Dynamic Employee Stock Options

Article on a Superior Form of Employee Stock Options called Dynamic Employee Stock Options

First let us examine how the current ESOs work.

ESOs are granted with an exercise price equaling the present market price . The ESOs often have a vesting period of 1 year for about 25% percent of the total grant with the remaining vesting coming over the next three years. Taxes generally become due when exercises are made, not when the ESOs just vest.

When ESOs are exercised, all of the remaining "time value" above the intrinsic value is forfeited to the issuer. This could be a substantial amount when the volatility is high, the assumed interest rate is high or the stock is not very much in the money and when the time to expiration of the ESOs is still years away.

Assume that the issuer decided to add an element to the ESO contract which requires that upon exercise, all of the forfeited "time value" is automatically  reloaded to the employee in the form of new ESOs with an exercise price equaling the current market value when the exercise is made.

Below is an example of how Dynamic ESOs would work.

Assume the stock is trading for $20.00 when 3000 DESOs are granted with 10 years of life. The assumed interest rate is 3%, the volatility is 40 and the exercise price is $20.00. The theoretical value would be approximately $8.00 per share which is a total of $24,000 on the 3000 shares.

Assume that three years later, the stock is trading for $30,00 and all of the shares are vested. The "intrinsic value" is $10.00. The remaining "time premium" would be about $4.00 per share above the "intrinsic value", which will be forfeited upon exercise. So the time premium otherwise forfeited back to the issuer would be $12,000. Assume that the Dynamic ESOs required that the $12,000 be reloaded back to the Grantee upon exercise in the form of new DESOs whose value is $12,000.

Premature exercise of regular ESOs have two large penalties.

1) the early federal and state tax upon early exercise [total as high as 50% of the intrinsic value in some states] and 2) the forfeiture of the remaining time value.

The DESOs eliminate the forfeiture of the remaining time value.
DESOs accomplish a longer alliance between the issuer and the grantee and allow more efficient management by the grantee of their grantee ESO equity compensation. 

I live in New Orleans and understand that NASPP is having a conference at the Hyatt Regency on Sept 16-19. I would be happy to explain the concept to attendees of the conference as I believe that Dynamic ESOs are superior than regular ESOs for both the grantee and the siier.

More to come on DESOs.

John Olagues