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Presentation shows how to redesign Employee Stock Optionss to make them more effective, and more beneficial to all parties, including the company, the employee, and the wealth manager. http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470471921.html
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"Options were poorly structured, and, consequently, they failed to properly align the long-term interests of shareholders and managers, the paradigm so essential for effective corporate governance. The incentives they created overcame the good judgment of too many corporate managers.”
Alan Greenspan
The topic of this presentation is most relevant today as there are structural problems with the traditional employee stock options. Traditional options by their nature prevent effective long term alliances between employees and shareholders largely because of the risk-averse attitudes of the employees and their interest in reducing that risk. Unless the employees, managers or executives are willing to use hedging strategies involving selling exchange traded calls or buying exchange traded puts on company stock, their only choice to reduce risk is by early exercises and sell stock, and perhaps diversify the net after tax proceeds.
This strategy of making early exercises is so highly penalized in most cases of traditional ESOs that its unwise in all but rare cases to use the strategy. In fact, if unsophisticated employees are persuaded by wealth managers to use such a strategy, the employees should consider a lawsuit under SEC Rule 10 b-5
Is there a way to design employee stock options to make them more effective in accomplishing the goals for which they were created?Before we can answer that question, we must state the goals.
The goals are toA. Align the interests of the managers, officers and directors with the interests of the shareholders by making the value of their equity compensation dependent on an increase in value of the company shares. B. Attract and Influence high quality employees to be loyal long term employees.
C. Preserve and increase the cash position of the company.
D. Encourage early cash flows to the company from the early payment of the exercise price and the tax credits upon exercises.E. Allow for the efficient management of the granted options by the grantees.F. Maintain the theoretical costs of the plans to a modest level.
How well do Traditional ESOs accomplish those goals ?
A. The traditional ESOs do align the employee/executive with shareholders during the vesting periods and after vesting as long as the employee/executive holds the ESOs and the grantees understand the values and risks of the ESOs.
B. Company cash is preserved and indeed additional cash flows are generated by any early exercises (which are encouraged by the company and the options holders' advisers through their promotion of the premature exercise, sell stock and diversify strategy).
C. The traditional ESOs because of vesting requirements, non-transferability and non-pledgability make it difficult for risk-adverse grantees to efficiently manage traditional ESO positions. Premature exercises after vesting require penalties to the grantees in the form ofa) a forfeiture of the remaining "time value" which is quite high when volatility is reasonably high and b) an early payment of taxes. D. Early exercises, usually followed by sales of stock cause an early termination of 100% of the grantee/shareholders alignment and long term incentives from those options. E. Theoretical expenses against earnings are moderate, given the restrictions, although "fair values" on the grant day are often understated by the company.
What are Dynamic Employee Stock Options?
Dynamic Employee Stock Options are Options whereby the settlement of the exercises consist of the purchase of less than 100% of stock (perhaps 75%) plus payments in the form of new ESOs with new 10 year maximum expiration and current market prices as the exercise prices.
The exact value and number of new ESOs is determined by a formula which includes a percentage (perhaps 25%) of the full intrinsic value of the options upon exercise plus the recovery of the otherwise forfeited remaining "time value" in 100% of the options. Exercising Dynamic ESOs results in the "fair value" of the resulting combination of stock and options being equal to the "fair value" prior to the exercise. However, the exercise will cause a tax liability on 75% the intrinsic value of the options. No "time value" is forfeited although a partial penalty for an early tax payment is incurred.
The following ESO plan goals are enhanced(see next slide).
A. A substantial alignment of interests is extended past the exercise and sale of stock as the grantee still will hold substantial new ESOs.
B. Company cash is preserved and earlier cash flows will come to the company since the employee will likely exercise earlier. The two penalties of early exercises (i.e. forfeiture of "time value" and an early tax payment) by the grantee are substantially eliminated. The grantee, therefore will likely exercise much earlier causing more and earlier cash flows to the company. C. Efficient risk management of the grants by the grantee is facilitated since most of the penalties of early exercises of traditional ESOs are eliminated. The stock can be sold and hedging will not be necessary. D. The theoretical costs to the company of the Dynamic ESOs are about 3.5% greater than traditional ESOs.
The terms of the settlement of the exercise could be the following.
For example: Upon exercise, grantee receives 75% (rather than 100%) of the stock at the exercise price plus new ESOs with new 10 year expiration dates and market value exercise prices. The "fair value" of the new ESOs would equal the sum of a) + b):
a) 25% of the "intrinsic value" of the exercised ESOs that would have been gained on a traditional ESO exercise, plus
b) the amount of the remaining "time value" otherwise forfeited to the company upon early exercise of 100% of the employee stock options.
The receipt of 75% of the stock could be changed by the company to receipt of 60% or 80% of the stock at the exercise price, which will change the 25% of new options to 40% or 20%.
The grantee would receive, in total, new options equal to 40%, 25%, or 20% of the full "intrinsic value" plus the return of the otherwise forfeited "time value" in new options.
The plan could give the choices of the percentages of stock received to the grantee or pre-determined by the company.
The following two slides are familiar graphs. They illustrate among other things, the value of the "time premiums" (i.e. time value) and "intrinsic values" and how they change with different volatilities and different prices of the stock at different times.The slides also show the net take home amounts after tax for traditional ESOs exercised, assuming a total tax of 40%.
The companies will take the "intrinsic value" as a tax deduction upon the exercise. Dynamic ESOs will have different results. The grantee gets less stock upon exercise than with the TESOs but the grantee gets a new load of new DESOs. The tax deduction to the company will be reduced.
Let us assume that the 1000 vested ESOs in the slides were Dynamic ESOs with a 75/25 split upon exercise with the stock at various prices and various times remaining.
First we use the .30 volatility graphs A. Employee exercises when the stock is trading at $30 with 5.5 years expected time to expiration. The results are: the employee receives 750 shares for a purchase price of $20 and receives new ESOs with an exercise price of $30 with 10 years to expiration. The new ESOs have a value of $2500 from 25% of the "intrinsic value" plus $6114 of "time value" = $8614.
He would receive 720 new ESOs, which are valued at $8614. The "fair value" of the package upon exercise, that the employee receives is $7500 in intrinsic value + $8614 in new options value. Which equals the exact value the employee had prior to exercise.
B. If the employee waited until the stock increased to $50 to exercise and there were 3.5 expected years to expiration, he would again receive 750 shares at $20 and new DESOs as follows. The new options value is $7500 (i.e. $30 x 2500) plus $3368 of "time value" = $10,868, giving 530 new ESOs with an exercise price of $50 with 10 years maximum life. The full value that the employee receives is $22,500 in "intrinsic value" plus $10,868 in new ESOs, which equals exactly the value prior to exercise ($33,368).
If the assumptions in the block of the second graph (slide 14) where a .60 volatility was used, then the "fair value" after exercise would be the same as the "fair value" prior to exercise, which are greater than the "fair values" when we assumed the .30 volatility.
For example. Assume that the stock was trading at $40 with a .60 volatility when the DESOs were exercised and the split was 75/25. The grantee would receive 750 shares purchased at $20, plus new options with an exercise price of $40 with 10 years maximum life and 6.3 years expected life. The grantees value is $15,000 in receiving 750 shares 20 points below market, plus $5000 in new options value, plus the "time value" of $6460 returned in the form of new options. The total is $26,464 in value. The $11,460 would equal 521 new options.
The only penalty for early exercise is that there is an early tax required on the "intrinsic value" (i.e. $15,000) received in stock.
Exercise of Vested 1,000 DESOs with 75/25 Split 1 2 3 4 5 6 7 8 9 Stock ….Ex ..…Vol.....Expected...Time value...25% of…Colum….Total New...Tot. Intr. Val. Price….Price…….......Time to exp...Remain...Intrin.Val… 5+6 ….Option. Rec..of Stock Rec.-----------------------------------------------------------------------------------------------
$30.….. $20…....30…....5.5 years……$6114..…$2500......$8614….....700...........$7500 $40…....$20…....30……4.5 years…….$4526…..$5000…..$9526….….580.........$15,000$50…….$20……30……3.5 years…….$3368…..$7500....$10,868 …...530.........$22,500$60…….$20……30……2.5 years…….$2372…$10,000…$12,372……503.........$30,000$30. …..$20…....60...…5.3 years…….$9300…..$2500….$11,800……715...........$7500$40.…...$20…....60……4.3 years…….$6460…..$5000….$11,464……521.........$15,000$50...….$20…….60……3.3 years…....$4740…..$7500….$12,240……445.........$22,500$60...….$20…....60……2.3 years…….$2670....$10,000…$12,670…...384.........$30,000
The options with a .30 volatility assume an interest rate of 5%The options with a .60 volatility assume an interest rate of 3%The amount of stock received upon exercise is 750 shares for a cost of $20 per share.All new ESOs have an exercise price equal to the market price and 10 years maximum life.Column 7 equals the total value of the new ESOs in each case. Column 9 shows the amount before tax
A fuller explanation of
Dynamic Employee Stock Optionscan be found at the following link
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https://docs.google.com/document/d/1wGrmquhWBKzRhVtP4RdbG5Yl6VcSW1aalDmt5vnKvE4/edit?authkey=CPWK1-kN&hl=en_US&authkey=CPWK1-kN
