Stock Options Cheered, but Employees Need to Know More
Take a look at this article/blog on Forbes: http://www.forbes.com/sites/ciocentral/2012/03/22/why-is-silicon-valley-so-clueless-about-stock-options
I haven't seen a cheer-leading article about stock options like this in some time, although he also comments on the need for employees to understand them better.
I have also found that employees are confused about some aspects of stock options and that can cost them whether in taxes, exercising them too early, or letting valuable options expire. That's a core reason we had started http://www.myStockOptions.com/ to serve as a good resources for knowledge and tools for employees on stock options, restricted stock, and other types of equity grants.
Small correction in article about the accounting treatment for stock options. It used to be that they did not impact the P&L and information about them only appeared in the footnotes. Now options are expensed based on their value at grant, using one of those complex valuation methods mentioned (Black-Scholes).
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Interesting article.
Stock Options are valuable tool, but I do not believe that most participants understand them or their real and potential value. I believe that there are some investors of start-ups (VCs especially) who believe they benefit from this lack of understanding. If employee #35 believes they will become a millionaire, they may come over from a more successful company. If the truth is that the options may only ever be worth a couple hundred thousand, it is something that can be dealt with in the future.
Optionees need to take responsibility for this understand the same way they need to take responsibility for understanding their investments in the 401K plans. Companies with any desire for truly motivating and retaining employee should also take a bigger role in communications. If both sides take responsibility, maybe we will all get to a better common ground.
I won't get into the difference in the market today compared to the Golden Age of Equity (1988-1999), other than to say that the differences are far greater than the similarities.
Re: Stock Options Cheered, but Employees Need to Know More
Bill Harris is right; most employees do not understand the full value or their options. A research project conducted by three business school professors established that: "Completing the stock option education program (which explains stock option fundamentals and clearly articulates the value of the recipients' option holdings) significantly changes recipients' estimated Forfeit Values". This research report was recently published in The Journal of Contemporary Accounting Research. A one page summary can be found at http://tiny.cc/n4gubw The personalized StockOpter report that was used in the referenced education has assisted tens of thousands of option holders to understand the full value of their options and when might be an advantageous time to exercise them.
Yes, the valuation methodology is based on the Nobel Prize winning Black-Scholes model, but option holders are smart people who can easily grasp and embrace option valuation concepts without diving into the mathematics. Employees who understand the full value (intrinsic plus time value) will realize the full benefit of their options as will their employer.
The ESOs certainly have a value above the intrinsic value, which you call "time value". Depending on many factors, like volatility, the expected time remaining, the relationship of the present price to the exercise price, the interests rate and the expected dividend, that "time value " can be large or small.
That value to the employee holding them also depends on the his/her ability to properly manage those ESOs to lower risk, taxes and maximize the return.
The "time value" can range from 30% to 70% of the value of the stock that the holder has the right to buy. For example: If the ESOs give the right to buy 1000 shares of the stock at $20 per share those ESOs when granted could range from $6000 to $14,000.
That "time value" decreases as the time to expiration decreases. That daily decrease in "time value" is called erosion or "theta" in the language of options professionals. Theta is one of the risks of holding ESOs, and exchange traded calls. A sale of calls reduces the theta risk that may be had from holding other calls and the theta risk of holding ESOs. So the only way to reduce the theta risk of holding ESOs for risk averse employees is to sell calls.
Of course the "time value" does decrease as the stock moves away from the exercise price but there is still a significant part of the "time value" remaining even when the stock is 50% above the exercise price or even 100% above the exercise price.
So if the employee is coaxed by wealth manager fiduciaries to make early exercises, the remaining "time value" which constitutes a value to the employee and an outstanding liability to the company is forfeited by the employee and the company has its liability reduced. The only way of reducing risk of theta and reducing the delta risk (delta is the amount that the ESOs are expected to change with a one point change in the stock) while avoiding the forfeiture of the time premium is to go to the options exchanges and sell the appropriate calls in an appropriate number.
Wealth managers, who advise making early exercises, selling the stock received and "diversifying" the net after tax residual amounts, either do not understand the above or are deliberately advising a strategy that accumulates Assets Under Management, while helping the company. They are violating their fiduciary duty to their clients and are violating SEC Rule 10 b-5.
John Olagues
Hi John,
What liability are you referring to in the follow statement?
"So if the employee is coaxed by wealth manager fiduciaries to make early
exercises, the remaining "time value" which constitutes a value to the
employee and an outstanding liability to the company is forfeited by the
employee and the company has its liability reduced."
Dan: That's a good question.
I will do my best to answer it so that you will understand it.
First, when the options are granted a contract is made between the employee and the company. That contract gives the employee certain rights and the company assumes certain liabilities to the employee.
The employee has the right to purchase the stock at a certain price over a certain period of time with certain restrictions. The company must deliver a certain number of shares at a certain price when the employee exercises regardless of what the market price is.
That liability of the company is required by FASB and the SEC to be valued when the grant is made, using theoretical pricing models. The employee may do his own valuing of his right. The liability to the company/grantor is that the company will have to sell the stock at a $20.00 exercise price perhaps when the stock is trading at $50 and it will cost the company $30 per ESO. The longer the contract runs the greater is the chance that the stock will go quite high above the exercise price.
Lets take the case at the grant day where the exercise price is $20 and there is a maximum of ten years to expiration. The value of the liability of the company is perhaps $8.00. Let us suppose that a month later the stock is $21 and the employee exercises the ESOs. The company therefore sells shares to the employee at $20 when the company could have sold shares at $21 in the market. It cost the company $1 when the theoretical liability was $8. So the theoretical liability of $8.00 was satisfied for $1.
The employee netted $1 for a right that had a theoretical value of $8. Effective he released the company from the contract for $1 where the company liability was in total slightly more than $8.
If the stock went to $40 after three years, the ESOs would have a value of the intrinsic of $20 and some "time value" of about $4.5. That $4.5 "time value" is the value of the expected increase in price over the remaining expected life of the options plus some other factors. If the ESOs are exercised early, with the stock at $40.00, the remaining time value is forfeited and it essentially is returned to the company and reduces the company'sliability to perform under the full term of the contract.
The idea of forfeiting time value may be explained by some others better than that. And perhaps they will come and add some additional insight.
John Olagues
John, in my 12 years of providing decision support tools for stock options I have found that employees rarely exercise their options because they are "coaxed" by a financial advisor or their company to exercise early. They generally exercise for 3 reasons: 1) they have to because the option is expiring or they are leaving the company, 2) the "talk" at the water cooler says it is time based on stock price or 3) they need the money.
I agree that the remaining time value when an option is exercised is forfeited which is why StockOpter.com's "Forfeit Value" calculation includes the time value of the vested options plus the total value of the unvested options. More info on this calculation can be found at: http://tinyurl.com/75byb6y.
Here's the real issue: most employees are exercising their stock options with no clue as to the amount of time value they are forfeiting because they are not provided with this information. Advisory firms that specialize in equity compensation generally understand the time value component and often use www.StockOpter.com to help employees make timely decisions (i.e. when TV is small compared to the intrinsic value). However, the pervaisiveness of time value education and on-demand calculation is woefully minuscule across all the companies, advisors and individuals that are involved in employee stock options.
So the solution to this problem doesn't start with hedging strategies. It starts with knowledge and for some reason that I can't explain companies are extremely reluctant to provide time value education and information to employees. Does anybody know why?
Dear Bill, you and your company are among the very few organizations who discuss the "time value".
Even, Bill Harris who wrote the article about the clueless grantees in Silicon Valley has a company, Personal Capital, which claims to be an advisory service but when making calculations of the values of ESOs gives only "intrinsic value" and ignores "time value" completely. So is he clueless or is there another motive.
If a grantee understands "time value", he will be reluctant to forfeit it when making early exercises, selling stock and diversifying and seek other ways to reduce risk. If a grantee understands "time value", he will understand that the highest risks of holding ESOs comes when the stock is perhaps 50% above the exercise price. He may even then understand that the only strategy to efficiently reduce risk is the sell calls. But that delays the highly desired early cash flows to the company that come from early exercises payments to the company and tax deductions to the company.
So the companies want early exercises and know that if their employees understand "time value", the early exercises decrease dramatically and early cash flows never come to the company. And the wealth managers know that AUM is delayed because the risk reducing sales of calls extend the life of the ESOs.