Most comprehensive Paper ever written on Employee Stock Options by the foremost expert in the world. www.truthinoptions.net olagues@gmail.com 504-875-4825 http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470471921.html

1. .
an analysis of
Employee Stock Options
not for dummies
Author John Olagues

2. .
Table of Contents
1) What are Employee Stock Options... Contract terms and restrictions
2) Purposes of the Employee Stock Options grants
3) Values of the Employee Stock Options grants
4) Risks of losing the Employee Stock Options value
5) Fiduciary Duties of advisers to reduce risks
6) Premature Exercises, Selling and Diversifying of ESOs and the consequences
7) Insider Trading Policies used to force early exercises
8) Probabilities of increased values
9) Early Exercises and consequences to the employee and the company
10) Taxes to the employee and the company
11) Dynamic Employee Stock Options..a new superior options design that works
1

3. .
What are Employee Stock Options?
Employee Stock Options are contracts between an employee or executive and the
company which grants the options. Most often these grants are substitutes for part of
the grantees compensation.
These contracts give the employee/grantee rights to buy a certain number of shares
of company stock from the company. The company assumes certain liabilities to
issue and deliver the shares to the grantee if and when the employee stock options
are exercised. These employee stock options contracts usually have the grant day
market price as the exercise price, have maximum time to expiration of 10 years and
can not be exercised until the options vest (perhaps 1 to 4 years after the grant).
The term of these contracts are outlined in the Employee Stock Plan and the Grant
Agreements.
The options are generally not transferable and not pledgeable.Generally, there are
no prohibitions in those contract documents against selling exchange traded calls or
buying puts to manage the employee stock options efficiently. The contract terms
cannot be changed if the change is detrimental to the employee, unless the
employee agrees to the change.
2

4. .
Google, Cisco and Apple Plan Documents
Below are links to the Google Stock Plan Document, the Cisco Incentive Stock
Plan document and to Apple's Stock Plan Document.
Google
http://www.secinfo.com/d14D5a.r3mD3.d.htm#1stPage
Cisco
http://www.secinfo.com/d14D5a.v5RKa.d.htm
Apple
https://mail-attachment.googleusercontent.com/attachment/?
ui=2&ik=53fbb1432b&view=att&th=13737f47396603d2&attid=0.
1&disp=inline&safe=1&zw&saduie=AG9B_P-
A3YBdVyb5dP27bKQ7mICC&sadet=1336839257456&sads=YngX7kheBqgErOKAMKEUXwfA0BQ
None have prohibitions against selling calls and buying puts.
3

5. Although all of the Stock Plan documents prohibit transferring or pledging the
employee stock options (Google allows a limited form of selling to selected banks
and under some circumstances the Cisco Employee Stock Options can be
transferred to family members).
Nor is there any prohibition against hedging in the Options Award Agreements.
Options Award Agreements generally outline the specific terms of a particular
award. For example: the Award Agreement states the number of shares that can
be bought, the exercise price, the vesting period(s), and the expiration date.
The Stock Plan and Award Agreements are the documents that constitute the full
contract between the company and the grantee regarding the granted equity
compensation.
Since there is no prohibition against hedging in the contract documents, why do
many companies discourage the strategy? Some even tell their employees that
hedging is prohibited by the plan.
If holders of employee stock options are prohibited from hedging ESOs, then why
is it not clearly written in those contract documents?
4

6. The answer is that the company officials know that there is generally no
prohibition in the company documents but they know that premature exercises
benefits the company in three ways as explained below. Therefore the company
encourages premature exercises.
1. On premature exercise, the employee forfeits the remaining "time premium",
which the company recaptures. In effect the company's remaining liability to the
employee is eliminated.
2. The employee pays an early tax, and the company gets an early deduction
from income tax, equal to the difference between what the exercise price is and
what the stock could be sold for in the market.
3.The employee pays the exercise price early and that adds to the cash flow to
the company also.
See the following slide for a better understanding of the consequences of early
exercises to the employee.
5

8. When most of the plans were established, there was no prohibition against
hedging. And the plans require that if there is a change to the plan which may be
adverse to the grantee, the company needs the approval of the grantee.
So the companies can not just insert a prohibition against hedging into their
present plans, because that diminishes the value of the ESOs to the existing
grantees and those who relied on there being no prohibition.
7

9. So the companies try to make employees think that there is a prohibition when
there is none. But there is a drawback to that strategy and that is if the company
adviser tells the employee he cannot hedge and the stock goes down after he is
told that he cannot hedge, the company would be liable for damages.
Also, in my opinion, the advisers who tell their clients that they cannot hedge
when the documents clearly allow hedging, open themselves up to a liability
similar to the company's liability.
The difference in value that the grantee will receive is on average about 40%
more from selling calls and buying puts compared with a premature exercise
strategy with the stock 90% above the exercise price after vesting. So the liability
is not incidental.
8

10. In summary, Google, Cisco and Apple have no prohibitions against selling calls or
buying puts in the plan documents. Holders of ESOs are free to manage their
equity compensation as they see fit as long as it is consistent with the Plan
Documents and Options Agreements, without further approval from anyone.
However, it does appear that Apple has in January 2012 modified its Insider
Trading Policy to try to prohibit all trading in puts and calls even when selling the
stock is allowed under 10 b-5 and their Insider Trading Policy. Similarly Google
apparently changed its Insider Trading Policy to prohibit "hedging"
There has never been and will never be a prosecution of a civil complaint or
criminal complaint under 10 b-5 for selling calls or buying puts when the sale of
stock is permitted by 10 b-5 at the same time in the same account. So why does
Apple and perhaps Google prohibit trading in calls and puts when trading the
stock is permitted under 10 b-5?
The answer is that they want to use the Insider Trading Policy to try to stop the
most efficient way of managing the grants by the owners of employee stock
options. They do this because efficient management by the employee raises the
cost to the company and delays the cash flows to the company. Selling calls
versus ESOs actually extends the alignment of employee /shareholders whereas
all alignment is lost upon early exercise and sale.
9

11. .
Purposes of the Employee Stock Options Grants
These options are granted to align the interests of the grantee with the shareholders.
They are granted as cashless compensation for past and future performances with
the company and to attract and retain long term high quality employees. But it is
undecided as to how effective they are in that objective. In addition, the companies
use the grants of employee stock options to preserve present cash. Options grants
are also made to generate future cash flows when the company issues and sells
new shares pursuant to the exercise of the employee stock options. New cash is
also generated when the companies deduct from taxable income the "intrinsic value"
of the employee stock options when exercised. A major portion of the entire cash
flows for some companies come as a result of exercises of employee stock options.
10

12. .
See the links below for how valuable those cash flows are to the companies.
http://www.slideshare.net/OLAslideshare/employee-stock-options-and-investments
http://www.slideshare.net/OLAslideshare/ssrn-id1101271
Effectively, the grant and exercise of the employee stock options become a form of
"money creation" for companies which have liquid markets for their stock. However,
this "money creation" that comes as a result of the issuance of and exercise of the
employee stock options, will come faster if premature exercises of the options are
made. Therein lies the reason behind the promotion of the early exercise, sell and
diversify strategy to the great mass of grantees other than some top executives who
understand the true "nature of the game" and hold their ESOs to near expiration.
11

13. .
Value of Employee Stock Options
Values of Employee Stock Options can be calculated using standard theoretical
models. The assumptions of "expected time" to expiration can be input into the
calculation instead of the maximum time to expiration in consideration of the
probability that the grantee will terminate employment early or prematurely
exercise the employee stock options.
The matrix on the following page illustrates the values of the employee stock
options on the grant day to buy 1000 shares when the stock is trading at $40.
12

14. Illustration of the values of the employee stock options on grant day using
different volatilities with the stock trading at $40, with an expected time to
expiration of 6.5 years.
# of ESOs.........Assumed.........Assumed........Expected time........Theoretical Value of
Granted..........Interest rate........Volatility........to Expiration..........1000 ESOs at grant
..1000.....................3%..................25..................6.5 yrs....................$12,600
..1000.....................3%..................40..................6.5 yrs....................$17,400
..1000.....................3%..................50..................6.5 yrs....................$20,470
.
SSo the "fair value" of 1000 ESOs or SARs granted with an exercise price of $40,
and with 10 years of maximum contractual life with a .50 volatility is $20,470
on the day granted. The perceived values of the options by the employee
may be more or less that the amounts stated depending on his expectations
of longevity with the company and the quality of advice received to manage
such grants.
The values in the right hand column are the values at risk on the day of grant.
These values erode everyday unless the stock increases in market value.
13

15. .
Risks of Losing those ESO values
What are the risks of losing the value of those employee stock options and
what are the fiduciary's duties to understand and advise reduction of that risk
efficiently. See the next two slides for an illustration of where the risk is the
highest when holding employee stock options. The illustrations show that the
best time to reduce risk is when the ESOs are moderately in-the-money. That
can be done efficiently only by selling calls and buying puts.
The following slides illustrate the risk of loss of the value granted and why
holding vested moderately in-the-money employee stock options unhedged is
more risky than holding deep in-the-money employee stock options.
The fourth slide addresses how to reduce that risk.
14

16. Illustration of the risks of losing the granted values with different
expected times to expiration and different volatilities.
Expected time........Expected Volatilities.......Probabilities of ESOs
to Expiration...........of the Underlying.............being Worthless
.......................................Stock.........................at Expiration
5 yrs..................................30..................................40
3 yrs..................................30..................................44
1 yr....................................30..................................47
------------------------------------------------------------------------
5 yrs..................................50..................................60
3 yrs..................................50..................................57
1 yr....................................50..................................54
------------------------------------------------------------------------
So with 5 expected years to expiration with a .30 volatility, the chance is 40%
that you will receive nothing for your ESOs. With higher volatilities, the chances
are higher that you will receive nothing.
15

17. Where is the Highest Risk when holding Employee Stock Options?
.
The Matrix below shows the “fair value” of employee stock options at various stock prices at different times to expiration. This
allows an examination of the changes in the ESOs value over times and the risks of holding the ESOs under different conditions.
Exer.......Stock.......Volatility......Days to..........Fair.......…......Time.
Price......Price..........................Expiration......Value...............Value
50………50.00.............35.............1400............14.01...............14.01 …......The color equations below show the % drops in the
50………56.25.............35.............1400............18.38...............12.13…........ESOs "fair value" with 25% drops in the stock.
50………75.00.............35.............1400............33.07 ………....8.07…........The largest % drops in the ESOs are with the options
50………93.75 ............35..............1400............49.48................5.75…........that are moderately in-the-money compared to the
50…..…100.00.............35..............1400........... 55.21...............5.21 ...........% drops in the deep in-the-money ESOs.
50….…. 125.00............35..............1400............78.73............... 3.73
50……..50.00..............35..............1000..............11.76...............11.76……......This is proof that when the stock is trading
50……..56.25..............35..............1000..............15.92................9.67……...... at $100 with an exercise price of $50, the risk
50……..75.00..............35..............1000..............30.58................5.58 ……..... is less than when the stock was trading at $75.
50……..93.75..............35..............1000..............47.22................3.47….....….The higher risk is from the higher volatility of the
50……100.00..............35..............1000............. 53.03................3.03….......…options values and the much larger erosion of
50……125.00..............35..............1000..............76.93................1.93…....…. higher “time values” when the stock
is moderately above the exercise price
50……..50.00..............35...............500................8.31................8.31
50……..56.25..............35...............500...............12.35................6.13............33.07 to 12.35 = 20.72 = 63% drop
50……..75.00..............35...............500...............27.42............... 2.47 …..…..55.21 to 27.42 = 27.79 = 50% drop
50……..93.75..............35...............500...............44.83................1.18….....…78.73 to 44.83 = 33.90 = 43% drop
50…….100.00.............35...............500...............50.97................0.97
50…….125.00.............35...............500...............75.61................0.61
16
.

18. Exercise...Stock.....Volatility.....Days to..........Fair…............Time.
.
Price.........Price.......................Expiration......Value..............Value
50……......50.00.............35............500..............8.31................8.31………
50……......56.25.............35............500............ 12.35...............6.11………
50…..…....75.00.............35............500.............27.42............... 2.47 ………
50…..…....93.75.............35............500.............44.83................1.18……….
50…….....100.00............35............500.............50.97................0.97………
50…....….125.00............35............500.............75.61................0.61...........25 % stock drops over 400 days show greater
percentage losses for the ESOs with lower "intrinsic
values" as shown in the color graphs shown below 50.............
50.00..............35...........100..............3.68...................3.68
50……... ..56.25.............35............100..............7.82.................. 1.57............ 27.42 to 7.82 = 71.5% drop
50……... ..75.00.............35............100............25.12........... .......0.12 .............50.97 to 25.12 = 50.7% drop
50……... ..93.75.............35............100............43.83.......... ........0.07..............75.61 to 43.83 = 43.0% drop
50……....125.00.............35......... ..100............75.05........ ..... ....0.05
If different percentage drops of the stock were examined, (for example 30 35, or 40% drops), the results of the percentage drops
of the options would show greater percentage drops. If the stock drops occurred over longer periods, the percentage drops in the
options would be even greater because of the greater erosion of the "time value" over longer periods .
This means that if fiduciaries are concerned with risk reduction, they are required to advise reducing risk when the ESOs are
most risky. And that occurs when the ESOs are moderately in-the-money. The strategy of early exercise, sell and diversify is
highly inappropriate when the ESOs are moderately in-the- money and that strategy is inappropriate except in rare situations. The
inappropriateness results from the required forfeiture of "time value" and the payment of an early tax and the questionable
benefits and costs of "diversifying". That leaves only one choice to efficiently manage ESOs that are significant parts of the
employees assets. That is to sell calls or do other efficient risk reduction trades in the exchange traded options markets.
When the stock is trading at 50% above the exercise price shortly after vesting, the only efficient way to reduce the risk is to sell
exchange traded calls. This means that promoting the strategy of early exercises, selling and diversifying under these
circumstances makes the advisers liable for violation of their fiduciary duties and in violation of SEC Rule 10 b-5. The following
slides will explain how to generally handle your options grants.
17

19. .
So, in view of the information in the slides above, how does a holder of moderately
in-the-money ESOs, (i.e. the stock is trading at $75 with a $50 exercise price)
efficiently reduce the risk?
The employee simply opens a brokerage account and sells some calls (perhaps 5
or 6 calls for every 1000 ESOs that he has that are vested). Perhaps the ones with
the exercise price of $80 or $85 with 9 months to 2 years time remaining are the
most appropriate. That would reduce his risk by about 35 % and he still has a
substantial alignment with the shareholders. If the employee sold more calls, the
risks and alignment would both be reduced further.
If he wanted protection against extreme downward moves, he could purchase a
small number of puts, perhaps in his IRA, and sell less calls.This strategy assumes
that there is no prohibition by the company and that the ESO holder has sufficient
collateral to finance the call sales or the put purchases and that there is a
reasonably liquid market to make the options trades.
On the other hand if the company wanted to facilitate the reduction of risk to holders
of moderately in-the-money ESOs without hedging, they could design the options to
better achieve all the objectives of the ESO grants. Check out the link below for a
much improved type of employee stock option which is illustrated at the end of this
book.
http://www.slideshare.net/OLAslideshare/new-
dynamicemployeestockoptionspresentati-4-12038997
18

20. .
Fiduciary Duties
Fiduciaries Relationships
“Fiduciary” relationships are those relationships existing between parties to a
transaction wherein one party is duty bound to act with the utmost good faith for the
benefit of the other; such a relationship ordinarily arises when one party reposes a
confidence in the integrity of the other, and the other voluntarily accepts that
confidence
Broker's General Fiduciary duties to client. A broker's fiduciary duties to a
principal may include an obligation not to advance the broker's own interests or
make a secret profit, a duty to account for all funds or property rightfully belonging
to the principal,and a duty of disclosure. A broker also owes a principal a of duty of
good faith.
19

21. .
Fiduciary’s duty to advise risk reduction. A broker, as an agent, has a duty to use
reasonable efforts to give his or her principal information relevant to the affairs that
have been entrusted to the broker.The rule requiring a broker to act with the utmost
good faith towards his or her principal places the broker under a legal obligation to
make a full, fair, and prompt disclosure to the principal of all facts within the broker's
knowledge which are or may be material to the matter in connection with which the
broker is employed, which might affect the principal's rights and interests or the
principal's action in relation to the subject matter of the employment, or which in any
way pertain to the discharge of the agency which the broker has undertaken. New
England Retail Properties, Inc. v. Maturo, 102 Conn. App. 476, 925 A.2d 1151
(2007), certification denied, 284 Conn. 912, 931 A.2d 932 (2007).
The duty to disclose could also include informing the the principle of varying risks
involved in a particular transaction, strategy or course of action.
20

22. Is a stock broker, wealth manager or broker-
dealer a fiduciary to a customer?
The ordinary relationship of a stockbroker to the customer is that of principal and
agent. In some respects a stockbroker is a trustee. A stockbroker, like any other
broker, is under a duty to act in good faith toward his or her customer,and,
generally, the relationship between a stockbroker and a customer is a fiduciary
one.
First Union Discount Brokerage Services, Inc. v. Milos, 744 F. Supp. 1145 (S.D.
Fla. 1990), aff'd, 997 F.2d 835 (11th Cir. 1993);Saboundjian v. Bank Audi (USA),
157 A.D.2d 278, 556 N.Y.S.2d 258, 11 U.C.C. Rep. Serv. 2d 1165 (1st Dep't
1990); Byrley v. Nationwide Life Ins. Co., 94 Ohio App. 3d 1, 640 N.E.2d 187 (6th
Dist. Erie County 1994).
- State common-law action for breach of fiduciary duty against a stockbroker based
on the handling of a stock brokerage account on behalf of a profit-sharing plan was
not preempted by ERISA; the state law involved was one of general application,
which imposed duty on all stockbrokers regardless of the identity of their
customers, and ran in favor of all customers, including employee benefit plans.
Duffy v. Cavalier, 215 Cal. App. 3d 1517, 264 Cal. Rptr. 740 (1st Dist. 1989).
21

23. .
So fiduciaries are obligated to identify and advise efficiently risk reductions to
their client.
However, if the fiduciary does so and the employee/client efficiently reduces
risk, it raises the costs to the company and delays cash flows to the company.
Indeed, it also delays the fiduciaries from getting "Assets Under Management".
So Craig McCann and Kaye Thomas in 2005, created a paper called "Optimal
Exercise of Employee Stock Options and Securities Arbitrations" for the
purpose of giving some alleged authority for the early exercise, sell and
diversify strategy. The paper overstates the merits of diversifying and
understates the penalties of premature exercises. It also avoids addressing
situations where the risks are greatest.
A further analysis of the paper is on the following two slides or can be found at
http://www.slideshare.net/OLAslideshare/debunking-of-mccann-thomas-paper
22

24. .
Summary of Craig McCann, Kaye Thomas paper promoting Early Exercise, Sell
and Diversify.
The strategy of early exercise, sell stock, and diversify rarely has any merit even in
the circumstance that McCann and Thomas artificially chose in their paper "Optimal
Exercise of Employee Stock Options and Securities Arbitrations", because the early
exercise penalties of forfeiture of the remaining “time value” and the payment of an
early tax, outweigh any advantage “diversification” may have.
So the promoters of that strategy minimize the penalties of early exercise and
exaggerate the merits of “diversifying” in order to help the companies, themselves
and the wealth managers at the expense of their clients/grantees.
They do not mention that the stock trading at their "Optimal Exercise Price" or higher
after three years of vesting has a 1 chance in 11 nor do they mention that highest
and most probable risks occur when the stock is trading substantially lower than their
optimal exercise price. Effectively, the alleged authoritative paper says to ignore the
highest risks, and wait for the risks to drop and then make early exercises, sell and
diversify. That strategy has been proven to be worthless.
23

25. .
However, if selling calls and/or buying puts, to reduce the risk of holding in-the-
money calls is prohibited by the company, which is rare, or if the employee has no
collateral to support the sales of calls or the buying of puts, then this efficient strategy
of selling calls is not available.The best strategy then is probably to assume the risk
and do as Steve Jobs, Ron Johnson, Paul Otellini, Larry Ellison, John Chambers,
James Dimon, and 135 Goldman Sachs executives and others did. See below. None
believed that early exercise, sell and diversify, as promoted by McCann and Thomas,
has any merit and held their employee stock options practically to expiration before
exercising and immediately selling the stock.
Steve Jobs exercised 120,000 on 8/12/07, ESOs expiring 8/13/07
Apple's R. Johnson exercised 200,000 on 12/1/ 09 ESOs expiring 12/14/09
Paul Otellini of Intel exercised 800,000 11/9/07, ESOs expiring 11/12/07
Larry Ellison of Oracle exercised 10,000,000 on 4/3/09, ESOs expiring 6/4/09
John Chambers of Cisco exercised 2,000,000 on 2/8/10, ESOs expiring 5/14/10
John Chambers of Cisco exercised 1,350,000 on 2/13/07, ESOs expiring 5/1/07
James Dimon of J.P. M. exercised 1,261,000 on 7/17/09, ESOs expiring 8/15/09
24

26. .
Insider Trading Policies and Equity Compensation:
Some Insider Trading Policies prohibit (or claim to prohibit) selling calls and buying
puts at all times, whether the covered person possesses non-public material
information or not. Those Insider Trading Policies even disallow selling "qualified
covered calls" in blind trusts and pursuant to 10 b-5-1 plans. Some of those Insider
Trading Policies prohibit trading calls and puts when selling long stock is 100%
consistent with 10 b-5. Under these conditions the possibility of a civil or criminal
proceeding being brought against the "qualified covered call seller" or covered put
buyer or his employer for a Rule 10 b -5 violation is zero. There never has been a
Rule 10 b-5 proceeding under such or similar conditions.
So why do they make such prohibitions in the Insider Trading Policy if the probability
of a 10 b-5 violation is zero?
25

27. .
The answer is that most Stock Plan Documents and Grant Agreements do not
prohibit selling calls or buying puts and the plans cannot be changed by the whim of
the companies to diminish the values of the equity compensation to the grantee.
If company changes the plan documents directly and the changes are harmful to the
grantee/employee, the company has breached its contract with the employee/
grantees. If they use the Insider Trading Policies to indirectly change the plans,
when the change is completely un-necessary to comply with Rule 10 b-5, the
contracts that the employee has with the company are similarly breached by the
companies.
So why do the companies risk litigation for breach of contract by diminishing the
value of employee stock options through prohibitions inserted in Insider Trading
Policies that have no value as far as protection against possible violations of 10 b-5?
26

28. .
"Qui Bene" Cicero asked?
The Company and the Wealth Managers benefit but the employee/grantee loses,
because the most efficient strategy to manage the grants of employee stock options
is to sell calls and to a lesser degree to buy puts versus substantially in-the-money
vested employee stock options. And that strategy becomes unavailable if a
prohibition is legally inserted in the Insider Trading Policy.
The employee is required to assume very big risks of loss because of a violation of
his/her contract with the company. Perhaps the designers have no idea of what the
consequences of these Insider Trading Policies are. Or perhaps they do fully
understand the consequences of their policies.
27

29. .
Just recently Apple Computer inserted a provision into its Insider Trading Policy
that appears to prohibit selling exchange traded calls or buying puts versus long
un-restricted stock or at any other time, even when there is zero chance of a
violation of 10 b-5.
This prohibition eliminates the only efficient way to manage an employee's Apple
equity holdings and as a result will transfer billions to the company from the
employees, while also benefitting the wealth managers as they now have an
excuse for not using an efficient management method.
28

30. .
But the Apple Employee Stock Plan and the grant agreements allow for selling
calls and buying puts to efficiently manage their equity compensation grants.
So this insertion into the Insider Trading Policy of a prohibition of selling calls and
buying puts constitutes a breach of the Employee Stock Options contract. If you
are an employee of Apple holding shares, or equity compensation grants, you are
affected by this breach, which interferes with your ability to manage those assets
efficiently. You should bring this matter to the attention of Apple and consider a suit
if you are damaged as a result of the breach
29..

31. Probabilities of Stock being Higher
It is estimated that 90% of the time, the stock which was at $20 on the grant day, will
be below $40 after 3 years from the day of grant for stocks with .30 volatility. And for
the stock which is presently $20, the probability is 70% that it will be less than $30
after 3 years after the grant day.
Wealth managers have a fiduciary duty to advise risk reduction in concentrated
positions. And, most of the time, their advice should come when the stock is less than
100% above the exercise price.
So how is it possible for wealth managers to advise efficient risk reduction most of the
time (i.e. 90% of the time) when their only tool is to make premature exercises, sell
stock and diversify?
Even if the "time value" is near zero, the early tax payment penalty makes it
inefficient. But they advise premature exercises anyway because of the benefits to
the company and themselves.
30

32. Early Exercises and the Consequences to the Employee and
the Company.
Slides 33 and 34 show the results of early exercises.The penalties to the employee
for early exercises of traditional ESOs are illustrated in red in slide 35 below. The
benefits to the employer are also illustrated in red in slide 36 below.
31

35. This slide shows the total penalties (red) for early exercises.
Exer... Market....Vol...Expected..TimeVal..Ear.Tax...Total....Net After Tax
Price.....Price............Time.Ex.. .Forfited...Penalty. Penalty...Proceeds
20...........30........30.... 5.5 yrs....$6114....$1200.....$7314......$6000
20...........40........30.....4.5 yrs....$4528....$1918.....$6418.....$12,000
20...........50........30 ....3.5 yrs....$3368.. .$2100.....$5578.....$18,000
20...........60........30.....2.5 yrs....$2372....$2000.....$4372.....$24,000
1000 ESOs exercised .30 Vol, 5% risk free Interest rate, "0" dividend
--------------------------------------------------------------------------------------
20..........30.........60.....5.3 yrs....$9300....$1200....$10,500.....$6000
20..........40.........60.....4.3 yrs....$6460....$1918.....$8378.....$12,000
20..........50.........60.....3.3 yrs....$4740....$2100.....$6840.....$18,000
20..........60.........60.....2.3 yrs....$2870....$2000.....$4870.....$24,000
1000 ESOs exercised .60 vol, 3% risk free interest rate, "0" dividend
34

36. This slide shows the benefits to the company of early exercises.
Exer....Market..Vol...Expected.Time.Val.....Cash Flows.........Early Tax
Price....Price............Time.Ex.. Received..Ex.pr. tax cred...Credit Benefit
20.........30.......30.... 5.5 yrs......$6114.... ..$20K......$4K ...........$1200
20.........40.......30.....4.5 yrs......$4528.... . $20K......$8K........... $1918
20.........50.......30 ....3.5 yrs......$3368.... . $20K....$12K............$2100
20.........60.......30.....2.5 yrs......$2372.... ..$20K....$16K............$2000
1000 ESOs exercised. 30 Vol, 5% risk free Interest rate, "0" dividend
--------------------------------------------------------------------------------------
20.........30......60......5.3yrs......$9300.......$20K......$4K...........$1200
20.........40......60......4.3 yrs......$6460... ..$20K......$8K...........$1918
20.........50......60......3.3 yrs......$4740......$20K....$12K...........$2100
20.........60......60......2.3 yrs......$2870......$20K....$16K...........$2000
1000 ESOs exercised .60 vol, 3% risk free interest rate, "0" dividend
35

37. Taxes
.
Taxes upon Grant. There is no tax liability to the grantee upon the grant of
employee stock options and no tax deduction to the company.
Taxes upon Vesting. There is no tax liability to the grantee upon the vesting of
employee stock options and no tax deduction to the company.
Taxes upon Exercise. There is a tax liability to the grantee and a tax deduction
available to the company upon the exercise of employee stock options. That tax
liability and tax deduction equals a percentage of the "intrinsic value" of the
options.
Taxes upon Sales after exercising. Any gains or losses that are achieved
subsequent to the exercise of employee stock options are capital gains or
losses.
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38. .
Taxes upon exercise of employee stock options by certain officers and directors
may be delayed until the stock received is sold. This possibility is pursuant to
IRC Section 83(c)(3) and is very interesting. It says
(3) Sales which may give rise to suit under section 16(b) of the Securities
Exchange Act of 1934
So long as the sale of property at a profit could subject a person to suit under
section 16(b) of the Securities Exchange Act of 1934, such person’s rights in
such property are—
(A) subject to a substantial risk of forfeiture, and
(B) not transferable.
(4) For purposes of determining an individual’s basis in property transferred in
connection with the performance of services, rules similar to the rules of
section 72 (w)shall apply.
This means that for officers and directors, tax liability on stock received from
the exercise of employee stock options occurs when the stock is sold.
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39. .
How are the gains and losses treated for tax purpose if a
person sells calls or buys puts while holding recently vested
ESOs with an exercise price of $50 while the stock is trading
at $75?
We give the answer by using an example:
Assume that on April 18, 2012, you are not an officer or director and hold 10,000
vested ESOs to buy your company stock at $50 per share which is now trading at
$75. The value of the ESOs would be equal to about $350,000 (i.e. $250,000 in
"intrinsic value" and $100,000 in "time value"). Assume you then sell 60 calls with
an exercise price of $80 that expire Jan 2014 or 21 months from the day of sale.
Assume that the value is about $1350 per call making the 60 calls sell for $81,000.
You have reduced the delta risk by about 35% and reduced the daily erosion risk
about 100%. The calls will trade for higher prices than the "fair value" of the
Employee Stock Options with the same exercise price and expected time to
expiration including the "time value" and the "intrinsic value".
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40. .
There is no tax on the opening position. My view is that the two positions, (i.e. the
sale of the 60 calls and the 10,000 Employee Stock Options) are not offsetting as
defined in Section 1092. Even if the positions were offsetting as defined in Section
1092, any losses liquidated from buy back of calls, or expiration and assignment of
calls are deductible currently as short term capital losses since ESOs never have a
"fair market value" and never have an "unrecognized gain" which otherwise might
be used to delay the liquidated losses on the call selling transactions. My view is
that any liquidated gains on the sale of the calls are short term capital gains when
closed and reportable currently.
This treatment provides a manner in which the income taxes from the ESOs can be
delayed to near expiration day, and any gains on the calls can be delayed to
expiration day of the calls. But liquidated losses from the call sales (if there are
losses) can be deducted currently as short term capital losses.
If the employee wanted protection from extreme moves of the stock, he/she could
buy puts in an IRA and reduce the number of calls sold and achieve additional tax
advantages.
39

41. Dynamic Employee Stock Options
A New Design for
Employee Stock Options
40

42. "Options were poorly structured, and, consequently, they failed to
properly align the long-term interests of shareholders and managers,
the paradigm so essential for effective corporate governance. The
incentives they created overcame the good judgment of too many
corporate managers.”
Alan Greenspan
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43. The topic of this presentation is most relevant today as there are structural
problems with the traditional employee stock options. Traditional options by their
nature prevent effective long term alliances between employees and shareholders
largely because of the risk-averse attitudes of the employees and their interest in
reducing that risk.
Unless the employees, managers or executives are willing to use hedging strategies
involving selling exchange traded calls or buying exchange traded puts on company
stock, their only choice to reduce risk is by early exercises and sell stock, and
perhaps diversify the net after tax proceeds.
This strategy of making early exercises is so highly penalized in most cases of
traditional ESOs that it is unwise in all but rare cases to use the strategy.
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44. Is there a way to design employee stock options to make them
more effective in accomplishing the goals for which they were
created?
Before we can answer that question, we must state the goals. The goals are to:
A. Align the interests of the managers, officers and directors with the interests of the
shareholders by making the value of their equity compensation dependent on an
increase in value of the company shares.
B. Attract and Influence high quality employees to be loyal long term employees.
C. Preserve and increase the cash position of the company.
D. Encourage early cash flows to the company from the early payment of the
exercise price and the tax credits upon exercises.
E. Allow for the efficient management of the granted options by the grantees.
F. Maintain the theoretical costs of the plans to a modest level.
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45. How well do Traditional ESOs accomplish those goals ?
A. The traditional ESOs do align the employee/executive with shareholders during
the vesting periods and after vesting as long as the employee/executive holds the
ESOs and they understand the values and risks of the ESOs.
B. Company cash is preserved and indeed additional cash flows are generated by
any early exercises (which are encouraged by the company and the options holders'
advisers through their promotion of the premature exercise, sell stock and diversify
strategy).
C. The traditional ESOs because of vesting requirements, non-transferrability and
non-pledgeability make it difficult for risk-averse grantees to efficiently manage
traditional ESO positions. Premature exercises after vesting require penalties to the
grantees in the form of
a) a forfeiture of the remaining "time value" which is quite high when volatility is
reasonably high and b) an early payment of taxes.
D. Early exercises, usually followed by sales of stock cause an early termination of
100% of the grantee/company alignment and long term incentives from those ESOs.
E. Theoretical expenses against earnings are moderate, given the restrictions,
although "fair values" on the grant day are often understated by the company.
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46. What are Dynamic Employee Stock Options?
Dynamic Employee Stock Options are Options whereby the settlement of the
exercises consist of the purchase of less than 100% of stock (perhaps 75%) plus
payments in the form of new ESOs with new 10 year maximum expiration and
current market prices as the exercise prices.
The exact value and number of new ESOs is determined by a formula which
includes a percentage (perhaps 25%) of the full intrinsic value of the options upon
exercise plus the recovery of the otherwise forfeited remaining "time value" in
100% of the options. Exercising Dynamic ESOs results in the "fair value" of the
resulting combination of stock and options being equal to the "fair value" prior to
the exercise. However, the exercise will cause a tax liability on 75% the intrinsic
value of the options. No "time value" is forfeited although a partial penalty for an
early tax payment is incurred.
The following ESO plan goals are enhanced(see next slide)
45.

47. A. A substantial alignment of interests is extended past the exercise and sale of
stock as the grantee still will hold substantial new ESOs.
B. Company cash is preserved and earlier cash flows will come to the company
since the employee will likely exercise earlier. The two penalties of early exercises (i.
e. forfeiture of "time value" and an early tax payment) by the grantee are
substantially eliminated. The grantee, therefore will likely exercise much earlier
causing more and earlier cash flows to the company.
C. Efficient risk management of the grants by the grantee is facilitated since most of
the penalties of early exercises of traditional ESOs are eliminated. The stock can be
sold and hedging will not be necessary.
D. The theoretical costs to the company of the Dynamic ESOs are about 3.5%
greater than traditional ESOs.
E. Even the job of the wealth manager becomes much easier as he can not be
accused of mismanaging the ESOs.
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48. The terms of the settlement of the exercise could be the
following.
For example: Upon exercise, grantee receives 75% (rather than 100%) of the stock
at the exercise price plus new ESOs with new 10 year expiration dates and market
value exercise prices.
The "fair value" of the new ESOs would equal the sum of a) + b):
a) 25% of the "intrinsic value" of the exercised ESOs that would have been
gained on a traditional ESO exercise, plus
b) the amount of the remaining "time value" otherwise forfeited to the company
upon early exercise of 100% of the employee stock options.
The receipt of 75% of the stock could be changed by the company to receipt of 60%
or 80% of the stock at the exercise price, which will change the 25% of new options
to 40% or 20%.
The grantee would receive new options equal to 40%, 25%, or 20% of the full
"intrinsic value" plus the return of the otherwise forfeited "time value" in new options.
The plan could give the choices of the percentages of stock received to
the grantee or pre-determined by the company.
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49. The following two slides are familiar graphs. They illustrate among other things,
the value of the "time premiums" (i.e. time value) and "intrinsic values" and how
they change with different volatilities and different prices of the stock at different
times.
The slides also show the net take home amounts after tax for traditional ESOs
exercised, assuming a total tax of 40%.
The companies will take the "intrinsic value" as a tax deduction upon the
exercise.
Dynamic ESOs will have different results. The grantee gets less stock upon
exercise than with the TESOs but the grantee gets a new load of new DESOs.
The tax deduction to the company will be reduced.
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52. Let us assume that the 1000 vested ESOs in the slides were Dynamic ESOs with
a 75/25 split upon exercise with the stock at various prices and various times
remaining.
First we use the .30 volatility graphs
A. Employee exercises when the stock is trading at $30 with 5.5 years expected
time to expiration. The results are: the employee receives 750 shares for a
purchase price of $20 and receives new ESOs with an exercise price of $30 with 10
years to expiration. The new ESOs have a value of $2500 from 25% of the "intrinsic
value" plus $6114 of "time value" = $8614.
He would receive 720 new ESOs, which are valued at $8614. The "fair value" of the
package upon exercise, that the employee receives is $7500 in intrinsic value +
$8614 in new options value. Which equals the exact value the employee had prior
to exercise.
B. If the employee waited until the stock increased to $50 to exercise and there
were 3.5 expected years to expiration, he would again receive 750 shares at $20
and new DESOs as follows. The new options value is $7500 (i.e. $30 x 2500) plus
$3368 of "time value" = $10,868, giving 530 new ESOs with an exercise price of $50
with 10 years maximum life.
The full value that the employee receives is $22,500 in "intrinsic value" plus $10,868
in new ESOs, which equals exactly the value prior to exercise ($33,368).
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53. If the assumptions in the block of the second graph (slide 11) where a .60 volatility
was used, then the "fair value" after exercise would be the same as the "fair value"
prior to exercise, which are greater than the "fair values" when we assumed the .
30 volatility.
For example. Assume that the stock was trading at $40 with a .60 volatility when
the DESOs were exercised and the split was 75/25. The grantee would receive
750 shares purchased at $20, plus new options with an exercise price of $40 with
10 years maximum life and 6.3 years expected life. The grantees value is $15,000
in receiving 750 shares 20 points below market, plus $5000 in new options value,
plus the "time value" of $6460 returned in the form of new options. The total is
$26,464 in value. The $11,460 would equal 521 new options.
The only penalty for early exercise is that there is an early tax required on the
"intrinsic value" (i.e. $15,000) received in stock.
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54. Exercise of Vested 1,000 DESOs with 75/25 Split
1 2 3 4 5 6 7 8 9
Stock ….Ex ..…Vol.....Expected...Time value...25% of…Colum….Total New...Tot. Intri. Val.
Price….Price…….......Time to exp...Remain...Intrin.Val… 5+6.....Options. Rec...Stock Rec.
-----------------------------------------------------------------------------------------------------------------------------
$30.….. $20…....30…....5.5 years……$6114...…$2500......$8614….....700...........$7500
$40…....$20…....30……4.5 years…….$4526…..$5000…..$9526….….580........$15,000
$50…….$20……30……3.5 years……$3368…..$7500.....$10,868 …...530.........$22,500
$60…….$20……30……2.5 years……$2372…$10,000…$12,372……503........$30,000
$30. …..$20…....60....…5.3 years…….$9300…..$2500….$11,800……715...........$7500
$40.…...$20…....60……4.3 years…….$6460…..$5000….$11,464……521.........$15,000
$50...….$20…….60……3.3 years…....$4740…..$7500….$12,240……445.........$22,500
$60...….$20…....60……2.3 years…….$2670...$10,000….$12,670…...384.........$30,000
The options with a .30 volatility assume an interest rate of 5%
The options with a .60 volatility assume an interest rate of 3%
The amount of stock received upon exercise is 750 shares for a cost of $20 per share.
All new ESOs have an exercise price equal to the market price and 10 years maximum life.
Column 7 equals the total value of the new ESOs in each case. Column 9 shows the amount before tax
53

55. To further reduce the gaming of the timing of the sales of the stock
received from the exercise of the DESOs, the company would
compare the sales price with the average closing prices of the stock
for the 30 business days following the sales. If the sales price is
greater than the average, then the difference is returned to the
company. The difference can never be greater than the intrinsic
value received from the exercised options
To reduce the gaming of the grant day exercise prices, the company
would take the average closing prices of the 21 business days
following the grant day and make the exercise price equal to the
higher of the two.
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56. Conclusion
It has been estimated that there are 10 million employees in the U.S who
receive employee stock options yearly and millions more worldwide.
Very few of those employees, executives or their advisers understand the
nature of, the value of, the risk of losing that value or the proper ways to
maximize that value, reduce risk and delay taxes
It is hoped that this short book will increase those numbers.
55