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With potential tax increases ahead, your employees have more questions and concerns about year-end planning

From: myStockOptions, ECE November 2012 Sponsor

 

With potential tax increases ahead, your employees have more questions and concerns about year-end planning.

The articles and FAQ in the year-end planning section on myStockOptions.com provide helpful guidance and education.

The articles include:

Edited Tue, Dec 4, 2012 4:16 PM

Replies to this Topic

One of the best ways to determine whether to exercise and sell your stock options is to check your "Insight Ratios" (Time Value / Black Scholes Value).  The resulting ratio illustrates the percentage of theoretic potential to intrinsic value.  For example, an Insight Ratio of 10% means that 90% of the grant's value is in-the-money.  The lower the Insight Ratio the better the case for diversifying this year rather than next when taxes are likely to increase.  For more information on the Insight Ratio visit http://blog.stockopter.com.  For an easy to calculate and monitor your Insight Ratios sign up for the Trial/Demo at www.stockopter.com.   

I'm going to change the topic slightly.  Assuming taxes are going up (where else can they go) companies can minimize their employees taxes by accelerating the vesting of their restricted shares into 2012.  Has anyone observed this in practice?  Thanks

Hi Steven,

 

Great question.  I have heard of companies considering this step, but it rubs directly against the purpose of these plans.  If the vesting date is schedule for Q1 of 2013 we might see a few of these, but otherwise I think they will be very rare.

Between the increase in Social Security, the potential increases in Ordinary Income Tax and some of the other changes, this would seem very enticing, but the downsides are likely to be to high for most companies.

 

Dan

 

Dan

 

Thanks for your response, it is consistent with what others have been telling me, as well as the lack of observations I'm finding searching SEC filings.

 

Steve

Too many legal, tax (409A is RSUs), and shareholder optics issues with accelerations in vesting. Some companies with performance share grants and cash bonuses that pay out in 2013, but are based year-end 2012 results, may look to accelerate parts of these. Even this raises issues with any changes in outstanding stock grants.

Some companies with SERPs that have choice when to calculate and collect Social Security have also looked at doing it this year.

Bruce Brumberg, Editor
www.myStockOptions.com

Dear Friends:

Here is an article about how the CEO and the CFO of Goldman Sachs managed their grants of ESOs that were granted almost ten years ago.


 
http://www.bloomberg.com/news/2012-11-29/goldman-sachs-s-blankfein-cohn-take-profits-on-options.html


 
They exercised large numbers of ESOs between 1 and 3 days prior to expiration of the ESOs. Others were exercised 30 days before expiration.


 
Why did they wait to the last minute to exercise if these top executives believed that early exercising and sell and "diversify" has merit ? The answer is that they understand the penalties of early exercises and the incidental merits of diversifying.
Below are the actual filings to the SEC for those executives:


 
----------------------------------------------------------------------------------------
Lloyd Blainkfein.... CEO Goldman Sachs
SEC Form 4
http://www.secform4.com/insider-trading/1180587.htm


Gary Cohn....CFO of Goldman Sachs
SEC Form 4

http://www.secform4.com/insider-trading/1366945.htm


 
Surely these executives got the best advice and waited as long as the options contract allowed before exercise.
With the above in mind, let's consider the merits exercising in December 2012 to avoid the possible tax increases in 2013.


 
The extra tax would apply only to grantees with taxable income above $250,000, as proposed by Obama. So if the income from the ESOs does not raise the total to above $250,000 in any future year, there is no expected increase  in taxes in future years.


 
On another point :


 
Bruce:


 
In paragraph 10 of your link you suggest short selling against the box in 2012 against appreciated stock . Short selling against the box constitutes a "constructive sale" and will cause a capital gain in 2012.

However, sales of at- the - money calls will not create a "constructive sale" and can be used against stock, restrictive stock or unexercised ESOs and ISOs. Or a holder of appreciated stock could buy puts in his IRA against his stock and designate the two positions as "identified straddles". There is no "constructive sale". Any loses on the puts raise the basis of the stock and any gains on the puts are tax free or tax deferred.


 
Bill:


 
In my view, your "insight ratio" generally overstates the remaining "time value" because it assumes that the time remaining is the maximum time to expiration rather than the expected time to expiration. It also assumes no dividend even when there is a dividend. It therefore encourages a delay in exercising the ESOs, especially when there is a substantial dividend declared and the ex-dividend day approaches. With the approach of the ex-dividend day sometimes the "time value" is zero and there is no "time value" forfeited and the only penalty is the payment of taxes early.


 
Didn't mean to be too critical, but merely adding to the discussion.

John Olagues
P.S. Does anyone have a view of the impact of "special dividends" on the management of ESOs and restricted stock by the grantee or the issuer.

 

John,

If your goal is to justify a hedging strategy by minimizing the remaining time value of an employee stock option, StockOpter.com let's users include a dividend assumption and reduce the volatility assumption as necessary.  However, you are missing the point of using the Insight Ratio to analyze and monitor employee stock options positions.  Hedging strategies may not be viable for many stock option recipients because they are difficult to comprehend and potentially risky (i.e. selling covered calls requires a margin account).  The Insight Ratio of StockOpter.com provides option recipients and their advisors with a framework for making informed decisions prior to either hedging or diversifying.

Bill Dillhoefer

 

Bill:

I believe your concept of the "Insight ratio" as a guide for making decisions is a good one. However, you should make it as accurate as possible. That means incorporating the dividend automatically and using the "expected time" to expiration rather than the maximum time to expiration. Companies generally use an "expected time" to expiration of about 60-65% of the full time to expiration as an assumption for their models in calculating expenses against earnings. Grantees should discount the full time remaining consistent with their expected longevity with the company and their expected early exercise.

If the grantee understands that early exercises sell and diversify rarely has merit, he/she would would handle his ESOs similar to how Blankfein and Cohn did (i.e. hold them to the expiration).

If grantees want to reduce the risk of holding ESOs after the value of his/her holdings have increased substantially, the ONLY Efficient way is to sell calls and sometimes buy puts. Yes to reduce the risk with calls and puts requires margin.

Thanks for the reply

John,

Including a dividend and a shortened time to expiration will lower an option's time value and Insight Ratio drastically.  If the recipient exercises and sells the option based on this information they would indeed be diversifying prematurely. 

Removing the dividend and using the actual time to expiration will enable stock option holders to judge the optimal time to take action using the Insight Ratio without the risk or complication of a hedging strategy. 

I realize you firmly believe that selling market traded calls and sometimes buying puts is the best way to manage an option position, but the Insight Ratio approach is being used by thousands of individuals annually.  How many employee stock option holders are using hedging strategies?  It's probably a much smaller number.  Why do you think that is?  Please don't say that it's because of the greedy interests of financial advisors and issuing companies.  That's nonsense.  I believe it is because the complexity of hedging surpasses the risk reduction capacity. 

I will grant you that hedging is a viable strategy for some employee stock option holders but it is definitely not the ONLY efficient way.  Monitoring an option position using the Insight Ratio in StockOpter.com is also effective and efficient. 

Let's just agree that we disagree on what is the best approach to managing ones employee stock options.

Bill:

The management of grantee ESOs or ISOs can only be done efficiently by selling appropriate exchange traded calls or buying puts or combinations of the two.

To prove what I am saying is correct, I will offer to you or anyone else a bet where I bet you $1000 to your/their $500.00 that selling calls or buying puts will return a greater after tax result in any example you can find. So put your money where you mouth is.

The reasons that so few people use the selling calls and buying put strategy are the company and the wealth managers discourages and intimidates the efficient management, because efficient management raises the costs to the company and delays AUM to the wealth managers.

 

John Olagues

John,

You bet offer intrigues me. If what you say is always true then people should know about it.

I would like to propose a different bet.  Your $1000 against a free month of ECE sponsorship and is associated direct emailing of a single article to every member.  If you lose your $1000 will go providing a $1000 Scholarship offer for the CEP Institute at Santa Clara University.

If you agree we will finalize the details for the test on April 1, 2013.  We will use an example of a real stock option grant given and reported some time in early 2013.  The measurement period will run from 4/1/2013 through 4/1/2023, with progressive results posted each quarter.

Thoughts?

Dan:

 

To be clear my proposed bet is that for people who wish to reduce risk from ESOs and ISOs holdings:

1. Selling calls and/or buying puts in a smaller number to reduce risk, will get better results than:

2. Making exercises substantially prior to expiration, selling stock and diversifying into some form of diversification( perhaps the S&P 500).

Of course we will have to pick a stock that has calls and puts traded. We also have to pick a time frame of start to finish. We will have to make assumptions of the residency and tax status of the holder.

I will be happy to agree to your suggestion. You pick a popular stock and I will pick the calls and puts to trade. We can use Bill's Insight Ratio to assist on the determination of the terms of the selected ESOs or ISOs and the remaining "time value" if he wishes to participate. I/we can update the comparison weekly.

 

john Olagues

Thanks for the clarification John,

So if I understand right if my clients to not have traded puts and calls then this strategy will not work.  That puts us at odds with your statement.

"The management of grantee ESOs or ISOs can only be done efficiently by selling appropriate exchange traded calls or buying puts or combinations of the two."

Let me think about your proposal, since it won;t work for many companies that I work with.

 

Dan

Dan:

 

Most of the significant companies have exchange traded calls and puts. Small public companies and private companies do not.

Comparing the strategy of selling calls to reduce risk with the strategy of early exercise, sell and diversify requires that there exist traded calls and /or puts.

 

John

 

 

Dan,

John's offer does not make a fair comparison of hedging v. monitoring Insight Ratios. This is because the Insight Ratio approach wouldn't recommend premature diversification.  For example, an Insight Ratio of 8% means that 92% of the grant's value is intrinsic.  Diversifying at this point isn't premature. 

John's hedging strategy works best for options that are NOT deep in the money.  So it's an apple and oranges comparison with the Insight Ratio approach.  John is really suggesting that his approach is more efficient than exercising and selling immediately after vesting when the option has lots of time value compared to instrinsic value.  In those cases, I agree that premature exercising is not efficient, but the advisors using StockOpter.com are not recommending this.

Bill

Bill:

You are correct that the ESOs, immediately after vesting, do still have substantial amounts of "time value" remaining unless the stock is trading far above the exercise price and/or has a low volatility. It would be premature to make an exercise at that point in most cases.

 The question then becomes when is it appropriate to exercise your options.

If you believe that Blankfein, Cohn, Dimon, Chambers, Ellison and Jobs and many other top executives got the best advice, then the time to exercise is right prior to expiration. 

But for the regular manager who has a substantial amount of vested ESOs that are substantially in-the-money, he may be interested in risk reduction. He has only two choices, a) early exercise, sell and diversify or b) do as 135 executive of Goldman Sachs did. They sold calls versus vested ESOs. My contention is that in the great majority of the cases, selling calls is the only efficient strategy if risk reduction is desired. That is why I offer to the have the other wagere pick the stock and the circumstances. If, in the case where there is little or no "time value" remaining, the advantage of selling calls is not that great, although there is still some advantage even then.

The advantage of selling calls is substantial when there is a decent amount of "time value" remaining. In cases when the value of the remaining "time value" correctly calculated is 10-15% of the "intrinsic value", exercising is too early and calls should be sold. I am willing to wager that it is.

No one has ever and no one will ever demonstrate that the strategy of making early exercises when there is "time value" of 10 - 15% of the "intrinsic value is efficient. If it was then Blankfein, Cohn, Dimon, Chambers, Ellison, Jobs would have done it.

John Olagues

John,

CEOs such as the ones you cite are precluded from using hedging strategies so if they don't understand the Insight Ratio process for monitoring their options then the only alternative is to wait until right before expiration. 

I realize that using hedging strategies as a means of reducing the risk of holding employee stock options can be very effective.  There are just a number of barriers to implementing these strategies:

  • Officers and insiders can not use them
  • They can only be applied to publically traded companies that have market traded options
  • Implementation is highly complex and usually requires the assistance of an option expert such as yourself
  • Most advisors and stock plan professionals don't understand market traded options or ESO hedging strategies and therefore can't/won't recommend them
  • The individual needs to have option trading approval and a margin account

Since there are very few individuals using ESO hedging strategies, the barriers seem to outweigh the benefits.

Bill:

It may be the case that everyone of the CEOs that I mentioned were prohibited from hedging by the Options or SARs contracts between themselves and the company. However, there are no SEC rules that prohibit selling at-the-money  calls or out-of-the-money calls while holding vested substantially in the money ESOs or SARs.

My point in mentioning those CEOs was to illustrate that they waited to the end to exercise their ESOs and SARs and did not exercise substantially prior to expiration even though the "time value" was zero or very small. After they exercised they immediately sold the stock. The idea that exercising substantially prior to expiration, selling and diversifying the net after tax proceeds has some merit must have not been appealing to them.

 

It is true that to sell exchange traded calls, there must be a liquid market in the calls.

Any stock broker can execute the trades and I am sure that there are Wealth Managers who can and do it also. I agree that most advisors will not try the risk reducing strategies that I suggest. Why they do not, I am not sure of.

 

Yes the grantee would need a margin account and options trading approval. The approval is not that hard to get, especially if the client is advised by someone who is experience with risk reduction use of calls and puts.

 

Thanks for the replies.

 

john

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