Myth:

A myth has been promoted that executives would rather receive substantially less cash than the theoretical value of ESOs.

They claim that the theoretical values calculated by the Black Scholes model or lattice models overstate the true values, even when appropriate discounts are made for expected time to expiration rather than nominal time to expiration. 

They claim the non transferrability and the prohibition against freely hedging, reduce the values more. They claim that these factors are not accounted for properly.

They claim that executives perceive the values as equal to far less than the theoretical values, even values discounted for all differences in ESOs relative to listed exchange traded options.

Either the theoretical calculations are wrong or the executives' perceptions are wrong.

My belief is that both the theoretical calculations and the executives's perceptions are wrong.

Let us see why.

Theoretical Values

One problem with these theoretical values is that these are derived from models making the assumption that stock prices are lognormally distributed.

The market in exchange traded options reflect the fact that the models are not believed. Long term out - of - the money calls sell substantially below the expected theoretical values. Long and short term out - of - the money puts sell above the theoretical values suggested by the models. Why?

Are "collar" buyers and covered "writers" distorting the market? Or, is the market trying to correct the incorrect values suggested by the models? My belief is that both explanatons have merit.

Some try to explain away the fact that the options trade different from theoretical by claiming that the implied volatility is different for different strikes and times to expiration.

My belief is that the fact that listed options are trading different from theoretical values have little to do with implied volatilities but more to do with incorrect assumptions of distributions of stock prices. The maket in fact reflects that the theoretical values are incorrect.

In general if traders were premium sellers of out - of - the money calls or the related puts at theoretical values, then they would make a larger than expected profit.

Do the models actually give too high theoreticals for exchange traded options? In my opinion the answer is yes. The explanation for this is beyond the scope of this paper.

Non Tranferrability and Prohibitions against Hedging

How less valuable is an option which can not be transferred compared to one that can? That amount is hard to guess. Actually, the ESOs are transferable but there are costs to pay when exercise and transfer of the received stock takes place. Time premium is lost and taxes come early.

The lack of non- costly transferability is mitigated to a large degree if the employee/executive can hedge his employee options with listed options. If he can not hedge, then the employees/executives may indeed be correct in their perception of their ESOs having lower values.

The amount of reduced value because of non - transferability and non - hedging can not be calculated easily. But, there is certainly a reduction, especially in the perception of the ESO holder.

Taxes at Grant Day

Let's look at the choice of receiving $100,000.00 of cash or receiving $100,000.00 of theoretical value of employee stock options at grant day. We assume that appropriate discounts are made in the theoretical values for lack of transferability, prohibition or restrictions on hedging, vesting requirements, penalties on early termination , a tendency to exercise prematurely and any other factor that may objectively apply.

The employee must report the $100,000.00 cash payment as ordinary income and pay, when all is considered, an immediate tax of perhaps 40%. The employee who receives $100,000.00 of theoretical values pays no tax at grant.

The cash recepient then has $60,000.00 to invest perhaps in company stock or a diversified pertfolio. The expexcted return on his investment if he invests in the company stock or a diversified portfolio will be the same as the expected return on a $60,000.00 investment in the company's options.

A cash payment of  $100,000.00 and an immediate investment of $60,000.00 in the company stock is equivalent to a payment of  $100,000.00 restricted stock with a one day vesting period. Both require an immediate 40% tax. In both cases you have a $60,000.00 investment in the company's stock after tax witout borrowing.

The expected return on $100,000.00 of theoretical value of options on the company's stock is equal to 1.6667 times the expected return on $60,000.00 in the company's stock or a diversified portfolio.

However, the entire value of the ESOs will be taxed as ordinary income when liquidated (i.e. when the options are exercised and the received stock sold).

The value of the $60,000.00 after tax initial investment will not be taxed again, but the gain will be taxed at some rate perhaps as capital gain.

Conclusion

The receipt of $ 100,000.00 of accurate theoretical value of ESOs is more valuable than receipt of $100,000.00 in cash due to the fact that an immediate tax is required on the $100,000.00. The receipt of the $100,000.00 in true value of ESOs is more valuable since the employee incurrs no tax liability perhaps till 10 years later.

However, if the employee is very risk adverse, or needs cash or does not understand how to manage his ESOs he may perceive the $100,000.00 cash payment as more valuable. This is true if he also anticipates that he may be terminating soon with the associated reduction of time to expiration.

Of course the restrictions or prohibitions on transferability and hedging may have, in the employee's mind, a larger impact on the theoretical values than is provided for.

My guess is that executives who receive large amounts of options which have large theoretical values have an incentive in claiming lower perceived values and find arguments to justify those lower perceived values. They do so to defuse claims of over payments to executives and to justify continuance of excessive options grants to themselves.

Excessive restrictions and prohibitions on what the receipient of ESOs may do with his options do in fact decrease the true value and perceived value of those options.

Failure to consider all factors in appraising the options may result in an over- valuation for expense against earnings purposes.

John Olagues     olagues@hotmail.com