Incentive or Gift? How Perception of Employee Stock Options Affects Performance - 13 April 2011

Dear Dan:

I think your conclusions about the Wharton article are generally accurate. You say "the cases may indicate that people don't understand the value of their options until they cash them in".

In my view, grantees and even their advisers "don't understand the value of their options" when granted and when they cash them in. If they did, they would not exercise the options as early as they do which results in a forfeiture of part of that value better known as "time value".

Do any companies ever try to communicate the idea that the options have "time value" equal to perhaps 35-60 percent of the underlying stock when granted and they lose perhaps 1/2 or more of that "time value" when they exercise early? If there are any, I would be very surprised.

Do any of the organizations like NCEO or NASPP or others ever explain the "time value" or the forfeiture of the remaining "time value" upon early exercise or what can be done to manage the grants without such forfeiture of the "time value".

 I think the companies and those organizations would do well to communicate and educate the grantees on the values of ESOs and how to best manage them. Otherwise why grant equity compensation which none understand?

John Olagues

As a point clarification, the study found that employees performed better after they "profited" from exercising and selling their stock options.  This assumes that the company stock price increased nicely and that the employees made timely and prudent diversification decisions. 

This is an interesting study that can and will be interpreted in a varity of ways.  Here's one possible interpretation: if employees work harder when they profit from their stock options, it may behoove the company to provide decision support resources to facilitate better decisions. 

Bill:

I agree with your second paragraph.

But May I ask two questions?

Do you inform your clients of the "time value" forfeited back to the company when premature exercises are made regardless of what the employees do with the net after tax proceeds? Do you advise your clients of hedging strategies to reduce risk where no "time value" is forfeited?

Cheers:

John Olagues

John,

As we've disussed previously, I think the place to start is to inform and educate employees on the time value of their stock options.  Our stock plan communication and decision support platform (www.StockOpter.com) is designed to do this and calculate the time value forfeited when employees exercise.  However, if employees don't understand how much time value their stock options have at any point, they are not going to be able to comprehend hedging strategies.

Thanks Bill for your comments.

Perhaps organizations like NCEO, NASPP, World at Work, GEO  and the companies themselves would consider what you are saying and make an effort in that direction.

My rough calculations are that tens of billions each year in "time value" are forfeited to the companies by premature exercises together with the early tax penalties. If these organizations indeed cared about the welfare of the employee/owners, they would educate them.

Happy Easter

John Olagues