Underwater Stock Options Aren't Drowned

The following article was written by financial advisor John Olsen over 10 years ago.  At the time, the stock market like now had been hit with a substantial correction.  Company stock and option holdings had lost considerable value and many recipients believed the loss was permanent.  However, we all know the stock market recovered leading to the longest and biggest bull market on record.  So John's sage advice back then regarding providing equity compensation guidance bears repeating given the current financial crisis.

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For the last several years, having one’s money “in the market” has been like swimming against a rip tide.  No matter what you do, you seem to get farther and farther away from safety and closer and closer to getting sucked under.  Conventional wisdom tells us to “hang in there” because sooner or later the tide will change and we’ll be fine.

For most of us, that’s small comfort.  For our clients who have employer stock options, it may seem even worse.  Their incentive and non-qualified options are, in many cases, “under water” (i.e.: their strike price is higher than the current price of the employer’s stock). Some of those options may never have been “in the money”, but are a lot further away now. Others were “in the money”, but their owners waited too long to exercise them (or couldn’t exercise them because they weren’t vested), and now they seem worthless.

That’s not necessarily true, of course, but it can appear that way to many of our clients. Fortunately, there’s a tool that can help us help them understand the potential value of these submerged assets – a subscription website called  www.StockOpter.com (which, for purposes of this review, we’ll call “StockOpter”).

It’s a very powerful tool.  Like financial planning software, StockOpter allows us to compute, analyze, model, and manage. We can compute the current “in the money” (or “intrinsic”) value of our clients’ stock options and restricted stock and model their potential value, given hypothetical changes in stock price, stock price volatility, and interest and dividend rates. We  can  analyze the leverage inherent in  these holdings, and demonstrate when that leverage may be getting uncomfortably large or unprofitably small.   We can help clients manage vesting schedules and alert them to upcoming expiration dates.

But the real value of StockOpter lies not in its computational, analytical, and modeling capabilities (strong as they are) or in its capacity to manage data, but in its potential for managing one key relationship.   First and foremost, StockOpter is a relationship management tool.

All financial planning software deals with relationships, but these programs typically demonstrate how one set of data relates to another (e.g.: how a client’s current holdings relate to her projected retirement income or estate tax liability). By modeling changes in the nature of those holdings, and/or the rate of ongoing contributions to or distributions from them, we can “manage” the results (e.g.: in retirement income level or estate shrinkage).

But the key relationship, with StockOpter, isn’t how our clients’ incentive compensation relates to their overall financial well-being (although that’s certainly important).  What StockOpter.com helps us manage is even more crucial - the relationship of those clients to us, their financial advisors.  StockOpter is a counseling aid.  It enables us to monitor the intrinsic and potential values of our clients’ options so that we can alert  them to make appropriate and profitable decisions when those values change – as they surely will.

As a web-based tool, StockOpter offers access to analysis, alerts, and insights – both to us, as practitioners, and to our clients (if we allow those clients access to the website).  Its monitoring and alerts function will notify us (by email) of critical changes in values (e.g.: stock price, risk/reward ratios, the level of our clients’ concentration in employer stock & options) and of deadlines (upcoming vesting and option expiration dates), so that we can keep our clients fully informed – and advised.

There are several concepts which are unique to StockOpter, but two in particular can be of considerable value to clients. The first is “Forfeit Value”. This is the potential value of equity compensation  forfeited  when  an  employee  voluntarily  leaves  the  employer  prior  to retirement.  It is more than just the “in the money” value of the unvested options because options also have “time value” (by virtue of having a fixed exercise price and expiration date and because the price of the shares for which the options may be exchanged is not fixed). Stock option forfeit value is the sum of the remaining time value of the vested options and the full, or Black Scholes, value (in the money value + time value) of the unvested options. Forfeit value can often be a considerable sum – perhaps much greater than our option- holding clients realize. Our clients who may be considering a job change need to know what they might be leaving on the table.

The other concept unique to StockOpter – one that I like a lot, is ”Insight Ratio” – the time value of a stock option divided by its Black Scholes value.  Expressed as a percentage, Insight Ratio represents the remaining theoretical potential of an employer stock option, and can be used to determine whether it makes more sense to continue to hold that option or to exercise it now.  For example, an insight ratio of 10% means that 90% of the option’s value is “in the money” value – which is subject to loss if the stock price declines.  It equates to high risk and low further potential. By contrast, a 90% insight ratio means that 90% of the option’s theoretical value is time value, which will not be realized if it’s exercised today.   It equates to low risk and high further potential.

This concept provides an insight into a question that is – or should be – on the mind of every client who holds employer stock options – namely, should I exercise now or wait?  By sharing this insight (and others that StockOpter provides) with our clients, on a regular, ongoing basis (facilitated by the monitoring and alerts functions of StockOpter) we add value to our relationship with them.

In today’s climate of rampant stock price volatility, this relationship is more critical than ever.  Stock options that are “under water” (which our clients may now regard as “worthless”) may rise to the surface and beyond, perhaps very quickly. Options well “in the money” (with a low insight ratio) could plummet in value.  Clients who are kept informed can profit by being so – and we, their advisors, who keep them informed, will profit as well.

John L. Olsen, CLU, ChFC, AEP
olsenfin1945@gmail.com

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