If you’re a financial advisor with clients or prospects that receive stock options from their employers, it can be like falling into a well and finding a bag of money at the bottom. These individuals represent a fantastic long-term business opportunity; but there’s a catch, you need to be able to help them determine “why” and “when” they should exercise, sell and diversify.
Here's 3 quick lessons on what advisors need to explain to their clients to make timely and profitable decisions regarding their employee stock options (ESOs).
Employee Stock Options: 101
ESOs give the recipient the right (not the obligation) to purchase shares of their company’s stock at a set “exercise” price. These grants are generally subject to a vesting schedule (e.g. ¼ per year) that allows them to exercise/purchase, and have an expiration date (usually 10 years after the grant date). When the current price of the stock is higher than the option’s exercise price, the option is said to be “In-the-Money”. When the stock price is lower than the exercise price, the option is “Under Water” and has no value.
Stock option value is calculated with the following formula: Current Price – Exercise Price * # of Options. For example, if the employee is granted an option to purchase 1,000 shares of company stock at a price of $10 this option would be worth $10,000 if the stock price rose to $20 ($20-$10*1,000).
Based on historical stock market data, it is “likely” that an option will be “In-the-Money” after vesting and prior to expiration (i.e. after year 4 and before year 10 ). The challenge that employee stock options present is “at what stock price” should they be exercised to realize their value? Waiting until right before expiration is risky particularly if the option has been fairly deep in-the-money.
Employees can often establish “limit” orders or “10b5-1” trading programs that sets the price at which the option will be automatically exercised and the shares sold. Detailed information about Rule 10b5-1 can be found at Investopedia, but the question remains, “what’s a good target stock price?”
Financial advisors and their clients struggle with this question and often revert to something that has a lot in common with a “hope and a prayer” or a “monkey and a dart board.” However, there is a better way for determining a reasonable and rationale stock option exercise price target and it’s based on risk.
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The “Insight Ratio” implemented in StockOpter by Net Worth Strategies in 2003 is a great way to illustrate stock option risk v. reward. It’s simply the Time Value of the option divided by the Full Option Value. Both values are calculated by stock option valuation methodologies like “Black-Scholes”. Here’s a link to an in-depth explanation of the Insight Ratio.
An Insight Ratio of 10% means that 90% of the option’s Full Value is “In-the-Money” and at risk compared to the 10% representing the theoretical Time Value. As an option gets deeper in the money and closer to expiration the Time Value becomes smaller and smaller and the risk of continuing to hold the option becomes larger and larger.
The Insight Ratio can establish an acceptable level of risk which then can be used to calculate future stock prices. Here’s an example using the following assumptions:
- Current Stock Price: $95
- Target Insight Ratio: 10% (risking 90%)
- Date: 8/28/19 (for calculating time to expiration)
- Volatility: 30%, Risk Free Rate: 2.5% (from annual report)
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The above table calculates the current Insight Ratios and the future stock prices in 6-month intervals to reach the 10% target. The 2013 grant is deep In-the-Money, fully vested and approaching expiration resulting in an Insight ratio of 3.73% which is well below our 10% target. Consequently, we don’t need to calculate future stock prices and instead the future time periods are all labeled “<10%.”
The 2015 NQSO grant has a current Insight Ratio of 16.07% which is above our 10% target so we can calculate future stock prices to achieve 10% Insight Ratios at 6. 12, 18 and 24 months from the current date. Note that the future stock prices decrease over time. This is because the time to expiration is also getting smaller which is factored into the Black-Scholes calculation.
In this example, the 2015 grant will have an Insight Ratio of 10% “if” the company stock price goes from $95 to approximately $113 in 6 months or to $108 in 12 months. These stock prices for this grant can be used in a 10b5-1 trading plan, limit order or just to give the client an idea of when they should be pulling the trigger.
This "price targeting" methodology has recently been implemented in the StockOpter.com “Option Ratios” Dashboard. It provides a unique means of correlating risk and stock prices to facilitate realistic, rational and informed decisions regarding when to exercise and sell one’s employee stock options. If you are not a current StockOpter user you can play with this functionality using the sample data in the online demo.