Most efficient ways to manage grants of Employee Stock Options

Writing calls to reduce risk of holding in -the- money ESOs is a highly efficient strategy to reduce risk. But it also reduces the alignment between the ESO holder and the issuer. So the companies insert provisions into the grant agreements that prohibit such hedging.

But does hedging reduce the alignment more than early exercises and diversifying, and sales which are encouraged by advisers to reduce risk? Early exercises in fact reduces alignment more than hedging does

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Lets compare hedging with early exercises of ESOs.

1. Does hedging forfeit any time premium. Answer is no!

  But early exercises forfeits a lot of time value. The amount depends on the volatility of the stock, the interest rate, the time to expiration and the amount that the ESOs are in the money.

2. Does hedging cause an early tax when the hedge is created. Answer is that it does not.

 But early exercises does create premature taxes, which when state and federal taxes are concerned could be as high as 50% of the intrinsic value.

3. How much does the "writing of calls" reduce the alignment compared with the reduction of alignment that happens when early exercises are made and sales are made to pay the tax withholding? Answer: The reduction of alignment is greater by far from the early exercises.

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So why are early exercise encouraged by the companies and the grantee advisors, when hedging if allow results in far better results to the grantee making early exercises and sales.?

The answer is that the company benefits widely.

Most top executives wait to near expiration before exercises and never make premature exercises, unless that want to sell shares when bad news is coming.

 

John Olagues

 

 

 

Edited Sun, Aug 5, 2018 5:49 AM

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