ACA Journal; Scottsdale; Spring 1998; Elaine s Gill;

Volume: 7 Issue: 1 Start Page: 31-33 ISSN: 10680918 Subject Terms: Stock options Options trading Capital gains Executive compensation Geographic Names: US

Abstract: When the time comes to exercise their stock options, most rank-and-file employees cannot afford to shell out the cash. To avoid having to deplete their savings, most employees use cashless exercises. This allows employees, through a special program set up by the company or a broker, to exercise their options without a cash outlay or a surrender of currently owned stock. The broker will lend the money to exercise their options without a cash outlay or a surrender of currently owned stock. The broker will lend the money to exercise to the employee, who will immediately sell enough shares to cover the exercise price, taxes and commissions. The employee then keeps whatever is left in cash or stock. If the employee chooses to hold the stock, any future appreciation is taxed as capital gains when the stock is eventually sold.

Stock options have recently come into their prime. Although they have been around for several decades, they have never been as widely used or as varied in their design and application as they are today. While generally reserved for executives, many companies now are offering stock options to all employees. Virtually all the Fortune 1000 companies issue stock options and many corporations, including General Mills Inc. Procter & Gamble Co. Du Pont Co. PepsiCo and Kimberly-Clark, have broadbased stock option plans. A recent study by William M. Mercer found that 30 percent of the largest U.S. companies have established broad-based stock option plans.

What is the reasoning behind offering stock option benefits to all levels of employees, from executives to the rank and file? The most popular reason seems to be getting employees to think as owners. However, there are other reasons that emphasize tying employee wealth directly to stockholders and motivating employees to increase stockholder value. One of the best ways to increase stockholder value is by making each employee a stockholder. This effect can be achieved with stock option grants.

Most rank-and-file employees and many executives cannot afford to shell out the cash when the time comes to exercise their stock options. They need cash to cover both the share price and taxes when exercising nonqualified stock options. In addition, many employees do not have a large personal reserve of company stock to use as payment for the stock option grant when the time comes to exercise. This is commonly referred to as a stock for stock exercise.

To avoid having to deplete their savings, most employees use cashless exercises. This allows employees, through a special program set up by the company or a broker, to exercise their options without a cash outlay or a surrender of currently owned stock. The broker will lend the money to exercise to the employee, who will immediately sell enough shares to cover the exercise price, taxes and commissions. The employee then keeps whatever is left in cash or stock. If the employee chooses to hold the stock, any future appreciation is taxed as capital gains when the stock is eventually sold.

Commissions may vary by the size of the option exercised and by broker. Most companies use several brokers with established commission rates. A 1997 survey of stock plan design and administration by Deloitte & Touche LLP revealed that 76 percent of companies with stock option plans have a brokerassisted cashless exercise/same-day-sale program, while 47 percent provide for stock-for-stock exercises.

Cashless has become the most popular method of exercising stock options. However, utilizing this method begs the question of whether the employee ever really owned the stock. After all, the stock was bought and sold on the same day. A 1996 study by two associate accounting professors, Steven Huddart of Duke University and Mark Lang of the University of North Carolina at Chapel Hill, found that two-thirds of the exercise activity of lower-level employees occurred just six months after they were vested and the options were in the money. Senior executives exercised at half that rate. Ninety percent of employees in the study sold their stock immediately after exercise using the cashless exercise.

Ready Cash Temptation

One reason options are so popular is because after the initial vesting or holding period, they can be readily converted to cash, offering the prospect and danger of immediate gratification. This often proves tempting for people who view options as a quick money source instead of as a long-term wealth builder. In contrast, employees see 401(k) plans as retirement savings accounts because of plan restrictions and tax liabilities.

For many companies, a quick turnaround of options partially defeats the original purpose of getting employees to think as owners. Would you bail out of your business at the first sign of decline or after you have made a specified amount of profit, even though there is strong possibility of continued profitability? After all, once employees have exercised all their options, they are much less likely to be concerned with stock price and stockholder value.

Many companies have lengthened vesting periods so employees will take a longer-term view of increasing stockholder value. To foster employee stock ownership, some companies have required senior executives to meet defined stock ownership guidelines to increase their holdings of company stock.

The most popular type of option issued by companies is the nonqualified stock option, which does not offer favorable tax treatment at the time of exercise. According to the Deloitte & Touche survey, 92 percent of the companies surveyed issue nonqualified stock options. Because the gain is taxed as ordinary income when exercised, there is no incentive for employees to buy the stock and hold it because the taxes are the same regardless of the type of exercise.

Incentive stock options (ISOs) feature an incentive to hold on to the stock to qualify for favorable tax treatment. Upon sale of the stock, the increased value is taxed at the lower capital gains rates of 28 percent if the stock is held for one year or 20 percent if it is held for 18 months. Many companies do not issue ISOs because many employees use cashless exercises, which essentially turn ISOs into nonqualified stock options because of the immediate sale. Most ISOs are issued among newer, high-tech companies that have a primary focus on growing their business.

Educating Employees

Most employees are not familiar with the market and have never bought or sold stock before. Companies are educating their employees on how to get the most out of their options and on the value of holding stock after the exercise. These companies also are evaluating the dilution effect that large stock option grants have on stockholder value when employees use cashless exercises. Some companies have begun to reload or grant new stock options in the amount exercised at the current price if employees retain their stock after they exercise. These strategies are a big challenge when many employees are still grappling with how to invest their retirement savings through 401(k) plans. While no company wants the hassles of giving financial advice, many are walking a fine line by offering outside financial planning as a benefit to employees.

General Motors Corp. is initiating a training program to educate executives on the benefits realized from stock ownership, including continued growth of stock price, dividend income and possible favorable tax treatment. Eli Lilly & Co. attributes much of the success of its new GlobalShares broad-based stock option program to its focus on a simple, convenient exercise process. Similar to other corporations with broad-based programs, Eli Lilly realized the importance of employees having quick and easy access should they wish to exercise their options. For General Motors and Eli Lilly, most options are exercised cashless.

It is not enough to make employees stock owners for a specified period of time. Companies need to create an environment that allows people to act as owners. More often than not, it is a personal decision by employees to take the money and run. Many cash out to buy a house, pay college tuition or gain an immediate, positive cash flow. Other employees set targets and decide they will exercise at a specific price. When the stock price begins to dip, many employees panic at the thought of losing money and bail out through a cashless exercise.

It seems as though employees have turned stock option programs into cash programs, and companies have assisted by offering cashless exercises. However, employees cannot benefit from stock options unless the stock price increases during the term of the grant. Also, if employees have to pay for their shares initially through cash or stock, it may not be perceived as a true benefit.

A stock price increase benefits the corporation, employees and the stockholders. Stock options:

Align an employee’s personal financial success with that of the corporation.

Recognize the employee’s continuing contribution to the business.

Increase the employee’s share in the corporation’s success.

At the same time, stock options can increase employee awareness of the company’s stock price on a daily basis. When Chemical Banking Corp. issued its success shares, checking the quote in the newspaper became an early-morning ritual for some employees. As the stock price increased, so did their excitement. These are some of the reasons why companies have continued to grant stock options along with cashless exercises.

[Author note] Elaine S. Gill is Senior Administrator for General Motors Corp.’s Worldwide Executive Compensation Staff. She is responsible for assisting the world’s largest automotive manufacturer with total executive compensation strategy and development. She is instrumental in the development of various aspects of executive compensation, including long-term incentives, annual incentives, base salary and benefits. Her areas of expertise include executive compensation, human resources, industrial relations, manufacturing, mechanical and industrial engineering. She holds a B.S. in industrial engineering from North Carolina A&T State University and an M.S. in management from Kettering University. Steven Huddart

Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA

(814) 865-0041

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was last updated on Tue, Nov 27, 2012.