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.