1. Employee Stock Options: Introduction
  2. Employee Stock Options: Definitions and Key Concepts
  3. Employee Stock Options: Comparisons To Listed Options
  4. Employee Stock Options: Valuation and Pricing Issues
  5. Employee Stock Options: Risk and Reward Associated with Owning ESOs
  6. Employee Stock Options: Early Or Premature Exercise
  7. Employee Stock Options: Basic Hedging Strategies
  8. Employee Stock Options: Conclusion

As we saw in the preceding chapter, your Employee Stock Options (ESOs) can have significant time value even if they have zero or little intrinsic value. In this section, we use the common 10-year grant term to expiration to demonstrate the risk and reward associated with owning ESOs.

When you receive the ESOs at the time of grant, you typically have no intrinsic value because the ESO strike price or exercise price is equal to the stock’s closing price on that day. As your exercise price and the stock price are the same, this is an at-the-money option. Once the stock begins to rise, the option has intrinsic value, which is intuitive to understand and easy to compute. But a common mistake is not realizing the significance of time value, even on the grant day, and the opportunity cost of premature or early exercise. (Related: Concept of Risk vs. Reward)

In fact, your ESOs have the highest time value at grant (assuming that volatility does not spike soon after you acquire the options). With such a large time value component – as demonstrated in Section 4 – you actually have value that is at risk.  Think of time value as forming part of your compensation and explore alternatives to extract this time value, as we discuss in Section 7.

Assuming you hold ESOs to buy 1,000 shares at an exercise price of $50 (with volatility at 60% and 10 years to expiration), the potential loss of time value is quite steep. If the shares are unchanged at $50 in 10 years time, you would lose $35,000 in time value and would be left with nothing to show for your ESOs.

This loss of time value should be factored in when computing your eventual return. Let’s say the stock rises to $110 by expiration in 10 years time, giving you an ESO spread – akin to intrinsic value – of $60 per share, or $60,000 in total. However, this should be offset by the $35,000 loss in time value by holding the ESOs to expiration, leaving a net pre-tax “gain” of just $25,000. Unfortunately, this loss of time value is not tax-deductible, which means that the ordinary income tax rate (assumed at 40%) would be applied to $60,000 (and not $25,000). Taking out $24,000 for compensation tax paid at exercise to your employer would leave you with $36,000 in after-tax income, but if you deduct the $35,000 lost in time value, you would be left with just $1,000 in hand.

Before we look at some of the issues surrounding early exercise – not holding ESOs until expiration – let’s evaluate the outcome of holding ESOs until expiration in light of time value and tax costs. Figure 2 shows after-tax, net of time value gains and losses at expiration. At a price of $120 upon expiration, actual gains (after subtracting time value) are just $7,000. This is calculated as a spread of $70 per share or $70,000 in total, less compensation tax of $28,000, leaving you with $42,000 from which you subtract $35,000 for time value lost, for a net gain of $7,000.

Note that when you exercise the ESOs, you would have to pay the exercise price plus tax even if you do not sell the stock (recall that exercise of ESOs is a tax event), which in this case equates to $50,000 plus $28,000, for a total of $78,000. If you immediately sell the stock at the prevailing price of $120, you receive proceeds of $120,000, from which you would have to subtract $78,000. The “gain” of $42,000 should be offset by the $35,000 decline in time value, leaving you with $7,000. 


Figure 2: ESO representing 1,000 shares of stock and exercise price of $50 with 10 years to expiration 

Employee Stock Options: Early Or Premature Exercise
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