July 2000


By Elizabeth P. Anderson

Employee stock options have become an increasingly important part of American wealth. It is estimated that, if cashed in, the average senior executive's options would have been worth roughly $10 million at the end of last year--five times the 1995 level. And the prevalence of options is particularly widespread in the booming world of tech companies, which accounted for more than half the value of outstanding option grants.

This has left many executives with a variation on a curious, though pleasant, problem: what to do about an investment portfolio that's highly concentrated in one issuer; not just through directly held stock (see The CPA Journal, November 1999), but also by way of employee stock options. Such circumstances clearly call for diversification. With directly held shares, the need to diversify must be balanced against the costs of selling shares at a gain. But for options, the costs are a more complex matter, as greater volatility, the significance of "time value," and different tax regimes all influence the decision.

What Makes Options Different?

Options expire. The first difference between options and directly held shares is an obvious one, but it bears mentioning. Options have a limited shelf life, so the holder has to exercise them (buy stock at the exercise price) before expiration. The options holder's real choices are whether to exercise the options early, and if so, whether to hold onto the acquired stock or sell it.

Volatility. Among the most important considerations is that options can magnify the volatility of a portfolio, multiplying gains but also intensifying losses. This leverage--caused by options' controlling more stock than the options' value would suggest--is evident in Table 1. This stock trades at $100, but the options holder has the right to exercise the options at $70 (the exercise price). The intrinsic value of each option (the difference between the stock's market price and the exercise price) is $30. Thus, the holder is exposed to fluctuations in the entire $100 of stock price, while having only $30 of intrinsic value to absorb those ups and downs: The holder is effectively leveraged 3.3 to 1.

What happens if the stock drops by a significant amount over the next five years as the options approach expiration? Let's say by one-third. (Note: This represents the author's estimate of the impact of a negative-one standard-deviation event on the average single stock, likely to occur roughly one-sixth of the time. The value of the options is completely wiped out. And while an owner can wait for a recovery, the options holder has no such hope, since the options expire worthless.

Time value. Another factor may be less apparent, but is equally important: the need to consider an option's "time value" in determining the timing of exercise. Many executives think of the value of stock options only in terms of what they would gain if they were exercised immediately--the intrinsic value of the option. But time value is the other part of an option's worth, representing the potential growth of the option's intrinsic value in the period remaining before the option expires (see Table 2). In brief, if options are issued at a stock's market price (as they usually are), there's no immediate intrinsic value. But there is time value, because there's time for the stock to go up. Time value is lost upon early exercise, something that must be taken into account when considering whether to exercise an options position.

Tax rules. Finally, options operate under relatively complex tax rules compared with directly held stock. Generally, options come in two types: nonqualified and incentive options. The intrinsic value of nonqualified options--by far the more prevalent kind--represents tax-deductible compensation expense to the issuer when exercised. Conversely, at exercise, the holder is taxed immediately at ordinary-income tax rates on the option's intrinsic value. There's no way to avoid this tax, but because the cost basis for the shares at exercise is equal to their market value, there's nothing to inhibit the options holder from immediately selling the shares and reinvesting elsewhere. Holding on to the company shares after exercising a nonqualified option is the functional equivalent of buying them with cash on the open market, something we wouldn't suggest if the holder's assets are already highly concentrated in the employer's stock.

By comparison, incentive options seem, on the surface, to be a boon from a tax perspective. The holder does not have to pay ordinary income taxes at the time of exercise, and if the shares are held for at least two years from the date the company granted the options and at least one year from the date of exercise, any gains are taxed at the favorable long-term capital gains rates when the shares are sold. Of course there is a complication, as many readers are probably aware: The intrinsic value at the time of exercise must be considered in calculating potential liability under the alternative minimum tax, a topic far too intricate to explore here.

Avoid Rules of Thumb

When an investor considers reducing exposure to a concentrated position in stock or options, any number of rules of thumb seem logical but really aren't. For instance: sell a portion of the stock each year or every time it climbs 10% or more, or always hold options until expiration regardless of the risk to net worth. One common fallacy involves exercising options early and then holding the stock received in an effort to attain favorable tax treatment: The difference between the stock price and the exercise price is taxed at ordinary income rates, while the subsequent appreciation is taxed at generally more favorable capital gains rates. But this exercise-and-hold strategy is often counterproductive, because it reduces the capital invested (Table 3). The options holder pays less tax but cannot overcome the cost of paying taxes and the exercise price early and therefore winds up with less money. Borrowing to fund the stock purchase, as some advise, may turn out to be a winning strategy if the stock appreciates faster than the cost of funds, but it could be disastrous if the stock price falls.

Be Mindful of Economic Costs

In analyzing a concentrated stock and option position, one overarching rule makes sense: Reduce exposure to a prudent level while incurring the lowest costs that might otherwise be avoided. With stock, "avoidable" cost is the obligation to pay taxes on a sale of stock, since the owner could otherwise hold the shares until step-up at death and never pay capital gains taxes. For nonqualified options, the cost of exercise is the loss of time value. For incentive options, the holder loses time value at exercise and will also suffer ordinary income tax costs if the shares received are sold immediately for diversification purposes. Depending on individual circumstances, however, the extra tax cost may be preferable to remaining exposed to the stock.

In a much-simplified example, assume that the options holder--

* lives in California (and thus incurs relatively high state taxes),
* has $12 million in invested assets (excluding real estate), including $2 million in bonds and $10 million in Company XYZ vested options and stock (trading at $100), and
* has a projected annual volatility of 30% (about average).

This holder's net worth is highly concentrated in one position, so that her financial well-being is tied to the ups and downs of a single company. On its face, this situation would call for diversification. But evaluating the extent of the need for diversification requires an accurate assessment of the value of the single position (incorporating intrinsic and time value for options) as well as gauging the exposure the options create--since the inherent leverage of options means the holder controls more shares than the dollar value suggests.

What Are Options Really Worth?

To illustrate how a given option is valued, consider a hypothetical nonqualified-option tranche (or group of options with the same terms and expiration date) with the following attributes:

Stock price $100
Number of shares50,000
Exercise price$60
Ordinary-income tax rate46.67%*
Dividend yield 1%
Time to expiration1,328 days
Stock volatility 30%
Risk-free interest rate5%

*Federal, state, and local

Calculating today's intrinsic value is simple: We subtract the exercise price of $60 from the current stock price of $100, for an intrinsic value per share of $40. Calculating time value--the expected growth in the intrinsic value through the option's expiration date--is more complicated. We employ a version of the industry-standard Black-Scholes model, which uses the starting intrinsic value of the option, the stock's volatility and dividend yield, the time until expiration of the option and prevailing interest rates in order to

1) calculate a broad range of possible ending intrinsic values;
2) weight the possible outcomes to determine a weighted-average "expected" outcome; and
3) discount this expected outcome to a present-value equivalent. In this case, Black-Scholes has calculated a present-value expected outcome of $48.82 per share, of which $40 represents today's intrinsic value and the remaining $8.82 represents the time value--the present value of the expected
growth in intrinsic value during the rest of the option's life.

Per shareTotal
Intrinsic value $40 $2,000,000
+ Time value* 8.82 441,228
Theoretical total* $48.82 $2,441,228

*Based on a Black-Scholes options-pricing model

These amounts, however, don't take taxes into account. Next, we "tax" both intrinsic value and time value. Time value can't actually be taxed--because it disappears at exercise--but it represents the potential additional intrinsic value of the option, so that if the shares eventually rose, that appreciation would become intrinsic value and eventually be taxed at the option's exercise (See Exhibit 1).

In essence, the options holder has an economic loss if the options are exercised early, in this case $4.71 in after-tax time value, or $235,500 for 50,000 shares. This economic loss must be balanced against the risks associated with continuing to hold a large concentrated position.

How Sensitive Are Options to Stock Price?

As discussed, options add volatility to an investment portfolio, because they control more in the way of shares than their value would suggest. However, the relationship between option and stock value isn't constant, and in fact options' sensitivity to stock-price movements shifts depending upon a number of factors, including the length of time before the options expire and the amount of intrinsic value in the option. Continuing our example, we find that this tranche of XYZ options has a 89.11% sensitivity to XYZ stock (derived using the Black-Scholes model).

That is, for a $1 change in the stock price (given its current $100 level), the $48.82 option value will change roughly 89 cents, or almost twice as much on a percentage basis (1.83% vs. 1%). If you multiply the sensitivity by the stock price, the result is the investor's "effective exposure" to the stock. Subtract the pre-tax value of each option, and what's left is the implied "leverage" of the options (See Exhibit 2).

One side of this story is that this leverage increases volatility and therefore a portfolio's risk. But, by disposing of options, the holder can also disproportionately reduce exposure to employer stock. To determine which options and shares to eliminate, exposure reduction is compared directly to avoidable costs, including loss of time value and (for incentive options and directly held shares) taxes. The lower the ratio of avoidable cost to effective exposure limited for a given option tranche or stock lot, the more cost-effective it is to diversify by liquidating that tranche or lot.

Before taxesAfter
Avoidable cost
(forfeited time value)
$8.82* $4.71
Reduction of effective exposure$89.11$47.52
Cost/exposure reduction9.9%9.9%

*Per share

The next steps are to compare all of the investor's stock and options in XYZ (Table 4), rank them according to cost-efficiency and then calculate the level of exposure left after each group of options is exercised and each group of stocks is sold. An earlier expiration date does not necessarily mean that one option tranche should be exercised before another. Here, tranche 3 doesn't expire for more than 1,300 days vs. less than 900 days for tranche 5, yet tranche 5 is more expensive to exercise, because it is made up of incentive options, which incur tax costs in addition to time-value forfeiture. Also, it may be advantageous to sell directly held shares before exercising options.

Options are complicated, and decisions about diversification aren't obvious. It is imperative that taxes, although important, not be the only criterion in determining whether to exercise or sell options. Instead, the total economics of the situation must be considered: Taxes, time value, and the inherent leverage of options are all factors, as are intangibles such as are corporate culture that may inhibit a reduction in exposure to company stock. In all cases, tax, legal, and investment advisors can work together effectively to recommend the client's course of action. *

Elizabeth P. Anderson, CFA, is a principal of Sanford C. Bernstein & Co., Inc., and a director of Bernstein's Family Wealth Group, dedicated to helping high-net-worth private clients deal with complex investment planning issues.

Author's Note: The preceding example assumes that the stock received for the incentive stock options would be sold immediately, making the holder immediately liable for ordinary income taxes on intrinsic value. I consider this an avoidable cost, because the holder has the choice of retaining the stock indefinitely and thus deferring all taxes, with the downside of this strategy being continued overexposure to employer stock. In contrast, exercising nonqualified options subjects the holder to taxes on intrinsic value, an unavoidable circumstance no matter what is done with the shares received.

Milton Miller, CPA
William Bregman, CPA/PFS

Contributing Editor:
Alan J. Straus, LLM, CPA

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