By Stoddard Barnhill and Phillip Barnhill
This is a geeky treatment of a complex subject. Still, our singular intent in this blog is to introduce you to a statistical methodology to help optimize your option exercise strategy. Therefore, for this blog, we assume that our reader has a core grasp of the mechanics of equity compensation.
If you are new to Stock Options, please enjoy the article but call us immediately because some of this won’t make sense. BTW, if you’ve been exercising stock options for a while and you’ve suspected there must be a “better-informed way,” please call us, and we will bring these ideas to light in your life.
Are there conflicts of interest in option exercise timing? You bet! Here are 4 of them:
- Though it is obvious, it is worth mentioning there is always an inherent conflict of interest between the option holder and the investment manager providing advice on exercise timing.
- There is a not-so-obvious conflict around watercooler conversation amongst one’s peers simply because 9 out of 10 peers have differing non-disclosed needs and objectives from you!
- There are conflicts of interest between one’s ears. Here are the two most apparent conflicts:
- Fear Of Missing Out (FOMO). FOMO results in exercising too early after a run-up.
- Remember the line: “pigs get fat, hogs get slaughtered?” Hogs generally wait too long, seeking those last two bucks a share while risking a more significant loss from the eighty-eight bucks a share already earned.
- Lastly, the necessity of paying for a known expense like a child’s college education or vacation property is an excellent example of another potentially self-limiting conflict of interest.
- Exercising options early to pay $879,000 cash for the cabin can, in retrospect, had one held the options until they were ripe, make that cabin cost $1,750,000. Frequently, there are alternative ways to achieve the objective without prematurely exercising a grant. (This is a financial look only, not a holistic example).
So, C/Suite, what’s your magic formula? The Insight Ratio!
Long ago, we wanted to find a rigorous methodology, independent of human bias, to provide a fresh perspective to our clients’ option exercise considerations. So, we turned to a well-named index called The Insight Ratio, which has stood the test of time for over 20 years, and in our firm, at least six thousand individual stock option exercise decisions!
Who developed the Insight Ratio? Net Worth Strategies.
The Insight Ratio was developed by Net Worth Strategies, Inc., a company started by a retired IBM executive in 2000 who was continually frustrated that he never received proper counsel on when to exercise his IBM stock options. So Net Worth Strategies brought computing power and statistics into the decision equation. Ironic result: In the end, the Insight Ratio begins as a product of algebra: A + B = C! This equation needs to be understood before we share the simple beauty of the Insight Ratio.
A = The In-The-Money-Value of a grant (ITMV). ITMV is the difference between the strike price and the current stock price times the number of options in a particular grant. The greater the ITMV of a grant, the more one stands to lose if the stock loses value. (Hogs get slaughtered)
B = The Time Value remaining in a particular grant (TV). TV is a statistical calculation (which does take computing power) of the potential upside value remaining in a grant. When an option is newly issued, it has no ITMV, and so the grant’s value is composed of purely statistical upside. Thus, the smaller the TV becomes as the grant matures, the “riper” a grant becomes to exercise! (now we’re getting warmer).
C = The total value of the grant, otherwise known as The Black Scholes Value of a particular grant (BSV). BSV (C) is equal to the sum of ITM (A) plus TV (B). BSV is the statistical and mathematical calculation that most Fortune 500 CFO’s use to value option grants for accounting purposes. Our firm uses the same underlying assumptions that our clients’ CFO uses to calc the Black Scholes Value at a corporate level.
Hey, stop all this math blather; what is the Insight Ratio (IR)? Here it is: IR = TV/BSV
The Insight Ratio reflects option ripeness from a mathematically sound, statistically valid point of view!
- At any point in time, if we take the remaining upside in a grant (TV) and divide that by the total value of the grant (BSV), then we get an index number (expressed as a percent). The lower the percent, the riper a grant is to exercise from a statistical point of view!
- The Insight Ratio is a powerful tool over an officer’s option exercise career with broad and differing applications. For example:
- Initially, an officer may be skeptical of the validity of the Insight Ratio, so our team merely records the ratio for each exercise the officer makes. Over time, our client begins to notice a pattern and recognizes a statistical comfort zone unique to their personal risk/reward preference.
- We proactively alert a client when the Insight Ratio reaches their statistical comfort zone. Establishing a comfort zone leads non-insider, non-blocked clients to proactively place exercise requests at predetermined price points, so the option exercise process goes on autopilot! In addition, having a process ends the stress of exercising options.
- What about insiders? Learning a personalized statistical comfort zone can help build a more sophisticated 10b5-1 Trading Plan. Insight Ratio can be a recognized trade trigger in a Trading Plan!
The Insight Ratio is not about market timing or some crystal ball. Instead, we help our clients find their Insight Ratio number, sort of like finding their “sleep number!”
Senior leader clients do not want somebody telling them what to do. Instead, leaders want a personal advocate who is relentlessly aware of their family’s changing and unique needs who will proactively alert them to both dangers and opportunities and provide context for appropriate response.
Are you telling us that with over 6,000 individual option exercise experiences, the ONLY measure of ripeness you use is the Insight Ratio? NO!
There is wisdom in many counselors, so we advocate for utilizing all sources of input mentioned above but layer over your decision this fifth element, the Insight Ratio, which is 100% unconflicted by our flawed, human tendencies.
There are other great anecdotal decision metrics beyond the scope of this blog. However, for those senior leaders who have never calculated their Insight Ratios, at no charge, we will provide an Insight Ratio analysis for every option grant you hold. The payback for your indulgence can be in the millions of dollars throughout your option exercise career. So call us, and we’ll roll up our sleeves for your family.
The Insight Ratio is a copyright of Net Worth Strategies, Inc. and is part of their professional equity compensation analysis platform StockOpter.com.