Conerly Consulting LLC

Investment Planning and Employee Stock Options

William B. Conerly, Ph.D. Published in The Oregon Certified Public Accountant, Oregon Society of Certified Public Accountants, January 1998.

Employee stock options are increasingly being used to compensate and motivate workers, both senior executives and rank-and-file staff. Over 2,000 American companies now issue options. Once a benefit only for high level executives, options are now granted to all employees by many companies. Firms such as Intel, Bank of America and Starbucks have announced stock option plans covering all employees. In addition, most employees at high-tech startups, as well as most senior corporate executives, now receive stock options.

As options become more common, the accountant will see more people trying to integrate their options into their financial plans. Because options can be a large portion of a person's net worth - maybe even a majority - an investment strategy must consider the special characteristics of options. Unfortunately, some elements of options are not well understood.

The option-holder will have some critical decisions to make. Whether they make the decisions themselves or whether they rely on an advisor, there are three key points that employees with options need to understand. We'll explore the three key points by going through three stages of options: 1) the initial grant, when the employee should start thinking about how the options tie his or her financial wealth to the fortunes of the company; 2) the middle stage, when the options are "in the money" and highly leveraged; and 3) the exit stage, when a strategy for cashing in the options should reduce the risk of selling at a temporarily poor price. Before that, however, we need to review the basics of employee stock options. Finally, to put the employee view into some perspective we'll examine the stock option program from the company's viewpoint.

Basic Elements of Stock Options

Stock option plans vary from company to company, so any specific advice will depend on the details of the particular options. Here's what a typical stock option plan might look like: employees are granted the right the purchase a certain number of shares of the company's stock, at a certain price, over a certain time period. Not surprisingly, the higher the employee's rank and salary, the more options he or she usually receives. The price at which the stock can be bought is usually the stock's price on the day of the grant. The time period for exercise may begin after a vesting period, or the options may vest immediately. The options typically expire in 5 or 10 years after the grant, though other time periods are occasionally seen. Vesting may be accelerated by change of control, as with the recent big bank mergers.

Options are not transferable, except upon the death of the employee. The exercise period may be truncated if the employee leaves the company other than through retirement. These details are specific to the plan and should be understood by the employee.

Tax treatment of the options depends on whether they are "non-qualified" or "incentive stock options" (ISOs). In either case, the employee reports no income from the options at the time of the grant.

The most common options are "non-qualified," in which regular income is recognized when the options are exercised. The income per share is the difference between the stock's market value on the day of the exercise and the option exercise price - in other words, the profit. It is regular income, regardless of how long the options have been held. The tax basis on the newly purchased stock is the market value of the stock at the time the option is exercised.

In practice, most stock is sold by the employee at the same time that it is acquired through exercise of the option. Some companies provide an introduction to brokers who coordinate with the company for "cashless exercise." In such cases, the employee need not put up any cash to exercise and sell the options. In other cases, stockbrokers make a loan for the purchase of the stock via the option, using the stock as collateral until it is sold by the employee.

Incentive stock options (ISOs) have more benign tax consequences. The option profit can be deferred until the stock is sold; and the profit will be treated as long-term capital gains if the employee retains the stock for 18 months or more. ISOs can trigger the Alternative Minimum Tax, though, so some tax advice may be needed before a decision to exercise. ISOs are much preferred by employees, but typically only granted to the most senior executives at a company.

Stage 1: Newly Acquired Options
Mary is happy. She's just got her first employee stock options in ErgoLit. If the company's line of ergonomically designed kitty litter is popular with the cat box set, she could be in the money. Or else, the options may expire worthless. At this point, Mary should understand that her financial future is tied to her company even more than it had been when her only compensation was through salary and other benefits.

Were Mary a compulsive financial analyst, she would calculate the value of her options using the Black-Scholes option pricing formula. That exercise often indicates that the value of an option to buy one share, calculated on the day the option is granted, is somewhere between 20% and 60% of the stock price. For example, we calculated the value of an option to buy one share of Intel at $80, when the current price was $80, assuming 10 years until maturity. Such an Intel option would be worth $48 if marketable.

The details of the calculation depend on the stock's volatility, time until the option expires, and interest rates. (In our Intel calculation we used the stock's historic volatility to predict future volatility, and we used current interest rates.) The value will change over time as the stock price moves up or down, as the stock's volatility changes, and as interest rates change. The Black-Scholes option value equation (for which Scholes recently won the Nobel prize) is fairly complicated mathematics. The application of the equation, however, is not nearly as scientific as the formula would appear because of the difficulty of estimating a stock's future volatility. The benefit of calculating the value is to give a ballpark idea of what Mary's options would sell for, if she were allowed to sell them. Even though the options are not transferable, they should be thought of as assets with value.

Calculating an option value might have a major impact on Mary's thinking, though: it tells her that she owns a valuable asset, whose value will rise or fall with her company's stock price. This is just another way to emphasize the connection between her company's stock price and her total net worth.

Diversification is the greatest challenge faced by option holders. At the initial stage, Mary should understand that any further investments in her company's stock will make her total net worth - investments, stock options and the value of her job itself - less diversified. I recommend to such clients that they not make further investments in their own company's stock, no matter how rosy the prospects for the company.

Diversification may be further hampered by the common practice of putting company stock into 401(k) plans. Sometimes that cannot be avoided - some companies match with their own stock and don't allow it to be sold. But Mary should avoid any discretionary investments in her company's stock, and also in stocks of other companies in the same industry.

Mary may know a lot about her company and her industry, and may know which competitors have the best prospects. That information can sometimes help a person pick stocks. But adding to Mary's financial exposure to her employer flies in the face of the diversification goal.

Stage 2: Options in the Money

Mike's stock options are two years old, with eight more years before they expire. His company, Eco-Leaf, has developed a wind-powered leaf blower that is the catalog favorite this Christmas season. His options allow him to buy Eco-Leaf at $20 a share, and the company stock is now trading at $30. The options are vested, and he's tempted to cash in.

Although we generally recommend against cashing in options very early, Mike has some reasons to consider it. Mike is young, and the options are his only financial asset aside from a meager savings account. Thus, his lack of diversification puts him at substantial risk of his company's stock price falling. Mike also has debt at high interest rates, so taking profits and paying down debt has some appeal. These factors have to be balanced against the leverage of the options, which will be discussed shortly.

First, however, look at Mike's colleague Maurine. She's older, with a substantial investment portfolio that's well diversified. She has no debt. Maurine should not be tempted to consider exercising her options this early. She and Mike need to understand leverage.

Options have leverage in the sense that the value of the option increases faster than the stock price. Suppose that Eco-Leaf stock rises 10%, from 30 to 33. The following table shows that the 10% increase in the stock price generates a 30% increase in option profits!

The Leverage of Stock Options
Stock Price	Exercise Price	Profit
$30	$20	$10
33	20	13
+10%		+30%

Another way to express the leverage idea is in terms of alternative investments: if Maureen were to exercise her Eco-Leaf options and reinvest the profits in another stock, she would need to find a stock whose return is three times the percentage increase in Eco-Leaf stock. Even if Maureen isn't too enthusiastic about Eco-Leaf's prospects, finding something three times better might be difficult.

The leverage isn't always 3-to-1, of course. The leverage ratio is equal to the current stock price divided by the option profit per share. (In this example, the $30 price divided by the $10 profit.)

Taxes have not been considered up to this point. If Maureen exercises her options now, she'll have to pay taxes this year. The options, however, can increase in value with no tax due until they are exercised. On the other hand, if Maureen shifts her profits into a stock investment, that asset's appreciation may be taxed at the capital gains rate. The tax consideration usually weighs on the side of holding the options rather than selling early: the benefit from deferring taxes is usually greater than the benefit of a lower tax rate.

So much for Maureen; what about Mike, who is undiversified? He will have to make that judgment. I would generally discourage exercising options very early. If he does decide to exercise, there is no reason to exercise all of his options. He can peel off a portion of his options, while keeping the rest.

Stage 3: Exit Strategies

If the stock price has not tanked, then the options will eventually be exercised. Waiting until the last day is a viable strategy, but early exercise will sometimes make sense.

Let's revisit Mike five years later. Eco-Leaf stock has risen to $200 a share, so Mike's options have a profit, if exercised now, of $180 a share. Mike is living a middle class life with a million dollars worth of options. But now that the stock price is high, the leverage has fallen. Recall the formula for leverage: price divided by profit. That is now 1.11 (the $200 share price divided by the $180 profit). If Eco-Leaf stock rises another 10%, his option profits would increase by only 11.1%. The lower amount of leverage means a weaker reason to continue holding the options. Mike may have spent the five years paying off credit card debt and buying a house, and still not have significant investments beyond his options. Lack of diversification and low leverage now leads Mike to exercise some options.

Manny is also going to exercise his options, but for a different reason. His company, the Bank of Many Names, has been acquired by First Chase Nation, which is eliminating Manny's job. The previous merger, (when Last Local Bank was acquired by BMN), Manny stayed on and his options in Last Local became options in BMN. But Manny can't dodge the latest merger, and under the terms of his stock option plan, he has one year to exercise them.

Both Mike and Manny now must decide exactly when and how to exercise their options. They can exercise them all at once, the day that they make their decision. Or they can wait until the price "feels" right. Or, in Manny's case, he can wait until the very end of the option period. There is no perfect answer without perfect foresight of the stock market. Many employees fret, kicking themselves if they exercise early and the stock rises, or kicking themselves if they exercise late, after a market correction.

Another path open to them is dollar cost averaging. Usually thought of as a way to buy a mutual fund, dollar cost averaging can be used to exercise a block of options as well. If 1000 options are to be exercised, the employee could exercise 250 each quarter for one year. That reduces the risk of exercising the whole lot at a poor price.

For those, like Maureen, who have no need to exercise early, waiting until the end of the option period makes sense. She is likely to have received options annually, so when the first set is about to expire, there's another set a year away, and yet another set two years away, etc. (If they were bonds, we'd say that she had laddered maturities.) In effect, Maureen is getting the benefit of dollar cost averaging by exercising a block each year. To be even more cautious, she could do a quarterly exercise of one fourth the options due to expire that year.

The Company's Risks and Rewards

So far we have emphasized that the stock option plan puts the employee's net worth at greater risk. The flip side is that the company has reduced its risk.

Stock options are not given as a gift, but as part of a total compensation package. The alternative to options is either higher salary or some other employee benefit. In general, corporate earnings are correlated (though loosely) with stock price. At those times when the company is not faring well, lower salary expense will be helpful. That helps the company at the expense of the employee. On the other hand, when the company is doing well, its stock price will rise, options will be exercised and total stock outstanding will increase. That will depress earnings per share and dilute the holdings of other shareholders. Companies frequently buy back stock to offset the stock newly issued to option holders, making options a drain on cash, albeit deferred. So the company benefits from options during hard times, and is worse off due to options in good times. That's a classic definition of reducing risk.

Bondholders, it might be noted, are completely better off by a shift in compensation away from salary toward options. If the company's earnings weaken, the lower wage compensation (allowed by the stock option program) reduces the risk of default. And because bondholders don't benefit from higher stock prices or per share earnings, the stock dilution does not concern them.

The classic case of options - the small start-up company - illustrates the power of a stock option program. In the early days of the firm, cash is preserved by compensating employees with options. If the company prospers, it often prospers exceedingly well, and can thus afford the dilution caused by the stock option program.

Options may also have a role in motivating employees. For large corporations, that connection has to be more emotional than rational. One lower-level employee of a 10,000 person company is not going to have much effect on the stock price, regardless of how many options that employee has. However, there certainly are some employees who feel a greater sense of identity with the company, and put forth greater effort, because of the options.

Conclusions

Options will disappoint employees at some companies, and make millionaires of employees at other companies. Along the way employees will have to make some hard investment decisions. Without giving investment advice, an accountant can help the employee make these decisions by emphasizing three points:

Options give the employee a stake in the company's fortunes. The larger the stake, the less diversified the employee's assets.
Options have leverage. The option-holder gains more than in proportion to increases in the stock price. This leverage, though, declines as the profit of the position increases.
Spreading the exercise of the options over time reduces the risk of selling at a poor price.

William B. Conerly is President of Conerly Whelan Inc., a Portland investment management firm serving individuals, pension funds and charitable foundations. He was formerly Senior Vice President and Economist at First Interstate Bank, where he had personal reason to study stock options. Conerly has a Ph.D. in economics from Duke University, sits on the Governor's Council of Economic Advisors, and is a frequent speaker at OSCPA meetings.