iOptions Goes Where Microsoft, Google May Have Feared to Tread - 15 May 2009

How do ECE members feel about this concept?

Would you consider opening your stock options pans to allow employees to sell options an their options?

From an investment standpoint, this is a very sensible thing for employees. Many, if not most, companies with executive options don't allow hedging strategies, arguing this vitiates the whole idea of having some skin in the game.

For people below this level, however, this seems like a sensible thing for companies to let people do and maybe even facilitate their doing, provided that they make equity grants periodically. That way, ordinary employees have a continuing stake in how the company does, but once an existing group of options vest, they will not be at so much risk. Ironically, this may encourage employees to hold onto their options longer than they otherwise would -- you don;t have to sell to lock in all your gains. One strategy for a company might be to facilitate these kinds of hedges for employees, but only allow x% (50?) to be hedged for any one group of vested options.  Employees could also just sell.

I wonder what this would mean for ISO's. If you hedge an option to meet the holding requirements, woudl the IRS think highly of that or consider it just a strategy to avoid taxation?

I agree with Corey Rosen that it would be "sensible" to allow stock plan participants to realize some of the time value in their vested options by selling calls on them.  However, the impediment here is that employees don't understand the concept of "time value" because companies in general don't provide employees with this type of information regarding their stock options.  I've heard that companies with tradable option programs rarely have any takers.  Companies would need to enhance their stock plan education programs to provide information on time value for option trading programs to work.

I would consider it with considerable employee training and education.

Let's hear from the plan designers and complensation consultants.

What percentage of you past 2 years of clients would be candidates for this sort of program?

How would you communicate its value to shareholders?

Would you this a plan design issue, or is it something that your would let them company think about after your engagement was finished?

Let's hear from the valuation experts.

How does this change valuations?  Or does it change them at all?

Would this make options more or less valuable (according to models or opinion)?

This innovation would increase the value of the options at grant date. The reason is that right now employees have to exercise early in the life of their grant if they want to get any value from the award. If they can write (sell) an offsetting option, then they can realize value earlier without exercising their employee option.

Net result is that the average life of the options would increase, and so the associated compensation cost would increase as well.

If you compare to Google's transferable option, the valuation increase here is likely higher. The reason is that Google employees "see" a higher value earlier in the life of their option than they would compared with a traditional option, and so they tend to exercise earlier than for a traditional option. This partially offsets the 2 year life increase because the investment bank will hold the option for 2 years after the employee "exercises" (really transfers). My firm does the valuation for Google's transferable options so I am quite familiar with all the valuation issues for these types of complex instruments.

In the present case, employees might logically keep writing offsetting calls against their option until the option expires or they terminate. If they do that, there would be likely be a substantial increase in expected term and hence expense for the company. The percentage of employees participating and the post-vest termination rate for the employees would then be the biggest drivers of the valuation.

There is never any free lunch under FAS 123R. If a new design increases the economic value to the employee it will likely also increase the expense to the company. The only exceptions are designs that reduce the "wedge" between expense to the company and the perceived value to the employee. This innovation does not do that.

If a company now explicitly permits an employee to hedge, then there is also a good argument that this is a modification of the option because the fair value has now increased. I'm less clear on what should happen if the employer does not address this explicitly - the original fair value of the award is increased by this technique and so the original fair value of the award is now shown to be incorrect in light of this new technique. But FAS 123R makes no provision for revaluing an equity (non-liability) award that is not modified. So that raises the interesting question of whether you can get an implicit modification of the award without any explicit action by the company.

Peter

Just thought I would put my two cents here.

Just about all companies have Stock and Options Plans that prohibit transferring, or pledging the ESOs as collateral .

Most plans do not prohibit hedging of the ESOs. Although, there are some that do prohibit hedging against company stock or ESOs. The hedger in most cases is required to deposit margin to sell calls. If he buys puts he has to pay for the puts. Often the hedger owns stock that can be used for collateral thereby eliminating the cash deposit.

Hedging gives an alternative to premature exercising as a way to reduce the risk of holding ESOs, which if done efficiently will substantially improve the net outcome to the employees.

The IOptions plan in my view is unworkable unless the companies not only modify their plans to allow pledging of the ESOs, they will also have to eliminate the requirement of reduced time to expiration upon termination.

Even if the above is done, the IOptions plan exposes the employee to premature exercise of the ESOs by the broker if the stock runs up, causing a forfeiture of time premium and an early tax. The plan I am sure will have increased transaction costs.

If the firms are willing to accommodate the interests of the employee to the degree of altering the plans to promote risk reducing hedging, there are easier ways to reduce risks by designs of the plans itself.

Yes, it is true that allowing hedging and making the ESOs pledgable will increase the value a bit. It only adds value if it allows something to be done that can not at present be done.

Since effective hedging can be done at present, the value increase is small. Or perhaps the "fair value" used to calculate expenses against earnings is understated and the realization of that fact would require a higher "fair value"

John Olagues