IMAGE: Marco Rubino / 123rf.com
By John Lau CFP®, CPA, RIA, M.S. (Tax)
Employee stock options (ESOs) are a form of compensation corporations give to executives and senior employees. Unlike salary or bonuses, the value of a stock option increases with the price of the company’s stock. The idea is so that the stock option would serve as a performance incentive for the employees. Employee stock options can be worth tens or hundreds of thousands of dollars—or more. Unfortunately, most option holders focus only on the in-the-money value and cash-out value of their portfolios. To do so would be a mistake, which may lead to leaving a lot of money on the table. To properly assess your stock option portfolio’s value, it is important to also take into account time value and your option portfolios’ forfeit value. Here are the 5 ways to value your options:
A. In-the-Money (ITM) Value: The ITM value is the difference between the current “fair market value” (FMV) per share of your company stock and your exercise price (or strike price) times the number of options. ITM value is sometimes known as the “intrinsic” value. ITM value applies to both vested and unvested options. You cannot, of course, realize the value from your unvested options until they vest.
B. Cash-Out Value: This is the net-of-tax value of exercising and selling your vested stock options at a given FMV. This is the net in-the-pocket value of your vested stocks after taxes are paid. Remember, you cannot realize the value from your unvested options until they vest.
In addition to the two common values above, there are two additional unique values of your Employee Stock Options: “Black-Scholes Value” and “Time Value” that can be used to help you make better decisions about when to consider exercising your stock options.
C. Time Value (TV): Time value is an important metric at determining when to exercise options because, as the Time Value decreases, so does the value of holding the option. There are three important factors that determine the Time Value of your options:
- The expiration date: the greater the time until expiration, the greater the Time Value of the option.
- The strike price: Time Value decrease as your option’s in-the-money value increases.
- Stock volatility: an option on a stock whose price is highly volatile (i.e., fluctuates substantially) will have a greater Time Value than an option with lower volatility because it reflects a heightened potential upside of the stock.
D. Black-Scholes Value: This represents the TOTAL value of your stock options, including “intrinsic” value (In-the- Money value) and Time value. ITM options with a low TV may be good candidates for diversification.
E. Option Forfeit Value: The Forfeit Value (FV) is the opportunity cost associated with leaving your company. It is how much you are leaving on the table by leaving your current employer. It is a value that should be taken into account in considering the offer from the new employer. The FV includes not only the ITM of your unvested options, but also their TV. In short, your FV is the sum of the TV of your vested options and the Black-Scholes Value (i.e., ITMV + TV) of your unvested options.
Employee stock options can be worth tens or hundreds of thousands of dollars—or even more. Proper valuation of your employee stock option portfolio would help you evaluate your equity compensation holdings in relationship to your personal financial goals, and to help establish a framework for making informed decisions about when option exercises should be considered. To your health, wealth, and happiness.