite is true with the drop in value.  A 25% drop in the value of the stock could result in a 50% or more drop in option value.  In fact, I have seen scenarios where a 40% drop in the stock price eliminated the entire value of all the options.

3.  Illiquidity
Holders of employee Stock Options do not have the liquidity of individual stocks.  The first liquidity event may not be for several years until the options vest.  Once the options vest, they become liquid, assuming that the price is above the original grant price.

Timing is important.   As discussed in last week’s blog, options have an expiration and it is a race against time when determining when/how/amount to exercise.

When analyzing their portfolios, the option holder needs to be aware of the tremendous risk that options have, especially if they represent a large percentage of their portfolio.

Dan’s Moral: Understanding the volatility (up and down) is critical to managing wealth.

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For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and view Dan’s profile on Linkedin http://www.linkedin.com/in/danlangworthy

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Simply stated, there are two components that make up the value of a stock option.  In order to better understand the value of stock options we need to become familiar with these two components referred to as the intrinsic value and the time value.
Breaking it down to the next level, we  define the intrinsic value as the difference between the current stock price and the exercise price.

For example:   Let’s examine the event of 5,000 stock options issued at $25 per share.  At the time of exercise, the  current price of the stock is $40 per share, thus, putting the intrinsic value at $75,000 (($40-$25) X5000).  This factor is often referred to as the bargain element.
Progressing along to the time value of the option, we can represent that the time value is the value based on the potential increase in the stock, between now and the expiration of the option.  Keep in mind that in general, most options have a life of 10 years.  The longer the option has until expiration the greater the time value.   Furthermore,  the time value will continue to diminish over time and at expiration the time value becomes zero.
When we tie it all in together, it is  important to remember that the time value of an option can vary drastically depending on the expiration, as well as the volatility.
Dan’s Moral:  The value of stock options can be worth more than the intrinsic value.  Be careful not to be discouraged by the current cash-in-value (intrinsic value) of your options as the overall value when including the time value may be much higher.

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For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and view Dan’s profile on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

As a follow-up to my last blog about the large tax implications from exercising nonqualified stock options (NQSOs), let’s look at converting the bargain element of incentive stock options (ISOs) into long-term capital gains.

Except in rare situations, exercising ISOs will produce the same or better tax result, taking AMT (alternative minimum tax) into account.

Here are the tax benefits for ISO holders:

1. At the time the options are exercised, there is no regular income tax.
2. If the shares are held long enough to avoid a disqualifying disposition¹, any profit from the exercise will be taxed as long-term capital gain.
3. The bargain element from exercising ISOs or selling shares later is not subject to income tax withholding or social security tax.

An option holder who exercises ISOs and holds the shares for a year or more after exercising them will be subject to AMT on the bargain element regardless of the stock price. 

Obviously, the risk associated with ISOs is being subject to AMT in the calendar year of exercise, then holding the shares beyond the calendar year in which they were exercised to obtain the long-term capital gain rate—only to see the stock drop before the one-year holding period ends. As mentioned in an earlier blog, one way to reduce the risk is to reduce the holding period in the year after exercise, i.e., exercise ISOs early in the year so shares can be sold by December 31 to eliminate the AMT liability.

Dan’s Moral: Timing is everything when exercising ISOs, then holding and selling shares to reduce the tax liability by more than 50%.

¹Disqualify disposition: In order for the option holder to avoid a disqualifying disposition they must meet both of the following requirements:

1. No disposition within two years of grant date;
2. No disposition within one year after the shares are transferred (exercised).

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

I recently met with a client who had stock options in Praxair (PX). He called because the options were nearing expiration, and these were the only options he had received from the company.  He wasn’t familiar with how options work, so I explained some of the basics.  His biggest misunderstanding was in the taxability of his non-qualified stock options (NQSQs).  He was granted these options in 2001 when the stock was trading under $20/share. After a 2-for-1 split in 2003, the stock is now trading at over $90/share and he was looking at a large tax bill. 

For NQSOs the bargain element (gain) in options is taxed as ordinary income.  The price of the stock at the time of exercise becomes the new basis of the stock if it is exercised and held, and the holding period also starts on the day of exercise.  Whether the shares are held or sold immediately (cashless exercise), the bargain element will be subject to income tax withholding (federal, state, social security and Medicare).  The amount of this withholding can exceed 40%, resulting in less liquidity than expected.

The tax treatment for Incentive Stock Options (ISOs) gives the executive the ability to convert the bargain element into long-term capital gains—the topic of my next blog.

 Dan’s Moral:  Know the tax implications of the options before they are exercised.

Daniel Langworthy does not provide tax advice.  Please consult a qualified tax advisor.

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In my last blog, I discussed how the “AMT Buffer” can allow the executive to exercise incentive stock options (ISOs) without incurring any regular income tax or alternative minimum tax. In this blog, I will show how to determine the number of ISO Shares to sell to use up the AMT Buffer amount.

To find out how many ISO Shares can be exercised without increasing additional tax, we need to know the following three things:

1. AMT Buffer: Difference between the regular tax and the tentative minimum tax (TMT)— discussed in most previous blog.
2. Effective AMT Rate: Depending on income levels, the effective AMT rate can be substantially higher (up to 35%) than the nominal rate (26%-28%), because the AMT exemption is being phased out. One the income threshold is reached, the AMT exemption phases out at the rate of .25 for every dollar of added income.
3. Bargain Element Per Share: Difference between the current stock price and the exercise price. For example, if the ISOs have an exercise price of $25/share and the current stock price is $40/share, the bargain element is $15/share.

With these three pieces of information, we can determine how many ISO shares to sell as follows:

        I.            Divide the AMT Buffer by the effective AMT rate to find the dollar amount of AMT income based on the AMT buffer. For example, if the AMT buffer is $15,000 and the effective AMT rate is 28%, divide $15,000 by 28% ($53,571). This is the amount that can be added to AMT income without increasing the tax.

      II.            Divide the amount from above ($53,571) by the bargain element per share to determine how many ISO shares can be exercised without incurring any tax liability. If the bargain element per share is $15 and the AMT buffer is $53,571, we could exercise 3,751 ($53,571÷$15) shares without incurring any tax liability.

Dan’s Moral: AMT buffer is the secret to exercising the right number of ISO shares to avoid additional tax.

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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.