To Exercise or Not to Exercise Your Employer Stock Options
If employer stock options represent a major component of your overall compensation, you have a number of decisions to make. Should you hold your options and if so, for how long? Should you exercise your options now or wait until your company’s stock price rises. What
if it doesn’t? And what happens to your options if you retire or leave your company for another employer? Maximizing the value of your employer stock options requires you understand the ground rules and make decisions without letting emotion cloud your judgment. Perhaps a good place to start is to determine how much your options are really worth.
Calculating Intrinsic Value is Simple
Your employer stock option entitles you to purchase 100 shares of your company stock at $40 per share or $4,000. The stock is currently selling at 55 or $5,500 for 100 shares. The intrinsic value of your option is, therefore, $1,500 ($5,500 - $4,000). But options have another component that is also worth something – a time value.
Calculating Time Value is More Difficult
In the example above, imagine your option expires today. You would have to exercise it immediately to realize its intrinsic value of $1,500. But what if it didn’t expire for another two years? Or maybe for another five years? Would the option be worth more than its intrinsic value? Would its value increase according to the time remaining until expiration?
In 1973, three economists, Fischer Block, Myron Scholes and Robert Merton developed a formula that enabled investment professionals to price listed options more accurately. The formula is too complicated to explain briefly, but it incorporates such factors as the exercise price of the option, trading price of the stock, amount of time left until the option expires and such additional variables as any dividends paid by the stock and the tendency of the stock price to fluctuate.
There are shortcuts you can use to calculate approximate value without immersing yourself in complex formulas, but perhaps the best advice we can give to any executive with substantial employer stock option holdings is the following…
Don't Try This at Home
Calculating the value of your options can help you determine what percentage of your overall compensation they actually comprise, but it’s no guarantee that your options will be worth their calculated value when you exercise them. Don’t be lulled into thinking that managing your options is something you can do on your own, despite the demands on your time elsewhere. At Lenox Advisors, we work with executives who are:
- Trying to determine the optimum time for exercising their employer stock options.
- Offered options as an incentive by a prospective employer and want to determine their total compensation for possible negotiation.
- Seeking to quantify their exposure to employer stock so they can refine their investment strategy and consider whether to add greater diversification to their portfolio.
Options are complex and come with numerous considerations. Contact us before making any irrevocable decisions.