As you’ve probably heard over and over, if a compromise can’t be reached by congress by the end of the year to address the deficit, the Bush tax cuts expire and automatic spending reductions of federal programs go into effect. The results of these actions are predicted to cause an economic recession which will likely reduce company earnings and stock prices for some period of time. So how will this effect the value of ones employee stock options? The short answer is “not good” and here’s why:

  • Stock options have leverage because of a fixed exercise price. Consequently, when the stock price goes down by 20% the value of the options will decrease by more than 20%. The table below illustrates that a 20% decrease in stock price from $45 to $36 results in a 56.93% decrease in the option value of this portfolio.

  • If you combine this decrease with an increase in tax rates, a once valuable stock option portfolio is decimated. The tables below illustrate the change in value of an employee stock option portfolio given a 20% decrease in stock price AND a 5% increase in the combined state and federal income tax rate from 35% to 40%. The result is a decrease in the overall value of nearly 60% from $157,203 to $64,728.

What does this mean for current employee stock option holders? It doesn’t necessarily mean that one should liquidate all of their options before the end of the year while stock prices are relatively high and taxes are at their current rates. The beauty of a stock option is that they are exercisable up until the expiration date and time usually corrects economic down-turns. However, for grants that are nearing expiration it’s a good idea to look at their current Insight Ratios. Option grants with Insight Ratios of less than 10% are good candidates for exercising and selling because the in-the-money value represents 90% of the option’s value and is at risk of decreases in stock price and increases in tax rates. Liquidation of grants with high Insight Ratios (i.e. above 50%) is generally not prudent because these options have a significant amount of remaining theoretic potential and positive leverage.

Let’s all hope that congress comes up with a viable alternative so we don’t go over the fiscal cliff and into a recession. But in the meantime, take a good look at your current employee stock option grants and discuss them with an experienced equity compensation advisor who can calculate their Insight Ratios and advise you accordingly.

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  1. Since I am receiving your messages, I feel compelled to reply.

    1. The volatility assumed in calculating “fair value” of the ESOs, should be the volatility implied by the exchange traded calls (with exercise prices and time remaining similar to the ESOs). The volatility that the company assumed on last grant day should be ignored. If there are no calls with similar terms, then the short term historical volatility should be used.

    2. Certainly the possible “fiscal cliff” and the desire that some may have to reduce risk should be considered. Persons holding ESOs with substantial “time value” remaining can reduce risk by selling exchange traded calls . This way they can reduce risk without early exercising and forfeiting the remaining “time value” back to the company and paying an early tax?

  2. Good discussion. As a retired (not by my choice) IBMer, I was fortunate that I began a second career as a Senior Retirement and Estate Planner. As such I took all of the risk out of my 401K portfolio by taking the funds and moving them into Loss Proof Insurance products. I now get a partial share of the gains in the Market, with ZERO exposure to Market loss. As an added bonus, you pay no fees, and there are still products available that will give you an immediate cash bonus in the double digits, just for moving into these vehicles. The Wharton School of business did the first real world study of these products, from their inception in 1995 through 2009. This study took real product and real customer accounts. It was the first study to actually track the effect of annual resets, etc. on real issued policies. The findings were amazing. These products outperformed investment in the S&P 500 over 70% of the time and a portfolio of 50% S&P 500 and 50% one year treasury bills 88% of the time. A chart in the study shows how an equal investment in each in 1995 was worth in 2009 (prior to the big hit the market took in 2009) and both Insurance products had significantly higher cash values than the traditional investments. All of this with taking zero risk in Market Losses. The study also noted that it did not subtract any broker, fund, or administrative fees from the results. So the actual gap in earnings is larger than the chart displays. Many investments take about 2-3% in fees annually in the open market (this is not the case with an IBM 401K).I would be happy to provide a copy of that study, and an offer to educate anyone in our group so they may make an informed decision to see if they think this may be a strategy they are interested in and if they could qualify for these products. Some of these products now come with riders that provide Long Term care,guaranteed income you cannot outlive, etc. that can be quite beneficial. Many Insurance Companies are either getting out of the LTC business, or significantly raising rates. I have several clients who had purchased LTC 15-20 years ago that have gotten letters this year raising their LTC rates as much as 92%! With these products the LTC is given to you based on the initial investment, and you pay no additional premiums to fund it. For example, a 65 year old woman can invest 100K and receive approx. 180K in death benefit, and 360K in LTC. With the Market being essentially flat for the last 14 years, everyone should take a look at it. The Market is set up for Fund Managers, Brokers, and investment firms to make money, not you the individual. I am sure they were not thrilled that a summary of the Wharton findings were published in the Wall Street Journal.

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