Employee stock options have a value when granted and until they expire. That value increases as the stock increases in value. This presentation explains why early exercise, sell stock and "diversified" is worthless, when risk reduction is considered. Top executives hold their ESOs to near expiration and never make early exercises since they understand the penalties of doing so. To reduce risk and taxes sell calls or buy puts. Its the only efficient way.
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2. If you own a substantial amount of vested employee stock options and
want to reduce risk of holding appreciated ESOs, there is only one
efficient way to do it. That is to sell (i.e. write) exchanged traded calls
and perhaps buy a number of puts when the ESOs are most risky.
Making early exercises, selling the stock and “diversify” has large
penalties and is essentially a bet against the company and a bet on the
broad market (i.e. if you diversify into the S&P 500 for example). Those
large penalties are in the form of forfeited “time value” and the
penalties of paying an early tax. The only time it is justified is when
there is little or no “time value” and ex-dividend day approaches.
However, no major wealth managers advise efficient risk reduction
because that strategy raises the costs to the company/employer and
delays cash flows to the company. Efficient management of ESOs by
the employee also delays and perhaps reduces future Assets Under
Management to the wealth managers.
I know of no organization in the equity compensation arena that
promotes efficient management of vested ESOs. In fact they
deliberately promote the highly penalized early exercise, sell and
diversify strategy. Why? They are certainly not promoting the interests
of the employees. Do they not understand what they are doing? I think
they know that they are choosing to help the company and the wealth
managers at the expense of the employees.
Below illustrates the large penalties of early exercises to the
employees which benefits the employer accordingly.
3. Penalties of Early Exercising ESOs and Selling Stock outweigh
any merits of Diversifying.
This slide shows the total penalties to the employee(red) for
early exercises of 1000 ESOs with a .30 Volatility, 5% risk free
Interest rate, "0" dividend, and exercise price of $20
Exer...Market...Vol...Expected….Time……Early......Total.....Net..After
Price….Price Time.to …..Value …..Tax Tax
…………………………..Expiration..Forfeited..Penalty..Penalty….Proceeds
20...........30........30......5.5 yrs.....$6114....$1200.....$7314.......$6000
20...........40........30......4.5 yrs.....$4528....$1918.....$6418......$12,000
20...........50........30......3.5 yrs.....$3368...$2100.....$5578......$18,000
20...........60........30......2.5 yrs.....$2372....$2000.....$4372…...$24,000
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Below are the penalties of early exercise of 1000 ESOs with a much
higher volatility of .60, a 3% risk free interest rate, "0" dividend
20..........30.........60......5.3 yrs.....$9300....$1200...$10,500......$6000
20..........40.........60......4.3 yrs.....$6460....$1918.....$8378......$12,000
20..........50.........60......3.3 yrs.....$4740....$2100.....$6840......$18,000
20..........60.........60......2.3 yrs.....$2870....$2000…..$4870......$24,000
4. The above slide illustrates that the penalties of early exercise are quite
large even when the stock is “deep in-the-money”. This contradicts the
basic theory of most advisers that through “diversifying”after exercising
ESOs and selling stock will increase returns with less risk.
See the Paper of Craig McCann and Kaye Thomas “Optimal Exercise of
Employee Stock Options and Securities Arbitrations” in 2005 which
promotes the early exercise strategy.
This is why the most noted CEOs in the U.S. practically wait untill days
or weeks before expiration to exercise and sell.
Below are some examples of noted CEOs exercising their employee
stock options.
Lloyd Blankfein CEO of Goldman Sachs
Lloyd Blankfein exercised 68,800 on 11/26-28/2012 expired 11/30/12
Lloyd Blankfein, exercised 90,681 on 8/11/2010 expired 11/26/10
James Dimon CEO of J.P. Morgan
James Dimon exercised 462,000 on 3/2/2012 ESOs expired 4/16/12
James Dimon exercised 1,261,000 on 7/17/09, ESOs expiring 8/15/09
5. John Chambers CEO of Cisco
John Chambers of exercised 2,000,000 on 2/8/10, ESOs expiring 5/14/10
John Chambers exercised 1,350,000 on 2/13/07, ESOs expiring 5/1/07
Larry Ellison CEO of Oracle
Larry Ellison exercised 10,000,000 on 4/3/09, ESOs expiration 6/4/9
Steve Jobs CEO of Apple
Steve Jobs exercised 120,000 on 8/12/07, ESOs expired 8/13/07
Tim Cook CEO of Apple
Tim Cook exercised 200,000 on 3/24/ 2012 ESOs expiring 3/24/12
Paul Otellini of Intel
Paul Otellini exercised 800,000 on 11/9/07, ESOs expired 11/12/07
Sam Palmisano CEO of IBM
Sam Palmisano, exercised 300,000 on 8/1/11, ESOs expiring 2/25/12
Rex Tilleson CEO of Exxon Mobil
Rex Tillerson exercised 197,300 on 2/23/11 expired 11/28/11
6. Now why would these executives, who can pay for the best advice, wait
until almost expiration of the employee stock options to make the
exercises? They have ignored the advice that is given by wealth managers
and stock brokers to the great majority of employees holding substantial
amounts of ESOs. That advice is to make early exercises when the stock is
trading about 110% above the exercise price after vesting. That advice is
promoted by the industry and allied organizations. In some cases advisers
have been sued for not giving such advise if the stock has subsequently
dropped substantially. See the Paper of Craig McCann and Kaye Thomas “Optimal
Exercise of Employee Stock Options and Securities Arbitrations” in 2005.
John Olagues
Olagues@gmail.com
504-875-4825 or 504-333-4065