LinkedIn Group Established for Equity Compensation Recipients

Dear Bill:

Will this group be told that efficient management of their Employee Stock Options requires avoiding premature exercises because premature exercises cause a forfeiture of the  "time premium" back to the company and a premature tax payment?

Will they be told, furthermore, that through efficient hedging with exchange traded calls and puts, a holder of ESOs can achieve 50 to 100% greater after tax results on average with less risk than the early exercise, sell and diversify strategy?

John Olagues

Hi John,

The purpose of the group is to create a forum of sound information for equity compensation recipients.  No one is dictating the content of this group and all points of view are welcome.  You obviously feel strongly about your approach to making prudent decisions regarding employee stock options so I suggest you join the group and create a discussion item to express your viewpoint. 

Bill Dillhoefer

Thank you Bill.

Please sign me up. The employees can only benefit from good discussions

Thank you

Bill Is it possible to have a webcast (s) where a panel discusses different strategies to manage equity compensation including the various types and methods.

For example the topics could be:

1. Understanding and managing risks of holding ESOs and other forms of equity comp.

2. Taxes rules that apply

3. Strategies fo managing to get the most with the lowest risk etc.

Perhaps it would work ?

John Olagues

John,

A webcast on the topic of equity compensaiton decision support with a panel of various authorities is a good idea, but it is a big undertaking that would require a good amount of effort.

One of the first things that has to be decided on is the audience.  Is this a webinar for Equity Compensation Experts (professionals) or Equity Compensation Recipients? 

I suggest that we discuss the details offline so give me a call.  In the meantime, I think it would be a lot easier for you to write a short white paper on your decision support strategy and post it on ECE and the LinkedIn group (ECR-DS).

Bill

Thanks Bill;

Many of the ideas discussed in such a forum could be helpful for both.

Some employees are quite sophisticated.

I'll get back to you and discuss the matter.

John

John,

There is a 4th strategy for managing stock options that will help identify the optimal time to exercise and avoid the complications of implementing a hedging strategy.  

This strategy involves automatic monitoring the "Insight Ratios" of vested options using www.stockopter.com (an equity compensation analysis platform).  This ratio is an estimation of the remaining theoretic potential of a grant so it is a good indicator of when to exercise.   

More information on this strategy and on the Insight Ratio can be can be found in the following article by John Olsen:

https://www.stockopter.com/University/Display/Display.aspx?identity=51

Great discussion.  Is there a FIFTH possibility?

Dan:

I am interested in hearing it.

Regardless of how many ways there are to approach the decision of what to do with your ESOs, it comes down to either

1) hold and hope for the best

2) Execise some or all and sell

3) Hedge some or all

With that in mind I will take two real life examples and give specific guidance as to what is the best strategy, in my view.

Example A) On January 20, 2009 Mr William Winters from JP Morgan was granted SARs to buy 700,000 shares of stock at $19.49. Today September 9, JPM is trading at 42.75. Vesting is 20% per year. The assumed volatility is .57 The assumed expected  time to expiration is 7 years from the grant. With the  stock at 42.55 the fair value of the of the 700,000 ESOs equals about $21 million (i.e. 23. 06 intrinsic plus 7 of time premium per ESOs).

Example B) On March 4, 2009  Mr. Johnathan Rosenberg was granted ESOs to buy 34,138 Google for 318.9. Today, September 9, 2009, Google is trading at 464. Vesting is 25% per year. Assumed volatility was 30. The assumed expected time to expiration is 7 years from the grant. The assumed volatility is .32. making the value of the 34,138 ESOs equal 241 x 34,138 = $8,227,258 (i.e. 145 Intrinsic and 96 remaining time premium per ESO.)

If after checking the Stock and Options plans, and any other agreement, these executives find that there is no prohibition against hedging, although there is a prohibition against transferring or pledging the ESOs, my advice would be to immediately sell calls or buy puts to reduce their delta risk by 15-25 percent. Specifically, they should sell slightly out of the money calls and buy a small amount of in the money puts.

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Mr Winters of JPM should sell 3000 Jan 2011 LEAP calls with a 50 strike price at 4.50. Proceeds from the sale are $1,350,000 and buy 800  Jan 2011 puts with a strike price of 45 at 9.20 for a cost of $720,000.

Mr. Rosenbaum should sell 200 Jan 2011 calls with a 520 Strike for 59.50 or $1,190,000.

Both also own shares that can be deposited to satisfy any margin requirements.

In the second to last line above there is a correction of an an error in price from "59.50 or $1,190,000  to 50.50 or $1,01.000".

 
John

                                         "In times of universal deceit, truth is a radical idea".

                                                                                                  George Orwell

Years ago, I used to think that the highly regarded practitioners in the ESO arena were just making mistakes about how to manage employee stock options. But now I am certain that they are not only making mistakes but they are deliberately deceiving their clients in their advice and in articles and books that have been written. The categories of mistakes and deliberate deceptions are;

1. They do not understand the risks associated with holding "naked" (i.e. unhedged) ESOs. Most of these advisers think apparently that if you just hold the options long enough, the stock will go up. They also think that there is a 75 to 80 percent chance that if a stock is trading at 20 today, it will be above 20 in three to five years from today. Of course the real chance is about 55 percent on average volatile stock and below 50 percent for higher volatile stock.

2. They claim that hedging reduces the alignment of interests between the share holders and the employee, which it partially does. But they say nothing about the elimination of mutual interests that occur when premature exercises are made along with sales of stock to diversify.

3. They create objections to hedging by dreaming up interpretations of the tax laws such as the application of Section 1092 to ESOs hedges and exaggerating the risks and the consequences of "mismatches" of tax treatments.

4. They find arguments to encourage premature exercises with the resulting forfeiture of time premium and early tax payments, by understating the value of the time premium forfeited back to the company and offering misleading scenarios of tax consequences.

The results of their mistakes and deliberate deceptions is that there is a transfer of 10s of billions of dollars from the employee/manager to the employer, the top executives and themselves as their deceptions are promoted and accommodated by the companies and the allied associations that have grown up around them.

If there are some who disagree with the above, let them come to this forum and express their disagreement point for point or attack me in another arena.

John Olagues

An interesting development has taken place in the J.P. Morgan listed puts and calls.

Mr. William Winters was noted as having received 700,000 SARs of J.P. Morgan with exercise price of 19.49 on Jan 20, 2009. I suggested that he could hedge those SARs by selling  Jan 2011 Leap calls (market price at 4.50) with an exercise price of 50 (3000 contracts) and buying January 2011 puts with a strike price of 45 (800 contracts) on September 9, 2009 for 9.20.

Presently, December 7, 2009, the stock is down 85 cents (41.78) cents. The Jan 2011 50 calls are trading at 2.95 and the Jan 2011 puts 45 s are trading for 8.45.

The implied volatilities are much lower than they were in September , 2009.

The reason for this is the expected sale of the  JPM TARP warrants this week. How did the drop in implied volatilities affect the values of the SARs?

It reduced the value by about 80 cents from what the SARs values were. So even though  being short premium on balance in the listed calls, the combined positions of short calls, long puts and SARs caused a loss of money because of the lower assumed volatility caused the SARs to decrease. Of course the loss would have been greater had he not hedged.

john

On September 9, 2009 I suggested that Johnathen Rosenberg of Google who had been granted ESOs to purchase 34,124 shares of Google at $318.9 in March 2009 should hedge that position. It was suggested that he sell 200 calls with a strike price of $520 expiring on Jan 2011. The price of the calls was $50.5.

The calls have increased to $134 showing a loss of $83.5 or $8,350 per call making a total $1,680,000 loss on the 200 calls short. He could have liquidated the $1,680,000 loss at the end of 2009 and probably reported the $1,680,000 loss against ordinary income. If he were to liquidate the loss, he could have immediately re-hedged by selling other appropriate calls and/or by buying appropriate puts.

The 34,124 ESOs have increased in value by $4,800,000 with no current taxes due, making the net gain of $3 million and a tax deduction.

He has another nine years to deal with the possible taxable income from the ESOs.

All of these strategies are explained in the book linked below:

http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470471921,descCd-google_preview.html

Regards;

John Olagues