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Fortune


How to Manage Your Stock Options

December 29, 1997

There are some simple rules, but also some surprisingly complex questions to ask, such as: Do you really know what they're worth?

Justin Fox Reporter Associate Eileen P. Gunn

A decade ago it mattered only to corporate kingpins and a few lucky people in Silicon Valley. Now it has become a nagging question for millions of Americans: What do I do with all these dang stock options my company keeps giving me?

As hard choices go, this surely falls in the category of dilemmas we all wish we faced. But the rapid growth of employee stock option programs (see the charts on the next page), coupled with the seemingly unstoppable rise of the stock market, means that before long it could be a dilemma we will all face. It's one more way--of a piece with the 401(k)'s triumph over traditional pension plans--in which regular people are having to make the investment decisions that will determine whether they retire to Hilton Head or to a job at the local Wendy's. With stock options especially, making the wrong choice can hurt a lot. Cashing in options too early can mean missing out on large, possibly huge, future gains. Holding on too long can mean losing it all if your once promising company slides into oblivion.

So what to do? There are a few simple rules--like not letting your options expire unused (it happens more often than you'd think) and making sure you aren't caught unawares by the tax code. But the question of whether to cash in your options early or late or somewhere in between is one for which reasonable people can come up with wildly different answers. Witness, for example, the cases of Miguel Jardine and David Southwell:

Jardine is a 24-year-old engineer who in August 1996 got a job at UUNet, a Virginia-based Internet-service provider. With the job came a modest helping of stock options, exercisable at the then market price of UUNet's stock. A few days later, phone company MFS acquired UUNet, a deal which converted Jardine's options into MFS options and made them start looking like more than a modest helping. Then, in December 1996, telecom giant-killer WorldCom bought MFS. After that, WorldCom's stock price continued to rise, and before long Jardine's once-modest package--now consisting of options to buy WorldCom stock--was worth between $150,000 and $200,000.

This meant big decisions for someone who just three years ago dropped out of the University of Southern California to work on the White House Website, a guy who until recently had a negative net worth. So far, with the just over 20% of his options that have vested, Jardine has opted to spend the money: to pay down student loans and credit card debt; to buy insurance, a new Volvo, and a diamond engagement ring for his fiancee (and now wife), Catherine. "I asked her in March, but she didn't get the ring until I vested," he says.

Jardine says he knows he might be missing out on future gains, but that's okay with him. "I've still got almost four years of vesting," he says. "If WorldCom does a tremendous job, I'll still benefit. But if WorldCom doesn't do so well, I'll know my family's taken care of."

Up in suburban Boston, 36-year-old David Southwell makes enough as chief financial officer of Sepracor, a small pharmaceuticals company, to afford a Volvo--and a Land Rover and a house--without dipping into his options stash. So he isn't dipping, even though his options are now worth about $13 million (of which $7 million is already vested and immediately exercisable). Instead, he's holding out for an even bigger jackpot.

Southwell, a former Lehman Brothers investment banker who took a pay cut to join Sepracor three years ago, acknowledges that "I'm totally undiversified; if a financial planner was to look at me, he'd say I'm crazy." But he figures it was a calculated gamble to come to Sepracor in the first place, so why not play out his hand? "I don't understand young people who gradually exercise stock options as they come out," he says. "If you're older, I can understand, but hey, if you're in your mid-30s, you don't need security."

Not every 36-year-old would agree, obviously. And in the end, any decision on options has to take into account just how much security you need and just how much risk you can take. But before getting to those kinds of judgments, it helps to know just what you're dealing with.

Here's how the stock options granted to Jardine, Southwell, and millions of others work: A company gives an employee options to buy a certain number of shares of the company's stock at a set price, usually the market price at the time the options are handed out. The options come with an expiration date and a vesting period. The expiration date is in most cases ten years from when the options are granted; after that, they become unusable. Vesting usually takes place over a period of three to five years. Some companies use "cliff vesting," in which all the options become exercisable at once; more common is a vesting schedule in which the first group of options becomes usable after a year and the rest on a monthly or yearly basis after that.

Because of how the Internal Revenue Service treats most options--when the options are exercised, it taxes the profit made as ordinary income--it is customary to sell the stock immediately after exercising the option to buy it. In fact, most companies have deals with brokerage firms in which employees can exercise their options and then sell the stock without putting up a penny. They simply get the cash, minus brokerage fees and income-tax withholding. (For information on so-called incentive stock options, which are taxed differently and can't be cashed in immediately, see the box at the end of this story.)

That's how an option works. A more complex matter is figuring out what it's worth. The obvious solution (used in the examples above) is to subtract the exercise price from the current market price of the company's stock. That is, if you were granted 1,000 options to buy stock at $20 a share, and the stock is now at $100, the options are worth $80,000--and if the stock is at $15, they're worth nothing. But it's not really that simple. "Suppose you have options that are out of the money," says Mark Rubinstein, a finance professor at the University of California at Berkeley. "The intrinsic value is zero. Would you be willing to give them away? No." That's because while the option has no value if exercised today, it doesn't have to be exercised today--and the price of the stock could go up before it does.

The stock options that companies grant their employees can't be bought or sold (they can be willed and, at some companies, given away). But if you exercise an option for a profit that's less than that option would be worth to a buyer, you are still in a sense leaving money on the table. And since Rubinstein and other finance experts have come up with reliable mathematical models for pricing options--Stanford's Myron Scholes and Harvard's Robert Merton won this year's Nobel Prize in economics for their pioneering work on options models--it's possible, if you have a math whiz at your disposal, to estimate just how much money you've left behind. The models, or sets of equations, use the option's exercise price and time to expiration, together with the underlying stock's market price, volatility, and dividend yield, to calculate a theoretical present value for the option.

For those who don't have time for the math, it's enough to remember this: The further away an option's expiration date, the greater the gap between what somebody would be willing to pay for the option and what you could make by exercising it. Which means that, according to options pricing theory, it makes no sense to exercise your stock options early.

So why is it that, according to a 1996 study by accounting professors Steven Huddart of Duke University and Mark Lang of the University of North Carolina, most employees exercise their options well before they expire? Do these people not understand how options work?

A lot of them don't. If you're a relative peon at a big corporation, with just-vested options that can be exercised now for a gain of $5,000 or $10,000--and you don't need the money--you'd be nuts not to hold on for a few years (unless you're convinced your company is run by nincompoops who are about to drive it into the ground). But according to Huddart and Lang's study, lower-level employees are most likely to exercise options the moment they vest. Bad move.

If, on the other hand, you're a big wheel at a big company, or any kind of wheel at a smaller company with a hot stock, your options could easily dwarf your other assets in value. In that case, exercising at least some of your options well before they expire can be the only sensible thing to do.

"If your net worth is 25% in one company, you need to start looking at doing some diversification," says Michael Beriss, a Bethesda, Md., senior financial adviser with American Express who counts Miguel Jardine among his clients. "There's nothing inherently wrong with exercising stock options early, as long as you've got something to do with the money."

Beriss and other financial planners have come up with a pretty standard strategy for people with outsized options hoards: Put yourself on a calendar and exercise your options bit by bit over a period of years. "You need to get the emotions out of it and treat it as a systematic way of unwinding a large position," says Mark Spangler of Seattle's MFS Associates. This averts the danger that one bad quarter for your company can take a huge swipe out of your net worth. (This effect can also be accomplished by buying puts--contracts to sell stock in the future at a set price--on your company's stock. But unless you're a top executive for whom exercising options early is a public relations no-no, most planners say buying puts to lock in options gains is more of a hassle than it's worth.)

The problem with such risk-minimizing advice is that the people who've had the most phenomenal success with options are the ones who have ignored it. The best-known examples of this are the multitudes of Microsoft millionaires. At Microsoft the main determinant of wealth is not your rank at the company but how long you hold on to your options. Spangler tells of a client who left Microsoft a few years ago and cashed in her options for an after-tax gain of $2 million. Four years later another client--one of that first client's former subordinates, who had gotten the same number of options at virtually the same time--decided to sell. Her options netted her $7 million after taxes.

Not every company, however, is a Microsoft. Employees of Oxford Health Plans, Ascend Communications, and Silicon Graphics all would have been much better off cashing in their options early, before their companies' stocks tanked. At Silicon Graphics, CEO Edward McCracken could have exercised his options for a gain of more than $70 million when the company's stock price peaked in mid-1995. He held tight; by early this December, the value of his options was down to about $10 million.

Like all investment decisions, this one is a matter of trading risk against reward. The rewards of holding on to your stock options can be huge. So can the risks. Says William Baldwin, an attorney who heads Tax & Financial Advisors, a Lexington, Mass., planning firm: "If you held on to the dear end and made good money, you took an unreasonable risk and won." The smartest strategy is the gradual selloff that the financial planners recommend--although you should always bear in mind that, as a rule, the longer you hold on to your options, the more you get out of them. That's not exactly a simple formula for options success. But there are some simple things you can do to get the most out of whatever options strategy you decide upon.

Most important, you should be well versed in the terms of your options--whether you can give them to family members or charities, how long you're allowed to hold on to them after you retire or leave your company for another job, and when exactly they expire.

Another, less obvious way to maximize the value of your options--once you've decided you want to unload some of them--is to pick the right ones to sell.

If you own company stock as well as options, it's almost always better to sell the stock first, because options have vastly more upside potential. If you've got $20,000 of company stock (1,000 shares at $20 a share) and the stock price doubles, your stake rises to $40,000. If you've got $20,000 of options (2,000 options exercisable at $10 a share, with the stock price at $20) and the stock price doubles, your potential options gain grows to $60,000. If you must unload options, always exercise the oldest, cheapest ones first. If the oldest options aren't the cheapest, you have to run an options pricing model to know for sure which ones are best to sell--if your options hoard is big enough, it's worth paying your friendly neighborhood finance professor or options trader a couple of hundred dollars to figure this out for you.

Finally, there are taxes. Federal income taxes on options are pretty simple, although it's worth planning at least a year ahead to see if you can tweak the timing of your options exercises to keep yourself in a lower tax bracket. State income taxes can be more complicated: They sometimes aren't automatically withheld from your options check, as federal taxes are, and if you wait until April 15 to pay them, you may regret it. The problem comes when you try to deduct that outsized state tax bill from the next year's federal taxes. "You could run into the alternative minimum tax or not be able to deduct it at all," says Greg Sullivan, a financial planner and CPA with the McLean, Va., firm of Sullivan Bruyette Speros & Blayney. "It's much better to pay the state taxes the same year as the federal taxes."

So what to do about all those options? Pay uncompromisingly close attention to the little things, like terms and taxes. And when you get to the big thing--deciding when to cash them in--compromise.


Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
huddart@psu.edu
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