Topic # 1 Question:  What are Employee Stock Options? Answer: Employee stock options (ESOs) are contracts between the company and an employee, whereby the company assumes a liability to issue and deliver shares to an employee pursuant to the employee exercising his/her right (but not the obligation) to purchase a fixed number of shares of stock from the company.  The exercise price is generally the market price when the grant is made and the maximum time to expiration of the contract is usually 10 years.

ESOs are granted to employees as substitutes for cash or other types of compensation. The purposes of granting ESOs is to align the interests of the employee with the shareholders while preserving and expanding  company cash positions. Additionally, grants of ESOs are made to competitively attract highly competent long term employees. 

Topic # 1 Question:  What are Employee Stock Options? (continued)  Contractual Terms and Restrictions  The specific terms of the ESO grants are contained in the Company Incentive Stock Plan document and the Grant Agreement. Most companies  prohibit transferring, selling or pledging ESOs and rarely some prohibit hedging and selling calls.

There may also be Insider Trader Policies and black-out periods that apply which restrict buying and selling any equity securities of the company, including unrestricted stock.  

   Taxes There are no taxes payable by the employee when the ESOs are granted and the company gets no tax deduction on the day of grant.Compensation income taxes become payable if and when the ESOs are exercised after vesting. The amount of taxable income to the employee and the amount deductible from taxes by the company upon exercise equals the "intrinsic value" of the ESOs when exercised. "Intrinsic value" is the difference between the exercise price and the market value of the stock when the ESOs are exercised. 

  Values of Employee Stock Options

At anytime from the grant day to their expiration, ESOs can be valued by using theoretical pricing models, properly adjusted to consider the differences of ESOs relative to exchange traded calls . But the ESOs can not be sold, transferred or pledged and therefore the value is slightly lower. ESOs are subject to vesting periods of one to five years before they can be exercised. The contractual terms generally do not prohibit hedging or selling (writing) "qualified covered calls". The values of ESOs are less than the values of exchange traded calls with the same exercise price and volatility due to restrictions mentioned above. But ESOs have substantially longer contract periods than exchange traded calls, which have a maximum of three years.

Values of ESOs (continued) The factors that are input into the theoretical pricing models to arrive at "fair values" follow: 1. The market price of the stock relative to the exercise price.2. The expected time to expiration.3. The expected volatility of the stock.4. The expected risk free interest rate over the life of the options.5. The expected dividends paid over the life of the options Higher market prices of the stock, longer expected time to expiration, higher volatility and higher expected interests rate all give more value to the ESOs at grant day and during the life of the options. Higher expected dividends lower the value of ESOs.

Companies, if they wish to report GAAP earnings, are required to value the ESOs at grant and deduct those values when and if the ESOs vest. The values may be perceived to be far different by the employee depending of his/her understanding of the ESOs and his/her expected longevity with the company.

 

Values of ESOs (continued) The following two slides illustrate the two components of the ESOs.Those components are the "time premiums"("time values") and the "intrinsic values".

The major differences between the two slides are the different "time values" resulting from the different assumptions of expected volatility.The second graph assumes a volatility of .60 and therefore shows higher "time values" than the graph with the assumed volatility of .30.

Both slides illustrate how the component values change as the stock price changes and time to expiration decreases.   

 

Values of ESOs (continued) The time value (i.e. time premium) in slide 7 at grant day equals approximately 41% of the underlying stock value.

In slide 8, the "time value" equals about 55% of the underlying stock value due to the much higher assumed volatility, even though the expected interest rate and expected time to expiration are lower.

Greeks:

Competent Valuers of  ESOs and exchange traded calls use certain Greek letters to designate concepts relating to calls, puts and ESOs. The most widely known is Delta which refers to the expected change of an option with a one point change in the price of the stock over a short period of time. For example: if a call or ESO on a stock trading at 100 has a .55 delta and the stock advances one point in one day, the expected increase in the value of the call or the ESO equals .55 of one point.

Gamma is a concept that refers to how the delta of an option changes as the stock move up or down or as time passes.

Theta is a concept which measures the daily erosion of the "time value" of calls, puts or ESOs.

Vega is a concept that gives an expected change in theoretical value to calls, puts and ESOs as a result of changes in the volatility of a stock.

Risks of losing those granted ESO ValuesSee Hoadley.net .....andhttp://www.hoadley.net/options/probgraphs.aspx? Generally stocks with reasonable volatilities have between a 40% and 60% probability of being lower than what they are currently trading for over time. That means that if a stock has a .40 volatility, the chance of your ESOs being worthless at expiration is greater than 50% if the stock is trading near the exercise price when the calculations are made. So for example: If you have just been granted 3,000 employee stock options to buy stock from the company at $20.00 per share over the next 10 years, the value may be $27,000 using a volatility of .40.If you hold the ESOs to expiration, the stock will be either higher or lower or near the same as it was on the grant day. There is approximately a 50% chance that you will lose the $27,000 if you hold the ESOs to near expiration and about a 67% chance that you will achieve less than the $27,000 from the ESOs. There is however, an 11% chance that the 3,000 ESOs will be worth more than $130,000 near expiration day.As can be seen, holding ESOs have substantial risk, which can be efficiently reduced if risk reduction is desired.

Ways to Efficiently Manage your Granted ESOs: 1. The simplest way is to hold the ESOs to near expiration, exercise when in-the-money and sell stock (unless the ESOs are ISOs).  

2. If risk reduction is desired, the most efficient way is to sell calls and/or buy puts reducing the delta and some theta risks of the 3,000 ESOs held. See the link below: comparing strategies 1 and 2.http://www.slideshare.net/OLAslideshare/comparison-of-two-options-strategies 

3. The method of premature exercise, sell and diversify is inefficient and has questionable benefits to the early exerciser. It is, however used by a vast majority of wealth managers. This is the only available method of risk reduction when employees are prohibited by contract from selling exchange traded calls and/or buying puts. If the stock is not very volatile and the ESOs have just small amounts of time remaining and the stock is trading far above the exercise price, the penalties of early exercise (i.e forfeiture of remaining "time value" and early tax payments) are small.

   

 Step by Step method of managing your grants of equity compensation. 1. Examine the Stock and Options Plan documents and Award Agreements and Insider Trading Policies so that you understand the nature of all your grants and what choices are available and what the restrictions are.

2. Do a valuation of all the elements of the grants. ESOs can be valued using theoretical pricing models. Restricted stock can be valued by discounting the current market stock value because of vesting requirements, performance requirements, and holding requirements after vesting. 3. Assign deltas and thetas to each element of grants and sum the total deltas and thetas. 4. Determine whether you are comfortable with the risks in such holdings and determine the most efficient way of managing the risks and taxes and to take profits.

  

   

 Step by Step method of managing your grants of equity compensation (continued)  5) After determining your total deltas and theta risks and after determining how much risk you wish to reduce, you should sell exchange traded calls and buy puts. Buying puts in an IRA is an interesting strategy. The number of calls sold or puts bought should equal the number necessary to accomplish your risk reduction strategy. 6) As the stock moves around or as time passes or as you are granted new ESOs and RSs, you should repeat the process above in 4&5, making necessary adjustments. 7) You should be conscious of taxes and try to avoid liquidating early gains. SEC Rules should be carefully considered especially if you are an executive.

If you carry out these procedures your after tax returns will on average be substantially greater than other methods, especially the making of premature exercises sell and diversify.