by Michael Ruzhansky, CFP®

One of the more frequent questions I get asked by clients and sometimes by their advisors is when is the best time to exercise employee stock options and sell the stock. As the stock market averages are hovering around all-time highs, I can not shake the feeling of dejavu. I have seen this movie before and it doesn’t end well. So I decided to publish a series of posts dealing with equity compensation planning. If you are joining a company or have been granted stock options at your current job, there are some important concepts you should understand about equity based compensation. The information below is meant to be educational in nature; I encourage you to seek assistance of a competent advisor.

Maximizing the value of your equity compensation requires a series of timely and balanced decisions over the life of the equity grant. Holding the options allows you to benefit from stock appreciation without laying out a dime. However, doing so for too long can diminish the value of the options or wipe it out entirely. If you are like most employees, you may think of the options as having a value equal to the current intrinsic value based on how the stock is trading on any given day. Intrinsic value is simply the difference between the strike price and the current market price of the stock. You may hear this value referred to as bargain element, spread, profit, and gain. It is important, however, to understand that intrinsic value represents only a share of the total value of the option.

What’s the other share? Think of an option as a perishable item with a ten year expiration date.* If you could sell your option with 8 years remaining until expiration, wouldn’t you want to be compensated for the potential upside the buyer is going to enjoy? Of course you would! And that is the second part of the option value or time value. Simply put, time value of an option is the potential incremental gain the holder of the options is expected to realize by continuing holding the option. The equation may be expressed like this:

Total Option Value = Intrinsic Value + Time Value

The only known variable in this equation is the Intrinsic Value. I don’t know about you, but it’s been a while since I had to solve an equation with two unknowns. Instead, what if we could calculate one of the unknowns or Total Option Value? Well, we can, using one of the several options pricing models used by professional traders to determine the price when they buy and sell exchange traded options. Bear with me for a minute and this will get better, I promise. One of such generally accepted models is the Black-Scholes option pricing model. It was first articulated by Fischer Price, Myron Scholes, and Robert Merton in 1973. Merton and Scholes received the 1997 Nobel Prize in economics for their work. They came up with a formula to calculate a weighted average profit from holding a stock option. Weighted according to the probabilities of each possible outcome. It is not a prediction of outcome!!! Rather, it’s an average of the possible outcomes which includes scenarios where options produce huge gains and scenarios with no gain at all. Still with me?

Stock Options planning is more of an art rather than exact science. Despite its somewhat academical nature, Black-Scholes calculation and the concept of time value provides very useful information for the option holder. Consider the following example based on a client experience I had several years ago.

I live and practice in New Jersey where Johnson & Johnson (JNJ) is probably one of the most widely held stocks or at least it was in not too distant past. Several years ago I was working up stock option analytics for a client in the context of a retirement plan. JNJ stock chart looked like a sleeping giant – it hasn’t done much in a decade prior to my analysis. Accordingly, with such low historical and implied volatility, the upside appeared limited and continuing holding the option appeared to be adding more risk than value to the portfolio. My initial recommendation was to realize most of the gains. Well, the sleeping giant has awoken and the stock has been on fire ever since. That’s the double edged sword of stock options. To put this in perspective, my client’s intrinsic value was in the millions; naturally, as a financial planner, I was worried about protecting the downside. For even a small percentage decline in JNJ price, would erase millions in potential gains in the options. My client, however, had a different outlook on the company. For those who want to know the rest of the story, we took some profits when the stock was in the $60s and let the rest of the stock options ride the stock market monitoring each and every grant along the way.

In conclusion, executive compensation packages are incredibly complex, yet they often make up a significant share of the wealth acquired and held by not only corporate executives but also rank and file employees. Don’t be lulled into thinking this is something you can do on your own despite the demands on your time elsewhere. You know what they say about attorneys who have themselves for a client. You need someone to inject discipline and professionalism into the process. Even professional athletes require coaching to hold them accountable in order to win championships. Oh, and we haven’t even scratched the surface on taxes, restrictions, time and manner of sale, etc., I will discuss these and other issues regarding corporate equity in subsequent posts.

*Majority of option grants have a 10 year term. However, there are outliers and it is important to know the term of the option for any calculations to be meaningful.

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