Make Millions More From Your Employee Stock Options - Forbes : 7 Feb 2012
Make Millions More From Your Employee Stock Options - Forbes
The IPOs of Zynga and LinkedIn have created roughly $16.7 billion in
market value. Assuming that about 20% of the equity went to
rank-and-file employees as stock options, the amount of instant wealth
could be more than $3.3 billion.
I’ve actually talked to some of these employees, who usually are in
their 20s and 30s (years ago, I wrote a book on employee stock options
and have an upcoming one on IPOs). Of course, a hot topic has been
taxes, especially the Alternative Minimum Tax. But there’s another big
question: When should I exercise and sell my options?
To help out, I usually provide some general advice and even put together spreadsheets.
But I never could find a useful online tool — until now. This week, Wealthfront
launched the Post-IPO Stock Sale Simulator. It’s a really cool way to
analyze scenarios for optionholders, looking at real-life data from 2000
to 2008 (a period that included more than 1,100 IPOs).
To get more insight on this, I talked to the company’s CEO, Andy Rachleff.
Rachleff is a former venture capitalist at Benchmark Capital and has
extensive experience as a board member of institutional investment
funds. Based on his background, Rachleff thought there was a big
opportunity to provide high-end investment products to those who are not
superwealthy — and that’s the focus of Wealthfront.
As for the Post-IPO Stock Sale Simulator, it looks at five main
scenarios when dealing with stock options: increasing, decreasing,
peak-dominated, U-shaped and oscillating. Each has two stocks for the
analysis.
For example, let’s suppose I owned $100,000 of vested stock options in Salesforce.com
(NYSE:CRM) when it came public in 2004. At the time, the company’s
industry — known as the cloud — was far from being a sure thing. As a
result, let’s say I sold all my shares when the lock-up expired (which
is usually six months after the offering). In this case, I would have
netted $160,000.
But let’s say I had more faith in Salesforce.com and held onto the shares for three years. The outcome: $369,000.
No doubt, this sell-no-shares approach is risky. There are countless
examples of tech companies that have faded away or gone bust.
This is why Wealthfront says a more prudent approach is to sell
shares over time. So with Salesforce.com, the gain would have been
$271,000 if I made 10% sales every quarter (this assumes a reinvestment
rate of 6%).
Again, these decisions have no clear-cut
more at link in title
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I know there are some pretty good wealth advisors and option strategists in the ECE.
What do you think about this proposal to "Make Millions More from Your Stock Options?"
Tom me, it seems to be a bit thin as a strategy. How about you?
Dear Dan:
I suspect that you will get no one from your group to make a serious comment on the article. Every adviser in your group promotes some form of early exercise sell and diversify strategy as if diversifying is some magic bullet which offsets the forfeiture of the remaining "time value" back to the company and requires the additional penalty of an early tax payment.
But these advisers are starting to realize that the early exercise, sell and diversify strategy, while providing the adviser with assets under management and the company with a reduced liability and early cash flows, does so at the expense of their clients and violates SEC Rule 10 b-5. So these advisers are now very cautious of going on record of promoting that strategy.
Mt. Tulli, like most of your advisers fail to mention the one efficient strategy to manage employee stock options positions if the employee/executive wants risk reduction and secure his/her gains. That is to sell exchange traded calls or to a lesser degree buy puts. There are no penalties to the employee/grantee, the restraints are few, the taxes are favorable and rarely do the contractual documents prohibit the strategy. Even ISS does not criticize employees and executives from doing so.
If the grantees hold the ESOs to where the ESOs are near expiration or so far in the money (perhaps 500% above the strike price) that the penalties are very small, the grantee may just as well exercise and sell, which is what famous executive like Jobs, Chambers, Dimon, Ellison and 135 Goldman Sachs executives did. And there seems to be more and more top executives holding their options to near expiration as time goes by.
But that strategy delays the cash flows to the company and delays Assets Under Management to the advisers.
John Olagues
Asking in advance when to exercise and/or sell is similar to asking when to begin collecting Social Security or whether to elect lump sum or annuity. I can give the correct answer if only the person were to provide his exact date of death, how the markets will do in the interim, and what interest rates will look like over time. Moreover, some people are risk-takers and others are more conservative. Furthermore, there may be other factors to consider. For example, it never looks good to see a CEO or other insiders bailing out of the stock while they are still in office. Different strategies work for different people. For those of us who are advisors, it is a matter of getting to know your client well and understand their objectives and tolerance for risk.
I hope I cleared things up and made this an easy decision.
Contrary to the Forbes article, there IS a sophisticated and easy to use online tool that helps stock option recipients make timely and profitable exercise and sell decisions. It is www.stockopter.com and it has been used for a number of years by financial advisors that specialize in equity compensation. However, there is also a "Participant" version that provides the same functionality for a single set of grants.
What is unique about StockOpter.com is that it calculates the time-value of stock options and uses it in metrics such as Forfeit Value (the full value employees are giving up when they leave to work for someone else) and the Insight Ratio (the percentage of time-value to intrinsic value). The Insight Ratio is the most effective means available for determining when to exercise and sell ones stock options. The lower the ratio, the greater the risk of continuing to hold the option. For example, if an individual exercises at an Insight Ratio of 5% they are securing 95% of the grant's in-the-money value and only forfeiting a small amount of time-value.
Selling exchange traded calls and puts to hedge ones employee stock options is hard to do without first understanding time-value. StockOpter.com provide this understanding by enabling individuals to do what-ifs and by sending them email alerts when decision criteria are triggered. The system also provide a series of Concept Videos that explain all the analytics in an easy to understand manner.
A demo for advisors and a 2 month trial for stock plan recipients is available at: www.stockopter.com. Additionally, a variety of resources on the topic of equity compensation decision support can be found at http://blog.stockopter.com.
Bill:
Your company does an excellent job of promoting an understanding of the "time value" of employee stock options. Without that understanding, it is, in my view, impossible to understand the value of, the risk of, or how to best manage those employee stock options assets.
After understanding the "time value", the next step is to understand that upon early exercise, the remaining "time value" which is still part of the ESO is forfeited back to the company. That penalty and the penalty of having to pay an early compensation tax should encourage the ESO holders to try to avoid those penalties. He/she can avoid those penalties and reduce risk of holding concentrated positions by using the strategy of selling exchange traded calls and buying puts as you mentioned.
John Olagues
www.optionsforemployees.com/articles
http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470471921.html
There are different tools and calculators for stock option and restricted stock planning, as www.myStockOptions.com also has them, including one with a patent. See www.mystockoptions.com/mytools for description of their features.
What works depends on what approach an employee or advisor feels most comfortable with and fully understands that no one can really predict where the stock price is headed. Different approaches to decision making work based on whatever type of goals or targets are set, whether they are based on share price, sales proceeds, size of option spread, remaining time-value/Black Scholes, remaining time left to expiration, and many others I have seen used. Plus the participant and/or their advisor needs to fully understand the tax consequences of the decisions, whether selling all the shares at exercise or vesting with restricted stock, or holding some.
My Dear Bruce.
When ESOs are granted, they have a value which may generally be anywhere between 30% and 65% of the value of the underlying stock That value is generally 100% "time value" with no intrinsic value.
If after the vesting period (perhaps three years) the stock has advanced from $50 to $75, the "intrinsic value" is $25 and the "time value" has decreased as time has past and the stock has moved away from the strike price. The remaining "time value" depends on the expected time to expiration, interest rates, volatility, expected dividends, expected return on holding the stock, and whether the theoretical model you are using is accurate. Neither the time value nor the intrinsic value changes because of the holders risk attitudes, other holdings, or anything else.
The risk of your losing the value of the ESOs in whole or part does not depend on your circumstanced or mind set. Your willingness to reduce the risk or maintain the risk does depend on your circumstances and mind set.
The way to efficiently reduce that risk does not depend on his circumstances or mind set. There is only efficient way to reduce the risk of holding ESOs with maximum time to expiration of 7 years, where the stock is 50% above the exercise price and that is to sell exchange traded calls or buy some puts. And that fact does not depend on your circumstances or mind set.
If the stock is 100% above the exercise price with max 7 years to expiration and a reasonable volatility, the only way to reduce risk is to sell calls and/or buy puts and that does not depend on your mind set or circumstances.
The strategy of early exercise, sell and "diversify" is efficient only in rare circumstances. and that does not depend on your mind set or circumstances. Of course if the company contract prohibits selling calls or buying puts which is rare or you have no other assets for margin purposes, the strategy of selling calls and buying puts can not be used.
Then the decision of what to do depends of many factor including a consideration of the penalties for early exercises and whether diversifying has any advantages that mitigate those penalties. In most cases the strategy of holding to the end or near the end will get better results than early exercise, sell and "diversify" and that factor does not depend on your circumstances or mind set.
John Olagues
This is certainly not my area of specialty, but.....
First: There is no "perfect" or "best" answer to this. A perfect or best answer would work better than the rest every time. The only perfect answer would be a time machine that allowed you to go back and place a trade on the date of the highest stock price.
As for the article:m The process of selling shares in small bunches over time is not new and really doesn't require a sophisticated system. A good financial advisor can do that.
The more complex process discussed by Bruce, Bill and John all have their merit and a wise optionee would be smart to look into each of them and see what fits their needs (and means.)
Regardless of the approach, all of them are likely to produce better results than bilndly guessing in the dark, and that is where optionees generally are today (and have been for the past 20+ years)
I agree with Dan. Any systematic approach to making timely and profitable equity compensation diversification decisions is better than the "Water Cooler" approach that most optionees are using now.
Bill Would you please explain precisely what "diversification" is, perhaps by giving some examples and please mention how "diversification" may offset the penalties of early exercises (i.e. the forfeiture of "time value" and early tax payment).
John Olagues
John, don't read too much into the word "diversification". In the context of my comment above it is just the act of exercise and selling ones company stock and options at some point (even your "hedging" strategy requires this). The StockOpter.com approach to making profitable decisions is to monitor the option's "Insight Ratio" and to exercise it when the time value is low. More information about the Insight Ratio and other StockOpter concepts can be found at: http://blog.stockopter.com.
Bill I am just trying to keep the discussion going to see if I can get any wealth managers to explain the merits of "diversifying". Perhaps "experts" like Kaye Thomas and Craig McCann, or other "experts" who claim that the advantages of "diversification" overcome the disadvantages of early exercises of ESOs will see the discussion and explain what "diversification" means.
I personally think that "diversification", when properly designed and carried out, does substantially reduce the risk of a portfolio. But holding 10 stocks instead of one, all of which are, to a substantial degree, correlated is not "diversification", although there is less risk.
John Olagues
Gentlemen:
Here is an article I just wrote that may shed some light on the dilemma that exists.
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Are Fiduciaries required to advise reduction of risk to holders of concentrated positions in employee stock options?
In a paper by Craig McCann, a former school teacher, attorney and SEC official and Kaye Thomas, a tax attorney and author we find them writing about how to handle your holdings of employee stock options.
Essentially they say that after three years, when the options are vested, the optimal exercise time to exercise is when the stock is about 110% above the exercise price. They say that if the stock is 110% above the exercise or higher, you should exercise. If the stock is lower you should hold on until the stock goes higher.
It reminds me of when Mark Twain was asked how to beat the market and he replied, "You buy 'em and when they go up you sell ‘em. As far as the ones that don't go up, you don't buy ‘em".
Now most stocks will be trading at a price between $70-$80 before they go above $110.
In fact the chance of a stock starting at $50 and in the future (perhaps 3 years later) trading between $70-$80 is four times greater than it trading between $110- $120.
Now, fiduciaries have a a duty to try to reduce risk, especially when the investment holdings are in a concentrated position of employee stock options.
Lets assume that a person owned 10,000 vested ESOs to purchase the stock at $50 and there are 4.5 expected years to expiration. Now lets examine the risks associated with the holdings when the stock is between $70-$80. If the stock drops 20% from $75 to $60 when expiration arrives, the value of the ESOs are worth $10, which is down 70-75% from its value when the stock was $75 with 4.5 expected years to expiration.
On the other hand, if the stock is trading for $115 and drops 20%, it would trade at $92 on expiration, making the ESOs with a $50 exercise price to be equal to $42 thereby losing $36 (i.e. about 45%) of its value when the stock was $115.
The chance of a 20% drop of the stock from $75 to $60 is the same as the chace of a stock with the same volatility dropping from $115 to $92.
So the risk of large percentage losses are greater when the stock is $75 than if it were $115 both with a $50 exercise price. And the chance of the stock being near $75 is 300% greater than it being near $115 after 3 years.
Therefore, it can not be denied that fiduciaries have a greater duty to reduce risk when the stock is near $75 than near $115. So why does McCann and Thomas, who call themselves "experts", not warn fiduciaries to reduce risk when the stock is $75, having started from $50 on grant day.
The answer is that the only way that risk can be reduced in these circumstances is through selling calls and/or buying puts.
Early exercise, sell and "diversify" forfeits the "time value" of $92,000 and will net after tax about 60% X $250,000 = $150,000. But selling calls and/or buying puts delays the forfeiture of the remaining "time value" back to the company and delays or may eliminate the early cash flows to the company and delays or may eliminate possible assets under management to wealth managers.
When all is said and done, if the holder of ESOs reduces his risks efficiently, it will reduce the grantee/company alignment accordingly but less so than early exercise sell and "diversify".
So there is a dilemma. Fiduciaries (i.e. wealth managers and financial advisers) have a duty to advise the reduction of the high risk of holding large concentrated positions in options on company stock.
Unless the structure of the ESOs contracts are changed to eliminate this dilemma, it will always be there.
So I, with help from Yingping Huang Ph.D. decided to re-design the traditional contract to eliminate the dilemma and improve the contract for all parties, the grantee, the company and the wealth managers.
Its called Dynamic Employee Stock Options. See the link below:
http://www.slideshare.net/OLAslideshare/desos-presentation-jan-03-2012
John Olagues
504-428-9912
olagues@gmail.com