Most efficient ways to manage your 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 often insert provisions into the grant agreements that prohibit such hedging.

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

.........................

Lets compare hedging with early exercises of ESOs.

1. Does hedging forfeit any "time premium" (i.e. the value of the ESOs over the intrinsic value)? Answer is no. Hedging captures "time premium".

But early exercises generally cancels the remaining "time premium" (i.e. time value) effectively giving back part of the value of the ESOs to the issuer. 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 do create premature taxes, which when state and federal taxes are considered could be as high as 52% 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 by writing calls is far less compared with the reduction of alignment from the early exercises, selling the stock, and paying the tax. Early exercises require the forfeiture of "time value" back to the company and an early tax. For example:

Assume the stock is trading for $50.00 when the 10 year ESOs are granted.

The grant of ESOs is for 1000 shares .The exercise price is $50.00 and the "time premium" at grant equals between $20 and $30 depending on the volatility and the interest rate assumed.

If the stock advances to $75 after 3 years, the remaining  "time premium "may be $10-$12.00 per share, which will be forfeited back to the issuer if an exercised is made then. The tax will be perhaps 50% of the $25,000 "intrinsic value". The tax on the $25,000 will be about about $12,500 in California. So the net profit received may be $12,500 and there is "0" alignment with the issuer after the exercise and sale of the $12,500 worth of stock. 

If a sale (write) of  calls with three years to expiration and an exercise price of $75 on 1000 shares would give perhaps $30,000 with the tax delayed for 3 years or longer and there continues to be an alignment with the issuer, although it is reduced.

-----------

So why are early exercises encouraged by the companies and the grantee advisors, when hedging, if allowed, results in far better results to the grantee.

The answer is that the company benefits widely from the early exercises than from hedging. The forfeiture of the ESOs "time premium" accrues to the issuer and the issuer gets an early tax deduction equal to the "intrinsic value" when ESOs are exercised.

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

For example Steve Jobs waited to the very last minute to exercise, thereby forfeiting no time value and delaying the tax for the longest time.

So why do the issuers prohibit hedging by selling (i.e. writing) calls but encourage early exercises, sale and diversify. They do so because the early exercise gives the issuer an immediate tax deduction and they receive the forfeited "time value" from the employee.

John Olagues