Getting Started In Employee Stock Options E-Book

John Olagues

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: The Getting Started In Series
• Sprache: Englisch

Seitenzahl: 312

Veröffentlichungsjahr: 2010

Beschreibung

An A to Z guide for understanding employee stock options (ESOs). In Getting Started In Employee Stock Optionsauthors John Olagues and John Summa provide a full understanding of ESOs and demonstrate how to make the most of them. Page by page this author team, a highly experienced options market maker and a professional trader, share essential information that you're probably not hearing anywhere else. This book contains the keys to managing and hedging ESO opportunities in addition to important tax and valuation guidance appropriate for the highest executives to the non-officer managers and the newly arrived employee. * Examines essential ESO issues, including tax consequences, risks, and industry pitfalls * Written by an experienced pair of stock option experts * Enables employees and executives to make more informed decisions regarding their stock options grants Written in a straightforward and accessible style, Getting Started In Employee Stock Options will help protect the value of your options, help you avoid costly mistakes, and allow you to take advantage of certain friendly tax rules. Some of the world's foremost authorities on options have endorsed Getting Started inEmployee Stock Options.

Leseprobe

Table of Contents

The Getting Started In Series

Title Page

Copyright Page

Dedication

Preface

Acknowledgements

Chapter 1 - Introduction

Chapter 2 - Preliminary Concepts and Definitions

The Company Stock Plan and the Options Award Agreement

Expiration Date

Vesting of Options

Transferability

Hedging ESOs

Theoretical Value

Intrinsic Value

Time Premium

Premature Exercise

Forfeiture of Time Premium

Premature Tax Liability

Nonqualified and Qualified ESOs

Stock Appreciation Rights (SARs)

Conclusion

Chapter 3 - Options Valuation and Basic Concepts

How Options Work

Understanding Options Valuation

Other Differences between ESOs and Listed Options

The Greeks

Rate of Change of Delta Risk

Measuring Time Premium Decay Risk and Reward

Chapter 4 - Risks of Holding ESOs (Unhedged)

A Highly Risky Situation

Conclusion

Chapter 5 - Tax Consequences of ESOs

If ESOs Are Hedged, Taxes Are Less of a Concern

Other Considerations

Chapter 6 - Straddle Rule and Tax Implications of Hedging ESOs

The Straddle Rule IRS Section 1092

IRS Section 1092 as Applied to ESOs

Buying Puts as a Hedge

Conclusion

Chapter 7 - Management of ESOs and Premature Exercises

Determining Value

Conclusion

Chapter 8 - Comparison of Premature Exercises with Early Withdrawal from IRA

IRA Early Withdrawal

Conclusion

Chapter 9 - Strategic Choices for Managing Your ESOs

Unhedged Positions Strategy

Hedging with Listed Options

Chapter 10 - Basic Hedging Strategies Overview

Theta and Delta Risk Reduction

Writing Listed Calls, Buying Listed Puts, or Short Selling Stock

Buying Puts for Downside Protection

Short Selling Stock as a Hedge

Chapter 11 - Constraints on Hedging Real and Imagined

The Case against Hedging

Is Hedging Too Complicated?

Chapter 12 - Premature Exercise Pros and Cons

Early Exercise with High Costs

Chapter 13 - Putting It All Together The 7 Percent Solution

The Industry Falls Short in Optimal Management Planning

Getting Started with a Hedging Plan

Preliminary Discussion

Applying the 7 Percent Solution

In-the-Money ESOs

Chapter 14 - Does Hedging ESOs Undermine Alignment of Interests?

Stock Plus Employee Stock Options

Conclusion

Chapter 15 - Why Do Companies Want You to Exercise Prematurely?

Reasons Why Companies Like You to Exercise

Chapter 16 - ESO Hedging Case Studies

Google

Yahoo!

Apple Computer, Inc.

Chapter 17 - ESO Valuation Methods

Valuation and Volatility Assumptions

Chapter 18 - Comparing Restricted Stock with ESOs

Restricted Stock versus ESOs

Conclusion

Chapter 19 - Google Transferable Options

Implications of Transferables

Closer Analysis

Conclusion

Chapter 20 - Introducing the New World Options Plan

Google’s Attempt to Capture “Time Premium”

The New World Plan

Conclusion

Chapter 21 - Understanding Executive Abuses I

Backdating

Conclusion

Chapter 22 - Understanding Executive Abuses II

Disguised Reloading

Accounting Costs

Compared with Backdating

Conclusion

Chapter 23 - Understanding Executive Abuses III

Pumping and Dumping

Mr. Lucky’s End

Appendix A - IRS Tax Implications of Hedging ESOs under IRS Sections: 1221, ...

Appendix B - Did the SEC Encourage Backdating and Spring-Loading?

Glossary

Index

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Getting Started In Employee Stock Options by John Olagues and John F. Summa

Copyright © 2010 by John Olagues and John F. Summa. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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eISBN : 978-0-470-57079-1

To Caroline and Christine Olagues . . . . . my Beautiful Daughters, who are alwayson my mind

and my friend and helper Susan Naughton

For Kelemuaand Wondifraw Summa, two amazing and wonderful kids

Preface

Estimates have been made that there are 10 million employees and executives in the United States, and millions more worldwide, who own employee stock options (ESOs). For a significant number of these employees and executives, ESOs constitute a substantial portion of their financial assets, and thus their net worth. Since holders of ESOs do not have the choice of selling these assets in a liquid market, as one might do with exchange traded options to lock in gains or reduce potential for losses, a plan for effectively managing ESOs over the long run must become the most prudent course of action.

Yet few employees and executives holding ESOs truly understand the actual and potential value of these assets. For these individuals, this book presents both a valuable source of accurate ESO information and, most importantly, the necessary tools for managing these wasting assets. The concepts and strategies explained in this book will allow grantees (holders) of ESOs, and their financial advisors, to optimize management of ESOs, and to avoid the common pitfalls. The grantee will thus be in a better position to maximize the value of his or her ESO holdings, while effectively managing ESO risk and tax liabilities.

Employee Stock Options (ESOs)

ESOs are contracts between the employee (or grantee) and the employer (or grantor) that give the employee the right, but not the obligation, to purchase common stock from the employer for a specific price for a specified period of time. The expiration date is fixed on the grant day but may change if the employee decides to terminate or is terminated earlier than expiration. The expiration date is generally ten years from the grant date.

This book, however, differs in at least one crucial aspect from others written on the subject. In this book, the reader will find strategies fully explained, including detailed case studies, involving the selling of exchange-traded (listed) calls and buying of exchange-traded (listed) puts, which are aimed at hedging the risk of holding ESOs while maximizing their potential value. As is demonstrated throughout the book, use of exchange-traded options is the best (and only) method available for efficiently and effectively achieving risk reduction while preserving and potentially enhancing the ultimate value of ESOs.

Typically, wealth managers and investment advisors and their tax accountants will recommend as a risk reduction plan the premature exercise of ESOs and sale of stock acquired by the exercise. A profit would typically be realized with the exercise of the ESOs and the sale of the stock. An advisor would probably encourage the use of the net proceeds to diversify into mutual funds and an assortment of stocks, while perhaps keeping some stock in the company for which the grantee works. This can be a costly move.

Imagine yourself owner of Google ESOs that were granted giving you the right to purchase 1,000 shares of Google at a price (strike price) of $300. Now fast-forward two years and the ESOs are vested. You exercised and sold the stock at $650, taking the net after-tax proceeds and investing in a diversified stock or mutual fund portfolio. Your gain would look something like $350 per each share of stock, or $350,000. But you would pay 40 percent of that in ordinary income taxes, leaving $210,000 in net gains after tax.

Given the declines across the board in the past year (2008), however, you could have been down as much as 50 percent, depending on where you parked your money. Suppose your losses on the diversified investment amount to minus 45 percent. This means that your diversified investment portfolio is now worth just $115,500. The $115,500 would then represent less than 30 percent of the “fair value” of the ESOs on the day you exercised them. You paid $140,000 in compensation income tax and forfeited $36,000 of “time premium” when you early exercised. Not a pretty picture, but a move taken by many ESO holders per advice from traditional wealth managers. Had you simply held onto your ESOs and bought some puts to hedge them, however, you would have come out much better.

With some simple hedging using listed puts and calls inside or outside of an individual retirement account (IRA), you could have avoided much, if not all of the large losses from the market decline hurting your portfolio and the payment of premature taxes. Even having hedged the ESOs, you would still have had potential for large upside gains. The hedges would have offset a large degree of the unrealized losses on the ESOs resulting from declines in the market for Google stock. For example, you could have made tax-free money on the puts, which would offset losses in theoretical value of your ESOs.

The Big Picture

The difference in traditional ESO management approaches and an ESO hedging approach is like the difference between driving a 1950s auto without wearing seat belts and driving a late-model auto with seat belts on and airbags operational.

Yet the ESOs you would still hold would have potential for recovery along with additional hedging for further premium capture through call selling. The difference in traditional management approaches and a hedging approach is like the difference between driving a 1950s auto without wearing seat belts and driving a late-model auto with seat belts on and airbags operational. You should get the picture. Old fashion is more than old—it is misguided and potentially very dangerous, financially speaking.

In our view, informed ESO hedging with exchange-traded options will lead to far superior outcomes than use of any other strategy currently offered by wealth managers and financial advisors. With the publication of this first-of-its-kind book, those superior outcomes are now in reach for most ESO holders.

Acknowledgments

We would like to acknowledge the following professionals for their assistance and helpful comments: Chris Murphy, vice president of Credit Suisse, employee options and restricted stock expert; Michael Gray, CPA, employee stock options professional, writer, and past president of Silicon Valley CPAs; Ben Gordon, president of Twenty-First Securities, arbitrage and hedging expert, writer, and columnist; and Tim Leung, PhD, assistant professor in Financial Mathematics, Johns Hopkins University.

Chapter 1

Introduction

If you are reading this book, it may be safe to assume you are a holder of ESOs, or advise others who hold them. As you will soon learn, there are choices available to ESO holders that go far beyond the traditional premature exercise plan offered by most financial advisers.

Consider for a moment an example where your ESOs have appreciated in value and you are faced with the choice to exercise them and then sell the stock, on the one hand, or hold on to the ESOs with all the associated risk in the form of possibly giving back gains resulting from the stock declining, on the other hand. Now imagine further that your financial adviser—and maybe you don’t need to imagine this—has suggested the early exercise route, resulting in long stock positions that you will then liquidate, to lock in value, and then diversify through purchase of a basket of mutual funds. These are common choices made by many ESO holders and may be one faced by you—not surprising, given that most conventional wisdom dictates this route. Perhaps you are grappling with this question right now. There are, however, other choices available to you.

The central thesis of this book is based on the idea that ESOs have a substantial value on grant day, which is the day they are issued to the employee or executive, and that premature exercises of these ESOs should be avoided because it sacrifices that value, known as time premium or extrinsic value. Avoiding premature exercise is crucial if you plan to maximize the long-term potential value of ESOs.

When ESOs are exercised prematurely, a large portion of the value (in the form of time premium) is sacrificed to the company granting them, and another part is paid to Uncle Sam through an early tax burden. Time premium can be substantial, depending on how much time remains on the ESOs and what levels of volatility exist in the underlying stock at the time. This becomes clear in the example presented below, where the grantee, who prematurely exercised his ESOs, realized net proceeds (after taxes) of less than 50 percent of the theoretical value of the ESOs he was holding! The lost value came from two sources—from time premium forfeiture and the early exercise tax liability.

Grant Day

The day ESOs are issued to the employee or executive.

Assume that the exercise price is $20 on an ESO and that the stock price on the grant day was $20 with 4.5 years remaining until expiration. While we need to make some assumptions about volatility and interest rates, they will not alter the basic outcome. If the grantee exercises ESOs at 100 percent above the strike price (i.e., at $40), the net proceeds upon exercise of the ESOs and sale of the acquired stock (1,000 shares in this case) would be $12,000 after taxes. But the theoretical value of the options prior to exercise was $24,526. The lower value resulted from $8,000 in taxes due upon exercise and $4,526 in time premium that was forfeited, giving a total value lost of $12,526. Thus, over 50 percent of the ESOs’ value was lost due to early exercise. Yet strategies can be deployed for avoiding this, and more importantly producing a superior tax-adjusted outcome.

Clearly, delaying tax payments and capturing more of the time premium otherwise lost upon early exercise is going to make for better management of your portfolio. As you will see in this book, it is possible through use of hedging with listed calls and puts to set a floor for the expiration value price of your ESOs should they expire out-of-the-money, while at the same time you preserve potential for upside gain. This is as good as it gets with options.

Tip

Delaying tax payments and capturing more of the time premium otherwise lost upon early exercise allows you to better manage your portfolio. Through the use of hedging with listed calls and puts, it is possible to set a floor for the expiration value price of your ESOs should they expire out-of-the-money.

With the preceding example as the key objective to keep in mind, this book guides you through the steps needed to avoid the trap of early exercise. By offering the best available strategies to manage (and hedge) ESO grants, this book enables grantees to reduce risks while maximizing ESO value and keeping tax liability to a minimum.

To provide the proper background, we present a full explanation of all the essential ESO concepts, including definitions of technical terms. This is followed by contrasting ESOs with exchange-traded (i.e., listed) options, pointing out their differences and similarities. Since hedging of ESOs is done with listed options, it is necessary to get a solid feel for the basics of these often misunderstood trading vehicles.

With the necessary understanding of both ESOs and exchange traded options, you’ll get introduced to the subject of ESO risk and reward scenarios, including the important issue of risk from premature exercise and early withdrawal from an IRA. This is followed by a detailed discussion of tax liability, including issues surrounding the so-called IRS Straddle Rule, the Constructive Sale Rule, the Wash Sale Rule, IRS Section 1221 and the tax implications of early exercise versus proper hedging of ESOs with exchange traded options.

The emphasis throughout this book is not on the design of the company’s options plan or the options agreement, except to the extent that the plan impacts the grantees. That said, this is the only book that explains and promotes strategies involving the selling of exchange-traded calls and buying exchange-traded puts to manage ESO positions. Ample use of case studies using exchange-traded call and put options provides an accessible vehicle for understanding the hedging strategies that are aimed at efficiently achieving risk reduction while preserving ESO value. Whether a holder of ESOs or advisor to ESO holders, we trust you will find this book offers a valuable new way of thinking about ESOs and their potential value.

Chapter 2

Preliminary Concepts and Definitions

Developing a plan to manage and properly hedge your ESOs requires a grounding in key concepts and terminology related to these assets. In this chapter, therefore, we begin by presenting a brief overview of the important company stock plan (CSP) and options award agreement (OAA), which form the legal framework between the options grantee and employer in terms of rights and obligations. We then provide extended definitions and explanations for related concepts, such as the grant price, expiration date, options vesting, and transferability, as well as a review of the basic components of options valuation.

The Company Stock Plan and the Options Award Agreement

The CSP is a document created by the company and generally approved by the shareholders. The CSP outlines the purposes of the plan, and is an essential part of the contract between the options grantee and the employer. The OAA, meanwhile, also is part of the options contract between the options grantee and the company granting the employee stock options. OAAs generally describe the number of options granted, the options expiration date, the exercise price, and the vesting periods and contain details of the specifics of each individual grant. We will address these concepts in more detail later in this chapter.

Did You Know?

The Company Stock Plan (CSP) is a document created by the company and generally approved by the shareholders. The CSP outlines the purposes of the plan and is an essential part of the contract between the options grantee and the employer.

For example, Google’s 2004 CSP, among other things, describes how many common shares are subject to the plan, and sets out the nature of the options grants and the procedure for making the grants. The CSP, furthermore, sets forth who administers the plan and gives information that relates to all present and prospective participants in the CSP.

In Section 1 of Google’s CSP, its purpose is stated, which is to “attract and retain the best available personnel for positions of substantial responsibilities by issuing various forms of equity compensation.” Section 2 of the CSP then gives a definition of an award as a general term that encompasses stock options, restricted stock, stock appreciation rights, restricted stock units, performance, and other forms of equity compensation.

Google’s CSP refers to the related OAA, mentioning that the term (i.e., the time to expiration) of each option will be stated in the OAA and that the exercise price (i.e., the price at which the grantee has the right to buy the stock) and the waiting or vesting period will be determined by the administrator of the CSP, and refers to the form and mechanics of exercising the options and the payment of the exercise price.

Google’s Options Award Agreement

The Google OAA gives all the detailed specifics that apply to the options granted by the company to the employees and executives. It covers the specific exercise price and other issues related to exercise rights, the total number of options granted, the vesting terms, the type of options, and the nominal expiration day. Key areas covered include early termination consequences, nontransferability, and tax obligations upon exercise. The OAA and the CSP constitute the sole contract between Google and the employee.

Grant Price

The grant price of the option is the price at which the employee or executive can purchase a specific number of shares of common stock from the company. The grant price is usually the closing market price of the stock on the day of the grant, unlike listed options, which have strike prices at standardized intervals (such as $10, $12.5, $15, $20, $25, etc.), the grant price by definition can be any price (i.e., whatever the closing price is on the day of the grant).

Sometimes if the stock declines substantially after the grant, companies may adjust the grant prices lower for executives. The grant prices of employee stock options (ESOs) have been subject to substantial controversy over the past several years as many executives have been accused of backdating grants to days when the stock was lower. There have also been claims that the stock prices have been artificially manipulated downward to accommodate grants to top executives. The grant price is also called the exercise or strike price; the latter term typically is used in reference to listed stock options.

Expiration Date

The expiration date of an option is the last day the holder of those options can exercise his or her options. For ESOs, the expiration date is often a maximum of 10 years from the date of the grant. Most ESO contracts provide a premature employment termination clause, specifying that the expiration date of options is accelerated to perhaps 60 days after termination. When making calculations of the value of the options at grant day for a company’s cost purposes, the company will use an “expected” expiration day, which is usually considerably earlier than the nominal day as specified in the OAA. There is a movement toward reducing the time to expiration used by companies because ESOs must now be expensed against earnings. A lower time to expiration assumed by the company means the ESOs have a lower theoretical value, and therefore the company shows a smaller expense. So we sometimes see companies using seven years instead of ten years to expiration. This expected time (used for cost calculations), instead of maximum contractual time to expiration, has significant valuation implications, which are explored later.

In some cases, companies such as Google assume that the expected time until expiration is three-and-a-half years when the maximum contractual time to expiration is ten years. The true value and actual costs to the company are indeed higher when 10 years is considered, and the actual ESO value to the employee/executive/grantees may be much greater than Google’s expressed costs, in our view.

Vesting of Options

Most employee options contracts have provisions that require the employee or executive (the grantees) to remain at the company in good standing for a substantial length of time before he or she fully owns the options and has the ability to exercise the right to buy the stock. The time between the grantand when the employee or executive owns and can exercise the options is considered the vesting period. Usually, the vesting period provision allows the grantee to exercise his or her options in a manner similar to the following: 25 percent of the grant vests and is exercisable after one year; 25 percent after the second year; 25 percent after the third year; and 25 percent after the fourth year. In some cases for certain executives, there have been no vesting periods on certain grants.

Vesting Period

The time between the grant date and when the grantee owns and can exercise the options.

Transferability

Generally, ESOs cannot be sold or transferred other than upon death or divorce. This provision is part of all stock and options plans in order to prevent the grantee from selling the contract to another party, thereby defeating the intended purpose of the grant. Companies also make the options not pledgable so that the grantee cannot use the options for collateral for a loan or to deposit into a margin account to satisfy margin requirements if trading listed options. A few companies actually prohibit employees and executives from trading any puts and calls of the stock of the company. All of these restrictions lower the real and perceived value of the options granted to the grantee. What is the point in lowering the value unless it results in a substantial benefit to the company? This raises questions about the supposed alignment of interest between grantee and employer. If employers have an incentive to lower cost to raise their bottom line, then the grantee is becoming a source of that added profit.

Hedging ESOs

Most wealth managers and financial advisers avoid the subject of hedging ESOs with exchange-traded puts and calls. They refer to several reasons why the client should not hedge his or her ESOs. Even prior books that have been written on the management of ESOs do not tell the grantee how to hedge, although they may introduce the concept. What are the major objections to the hedging argument?

One of the first objections to hedging is that the company does not allow it. However, most companies do allow it, even though there are certainly some that prohibit trading puts and calls entirely.

Did You Know?

Most wealth managers and financial advisers avoid the subject of hedging ESOs altogether. But many companies allow it, so do your research. Many of those same managers and advisers recommend premature exercise of ESOs because it benefits them and the issuing company!

To find out whether a grantee is allowed to use puts and calls to hedge ESOs, the grantee has merely to check his or her CSP and OAA. If there is no prohibition in those documents, then hedging is generally allowed . Another objection is the claim that hedging ESOs defeats the purpose of the options grant: the alignment of employee interests with the stockholders. Based on the presumption of alignment, hedging is thought to reduce this commonality of interests with the stockholders. That idea may have some truth to it. But hedging may preserve some of the alignment, unless the hedger eliminates entirely the upward profit potential.

Ironically, the common practice of premature exercise of ESOs, together with the sale of the stock, eliminates the alignment of interests 100 percent. But we see no advisers claiming that premature exercise and sale eliminates alignment. Why? Because premature exercises benefit the company and the wealth manager. Wealth managers have the objective of getting assets under management. It would be an awkward moment for a wealth manager to ask for a 1.5 percent fee to tell his client to not exercise his options until expiration unless, of course, he can show the potential value added from such a recommendation—something most wealth managers do not understand well. To understand this issue, it is necessary to get a clearer picture of how options are valued.

Theoretical Value

ESOs cannot be traded, but there are some exchange-traded calls that have similar characteristics to a particular ESO. This is not to say that there are exchange-traded calls with exact characteristics as the ESOs. But traded calls can help us determine the value of ESOs, whether the ESOs were just granted or were granted five years ago. In addition, there are theoretical pricing models (Black-Scholes, Cox-Rubenstein, etc.) that have been used for over 30 years to value exchange-traded options, which can be applied to ESOs.

These models, after proper considerations for the differences between the ESOs and standard traded calls, do give, in our view, reasonably accurate values for the ESOs. The accuracy depends on the reliability of the assumptions of expected time to expiration, volatility, and interest rates that are inputs into the theoretical models. It is also reasonable to discount the value of ESOs somewhat for restrictions on the options placed by the company and securities statutes that apply to officers and directors. In 2006, the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) announced that companies are required to value the ESOs when granted and to expense against earnings the fair value at grant day when the options themselves vest.

Fast Fact

In 2006, the Financial Accounting Standards Board and the SEC announced that companies are required to value ESOs when granted and to expense against earnings the theoretical value at grant day when the options themselves vest.

So, to be consistent with generally accepted accounting principles (GAAP), firms must value the ESOs on grant day and expense the theoretical values of the ESOs as they become vested. However, when reporting earnings, companies often report just non-GAAP results, thereby effectively not expensing the options at all—a subject that has generated some controversy and concern about the real value of companies and company stock.

Intrinsic Value

Intrinsic value equals the difference between the exercise price of employee stock options and the present price of the stock, assuming that the stock is trading above the exercise price. The intrinsic value is generally zero at grant day and is always zero if the stock is below the grant/exercise price. An important but often overlooked value dimension, however, is that even if there is no intrinsic value, there is still value in the options as is recognized by FASB and the SEC and the exchange-traded markets. We call this value “time premium,” which is a very real value, although in the case of ESOs, the value is always theoretical since they do not trade. All listed options that have any time remaining to expiration and that do not have intrinsic value carry a time premium component. Even options with intrinsic value will usually have some time premium. Call options that are far out-of-the-money (strike price is above the stock price) may have tiny amounts of time premium, as do those that have become deep in-the-money (strike price is far below stock price).

An important tax concept is that the amount that a grantee would be taxed on when exercising his or her ESOs is intrinsic value, not time premium. The intrinsic value, minus an appropriate tax that is withheld, is the amount that is received by the grantee if he or she immediately sells the stock received upon exercise. The time premium is forfeited upon early exercise and, in practice, represents a lost value, yet no tax offset is allowed.

Fast Fact

The intrinsic value, minus an appropriate tax that is withheld, is the amount that is received by the grantee if he or she immediately sells the stock received upon exercise.

Time Premium

When you take the total price of an option (theoretical or actual) and subtract the intrinsic value, any remaining value is known as time premium. The time premium of an option will be value added to any intrinsic value due to remaining life of the options, whether the options are ESOs or exchange traded. The time premium may differ, however, depending on the implied or expected volatility of the stock, interest rates, and the expected time remaining until expiration.

Of course, time premium also depends on the price of the stock in relation to the exercise price of the options. The time premium is greatest on the date of grant, especially when the exercise price is the same as the current market price (considered to be at-the-money). Time premium starts to erode on the first day that the options are granted and continues daily. Most importantly, the entire remaining time premium is forfeited back to the company when premature exercises are made. It is generally unwise to forfeit time premium.

Time (or Extrinsic) Premium

The remaining value when you take the total price of an option (theoretical or actual) and subtract the intrinsic value.

Premature Exercise

Simply put, exercises of ESOs that are made sooner than they should be made are known as premature exercises. And, generally, the ESOs should not be exercised much sooner than expiration day, unless an extraordinary event takes place or a relatively large dividend is declared. Making premature exercises of ESOs not only forfeits all of the remaining “time premium” but also incurs a premature income tax that could have been delayed or avoided. Premature exercising is the primary mistake that grantees make in the management of ESOs. The premature exercise is similar to an early withdrawal from an IRA or 401(k). But premature exercises are encouraged by many wealth managers.

Premature Exercise

The exercise of ESOs with substantial time remaining until expiration.

Forfeiture of Time Premium

This is one of the very important concepts to understand if a person is going to manage his or her ESOs properly. The time premium is the value above the intrinsic value of the options and is the amount that is forfeited back to the company when a premature exercise is made. Often, the amount is a large percentage of the ESOs’ value, especially if the stock is volatile and there is substantial time to expiration.

Intrinsic Value

The value of an option represented by the amount the option is in-the-money. It becomes income to the employee when he exercises.

Premature Tax Liability

When ESOs are exercised with substantial time remaining to expiration, that is referred to as a premature exercise. When ESOs are exercised, any intrinsic value of the options is considered compensation income and becomes currently taxable to the grantee. Our view is that there is an economic value in delaying or avoiding the paying of the tax on the intrinsic value and that alternatives to premature exercise should be explored—a major theme of this book.

Nonqualified and Qualified ESOs

Most ESOs are nonqualified, so most of this book focuses on nonqualified ESOs. Qualified options offer the grantee the opportunity to have the profit on the ESOs treated as long-term capital gains. In order to have such a treatment, the grantee is required to hold the stock at least one year after exercising the ESOs. It also requires the grantee to successfully deal with the alternative minimum tax (AMT) to achieve that benefit. Our view is that the proper management of ESOs, whether nonqualified or qualified, requires the avoidance of premature exercises while reducing speculative risk and taxes.

Tip

The proper management of ESOs, whether nonqualified or qualified, requires the avoidance of premature exercises while reducing speculative risk and taxes. With this in mind, then, treat qualified ESOs similarly as you would nonqualified ESOs until expiration day approaches.

The excessive concern for qualified ESO management and the attempt to achieve long-term capital gains is overdone, while the same advisers make cardinal mistakes in other areas. We believe that the best advice is to treat qualified ESOs the same as nonqualified ESOs until expiration day approaches and the possibility of achieving long-term capital gains is examined.