Description

1. Efficiently Reducing the Risks of holding Employee Stock Options and SARs

2. There is only one way to efficiently reduce the risks of holding substantial positions of Employee Stock Options and SARs. It requires selling exchange traded calls and to a lesser degree buying exchange puts.

3. If your advisors are advising making early exercises, selling the stock received and diversifying, there are either incompetent or they are working hard for the company and for themselves at their clients expense.

4. The reasons that exercising ESOs and SARs early, selling and diversifying is highly inefficient, is that when the ESOs or SARs are exercised early, the remaining “time value” is forfeited back to the company, (which reduces the company’s liability to the grantee and creates early cash flows to the company).

5. The early exercises also make the tax liability of the grantee come too early. Both of the penalties combined are so large as to make it clear that, in most cases, the hedging strategy far surpasses the strategy of early exercise sell and diversify.

6. Example 1 Assume that you own 5000 ESOs with an exercise price of $50. a .30 volatility, with no dividend with five expected years to expiration and the stock is trading at $80. The risk of losing a large portions of the value is greater with the stock at $80 than if it were trading at $120.

7. The value of the ESOs would be $180,000 (intrinsic value = $150,000 with time value = $30,000). If the ESOs are exercised by managers in California, they may net about $75,000 after tax for the asset that had a value of $180,000 prior to exercise. They then can buy $75,000 worth of diversified assets.

8. Example 2 Assume that you own 5000 ESOs with an exercise price of $50. a .30 volatility, with no dividend with five expected years to expiration and the stock is trading at $120. The risk of losing a large portions of the value is less with the stock at $120 than if it were trading at $80.

9. The value of the ESOs would be $365,000 (intrinsic value = $350,000 with time value = $15,000). If the ESOs are exercised by managers in California, they may net about $175,000 after tax for the asset that had a value of $365,000 prior to exercise. They then can buy $175,000 worth of diversified assets.

10. In both examples the manager has less than 50% of the value of what was there prior to the exercise and sale. The probability is very low that the manager will earn more on the net proceeds after exercise than he will earn from selling calls on the company shares prior to exercise. And that is why most top executives wait to near expiration to exercise their ESOs or SARS.

11. So in times like today where the market appears to becoming more volatile, it is wise to reduce risk efficiently. Rarely will early exercise sell and diversify have merit. Those who promote that strategy are generally violating their Fiduciary Duties to their clients. John Olagues olagues@gmail.com………. 504-875-4825