Across my desk this week came the latest report from Equilar, an executive compensation data firm, on equity trends. In their 2013 Equity Trends Report, key findings included upticks in the use of restricted stock and performance shares, and a slight downturn in the use of stock options. I’ll highlight a few of the observations in today’s blog.

• 40 Hot Corporate Prospects:  In their March 2013 Equity Compensation Report, the NCEO (National Center for Employee Ownership) identified 40 of the 900 largest public companies in the United States that provide broad-based stock options to employees.  If you are seeking new clients with employee stock options this is a great prospect list because it is almost impossible to find out who is granting what. Given these are broad-based plans, it is likely there are a large number of individuals in these companies that need help determining when to exercise their stock options.
• Creating an Executive Services Pilot Project Plan:  No matter how big or small your advisory firm, if you want to develop a successful executive services offering it is prudent to start with a pilot project and a documented plan.  Here is a list of items that should be included in this plan.
• Review Shows Companies Now Using a Mix of Long-Term Incentive Awards:  A review of 300 corporations by The Ayco Company shows employee stock options remain the most popular form of long-term incentive, but most companies are using a mix.
• The Secret to Profitable Stock Option Exercise Decisions:  Here’s an article you can provide to clients and prospects that explains the fundamentals behind using the Insight Ratio to make timely diversification decisions.
• Advice for Executives Regarding Their Stock Options:  An excerpt from a new book by Phil DeMuth, Ph.D. - The Affluent Investor – Financial Advice to Grow and Protect Your Wealth.  It provides practical guidance for executives and other affluent individuals.
• Employers Increasing Discounts in Employee Stock Purchase Plans:  A recent Fidelity investments survey reflects how improving economic conditions are prompting U.S. companies to enhance their Employee Stock Purchase Plans (ESPPs) to attract & retain employees. These “owned” shares should be included in every equity compensation analysis to identify diversification opportunities and concentrated stock positions.

Email Bill Dillhoefer at bdillhoefer@networthstrategies.com if you have any questions or ideas for future articles.

Determining the right time to exercise one’s employee stock options is the key to maximizing the value of this benefit.  Stock options are granted at a fixed exercise price and then must be exercised after vesting and prior to the expiration date to realize their value.  During the time between vesting and expiration the current stock price for publicly traded companies is likely to fluctuate significantly and no one can predict the peaks and valleys.  Consequently, it is important to have a disciplined approach for making profitable exercise and sell decisions (FYI, there is no good reason for exercising and holding Non-Qualified Stock Options, but that’s a topic for another article).

The secret to profitable employee stock option exercise decisions lies within the four main factors that affect their value:

1. The length of time until expiration; the shorter the time, the lower the probability that the value of the option will increase prior to expiration.
2. The in-the-money or intrinsic value (current stock price minus exercise price); the greater the in-the-money value, the more one has to lose by continuing to hold the option.
3. The expected volatility of the stock (a measure of the extent to which the price has fluctuated over time); the higher the volatility, the greater the probability that there will be higher peaks and lower valleys in the stock price prior to expiration.
4. The risk free rate of return (the rate on midterm Treasury bonds); an option’s value is enhanced by the return on the capital that would otherwise be invested in the stock in some other investment.  The risk free rate represents the return on this other investment.

The interaction of these factors is complex but there is a widely accepted methodology that uses them to calculate the full value of a stock option.  The Black-Scholes formula developed by Fischer Black and Myron Scholes was awarded the Nobel prize in economics in 1997.  Although the mathematics are somewhat complicated, the fundamental concept is that the value of a stock option is more than just its in-the-money value.  This is based on the probability that the stock price will will be higher than the exercise price before the option expires.  That is why options that are somewhat underwater (current stock price less than exercise price) can still have considerable value.  The difference between the Black-Scholes (or full) value of an option and the in-the-money (or intrinsic) value is the “time value”.  In other words, the full value of an option equals the in-the-money value plus the time value.

If we then divide the time value (TV) by the Black-Scholes value (BSV) and express it as a percentage, the resulting ratio represents the risk-reward trade-off of holding the option vs. exercising and selling it.  This ratio was coined the “Insight Ratio®” because it provides insights into determining when to exercise.  For example, an option with $10,000 of vested time value and $100,000 of  vested Black Scholes value would have an Insight Ratio of 10% meaning that 90% of this option’s value ($90,000) is currently in-the-money value (BSV – TV = ITMV).  If this ratio is low (i.e. under 20%), the option is a good candidate for exercising because there is a large amount of intrinsic value at risk compared to the probability of further gain (time value).  To further clarify this, let’s look at an example that calculates several Insight Ratios using the following assumptions:

• Current Date: 4/18/13 (for calculating time to expiration)
• Current Stock Price: $82.56 (Deere & Company, for calculating intrinsic value)
• Volatility: 33.60% (from 2012 annual report)
• Risk Free Rate: 2.00% (from 2012 annual report)

The following observations can be construed from the above Insight Ratio table (calculations by StockOpter.com):

• The first grant (NQ2005) is about 2.5 years from expiration and deep in-the-money ($58/share) so consequently it has a low Insight Ratio.  By continuing to hold this option the recipient is risking $192,480 of in-the-month for $9,104 of time value.
• The 3rd grant (NQ2007) is under water (exercise price greater than the current stock price), but there is $95,606 worth of time value because it has 4.5 years to expiration and moderate stock price volatility (33.6%).  By definition, the Insight Ratio for under water options is 100%.
• NQ2010 is slightly in-the-money and has 7.5 years left so time value makes up 94% of its full value.  It would not be wise to exercise this option now because it would mean forgoing a large amount of upside potential for a small amount of intrinsic value.
• The 2011 and 2012 grants are not yet vested so they have no exercisable in-the-money value or time value.  The Insight Ratio for unvested grants is also 100%.

Over the past decade the Insight Ratio has been used by hundreds of financial advisors to guide the stock option exercise decisions of their clients.  Typically, an Insight Ratio of between 10% and 20% is used to trigger an exercise “evaluation.”  The specific ratio used to trigger action may be adjusted up or down based on the following personal financial assumptions:

1. Use a lower ratio if there are sufficient diversified assets to meet the financial goal
2. Use a lower ratio if there is a long planning horizon (i.e. 10+ years to retirement)
3. Use a higher ratio if you are highly concentrated in company stock and options
4. Use a higher ratio if you are nearing retirement and have yet to achieve your financial goal

Let’s assume the executive holding the grants listed above is 15 years from retiring, hasn’t met his financial goal and is moderately concentrated in their company stock and options.  Given these Insight Ratios and personal assumptions, it would be reasonable to exercise and sell the 2005 grant and then continue to monitor the other grants (particularly NQ2008 and NQ2006).  When the Insight Ratios go below 11% a re-evaluation of the executive’s financial situation would be in order.

The secret to maximizing the value of ones employee stock options is fairly straight-forward.  Commit to a disciplined approach that uses the Insight Ratio to compare the risk (realized intrinsic value) to the reward (time value).   Otherwise, the alternatives are: 1) trying to predict when the stock price will peak or 2) hoping for the best right before the option expires.

Bill Dillhoefer is vice president at Net Worth Strategies, Inc. a service firm specializing in personalized equity compensation management.  Bill led the development effort of a web-based stock plan decision support platform: www.StockOpter.com.  This system is used by most of the major financial service firms to assist clients with company stock and options.  He is the editor of the StockOpter University Blog which is dedicated to the topics of when to exercise employee stock options and diversify company stock holdings.  Bill has spoken at the NASPP conference and to numerous advisor groups.  Connect with him on LinkedIn or follow him @StockOpter.

These intended changes are in sharp contrast to some of the downgrades many  plan sponsors made to their employee stock purchase plans over the past few years.  According to the study, 71% of the employers that made a change to their  employee stock plan indicated their changes were a result of the recent  economic downturn. Some of these changes included lowering or eliminating the  employee discount on stock (14%), shortening the “look back” period (6%) or  removing the look back provision altogether (5%).

“During the recent recession, some employers felt the need  to reduce or eliminate the discount in their employee stock purchase program –  just as many employers felt the need to reduce or eliminate their 401(k)  match,” said Kevin Barry, executive vice president, Stock Plan Services at  Fidelity Investments. “But as the economy continues to improve, companies are  reinstating their discount as they realize that an attractive employee stock  purchase plan can be a significant asset in attracting and retaining the most  talented employees – especially in competitive hiring markets like technology,  professional services and transportation.”

Employers View Stock Plans as a Top Company Benefit,  Retirement Savings Vehicle   The survey found that 50% of employers consider their employee stock purchase  plan part of the company’s benefits package, as opposed to a form of  compensation or other benefit. Nearly three-quarters (72%) of employers  consider the employee stock purchase plan to be as valuable as pensions and  dental benefits and more valuable than company-provided life insurance. And  more than a quarter (28%) felt their employees value the company’s plan more  than other company benefits.

When asked what results they hoped to see from changes to  their plan, 41% of employers surveyed responded they were strengthening their  plan to attract talent in an increasingly competitive hiring market. One-third  of employers (33%) indicated they hoped the enhanced plan would help retain  valued employees, and almost half (45%) felt improvements to the employee stock  purchase plan would motivate their workforce and improve morale.

In addition,  employers now realize that employee stock purchase plans can play a key role in  their employees’ overall savings efforts. A 2012 survey by Fidelity found  that the majority of company stock plan assets (57%) are being earmarked for  eventual investment or retirement savings after participants sell them, and  more than eight out of 10 employers felt their plan was an effective tool to  help their employees reach their financial goals. When asked what they think  are the most common ways in which employees use the proceeds from their stock  plan, 69% of employers said retirement savings, along with college savings (42%),  emergency savings (41%) and to reduce debt (33%).

Long-term incentive (LTI) awards typically account for a significant portion of the compensation received by corporate executives.  Within the universe of LTI awards there are four main types: 1) stock options and stock appreciation rights (SARs); 2) restricted stock and restricted stock units (RSUs); 3) performance shares and performance units; and 4) market stock units.

More than a decade ago, almost all large U.S. companies used stock options as their primary and, in many cases, exclusive long-term incentive award for executives.  There were a number of reasons for this, not the least of which was the accounting advantage that stock options offered to companies.  Since then, most companies have revised their mix of long-term awards and continue to do so on a periodic basis.  Part of the rationale for this is the expressed preference by corporate governance groups for more “pay-for-performance”, plus meeting the challenge of stock market volatility, and the elimination of the accounting advantages for stock options.  Most companies now utilize a mosaic of awards that provide a diversification of long-term incentives, which can add to the complexity of an executive’s understanding and the planning of their LTI strategy.

Ayco recently reviewed the long-term incentive award practices of 300 of its corporate clients focusing on the awards made to senior executives.  Data is derived from confidential information regarding award grants to executives, as well as disclosures made in 2013 proxy statements.  Among the 4 types of long-term awards monitored for the survey group, the following chart illustrates that the majority are granting a mix of 2 or 3 award types.

Here are the different types of awards and percentages found by Ayco among their survey group:

At 18 companies (6% of the survey group), executives were offered a choice as to their upcoming equity award.  Commonly, this is a choice between NQ (non-qualified) stock options (or SARs) and restricted stock or RSUs.  Typically, named executive officers are not eligible for this choice in awards.  Despite being somewhat more challenging to communicate and explain to award recipients, choice programs are extremely popular with employees.

For further information regarding these findings contact Richard Friedman at rfriedman@ayco.com.

An excerpt from The Affluent Investor - Financial Advice to Grow and Protect Your Wealth

Today’s corporate executives should spend at least as much care considering how to manage his stock options and restricted stock as he does managing his airline miles.  This is a daunting task, because the interwoven tax and investment issues are baffling.  For this reason, most employees use their options as play money and execute them either when they want cash to buy something or when they see everyone else executing theirs because the stock price has been high lately.  You can do better.

The idea is to maximize your lifetime wealth (return) while minimizing regret (risk).  You don’t want to be the guy who exercised his options for pennies when the IPO would have made him a multimillionaire, but you also don’t want to be the guy who hung on to his company stock until it got delisted and now faces a six-figure tax liability with an empty checkbook.  While the permutations go far beyond the scope of this book, here are some factors that impinge:

• Read your own employee stock option agreement.  Do not presume your deal is just like anyone else’s.  Circle the passage where it mentions your options’ expiration dates.  You don’t want to be one of the million employees Fidelity uncovered who let their in-the-money options expire.
• There are two components making up the total value of your options: their intrinsic value and their time value. Their total value is what you get from a Black-Scholes calculator.  Their intrinsic value is the difference between your strike price and the stock’s current price.  The time value is the difference between the option’s intrinsic value and its total value.  You don’t want to execute your options when they still have a lot of gas left in the tank in the form of time value.  For guidance here, I commend to your attention the reports available from www.stockopter.com.  These can form the foundation for a useful discussion with your advisor and CPA prior to making any moves.
• The more volatile the stock, the closer you are to retirement, the less bullish you are on the stock, and the more of your net worth is concentrated in it, the sooner you should exercise.
• It makes no sense to exercise non-qualified stock options and then hold the stock.  You are already over-invested in your company through your human capital.  Exercise, sell, and diversify.

Employee stock and stock options need to be considered in the context of your entire portfolio and not set to one side as if they didn’t exist.  I like the Quantext QPP Monte Carlo Simulator (www.quantext.com) for advisors as well as savvy do-it-yourselfers.  This Excel-based tool will let you experiment with changing the mix in your outside portfolio to compensate for the distortions of a concentrated holding, including your stock options.  The aim is to tune down the idiosyncratic risk and create a version of your personal fund.

Phil DeMuth, Ph.D. is an author, psychologist, and Managing Director of Conservative Wealth Management LLC, an investment advisor to high-net-worth individuals.  Phil’s articles have appeared in Barron’s, The Wall Street Journal, The Journal of Financial Planning and many other publications.  He has made TV appearances on the various CNBC shows, Forbes on Fox, and Wall Street Week with Fortune.  Phil has also co-authored seven books with Ben Stein on topics such as retirement planning, income investing, portfolio management, and alternative investments.

NCEO List of Companies with Broad Employee Stock Option Plans

For financial advisors seeking clients with employee stock options this is a great prospect list because it is almost impossible to find out who is granting what.  Given these are broad-based plans, it is likely there are a large number of individuals in these companies that need help determining when to exercise their stock options.

Financial advisors that can analyze and manage employee stock options are well positioned to attract clients from these 40 firms.  Refer to the article on the “Do’s and Don’ts for Engaging Corporate Executives” for ideas on pursuing this opportunity.

The NCEO analysis of the 900 companies indicates whether they have an ESPP (employee stock purchase plan), equity grant program (options and restricted shares) or an ESOP (employee stock ownership plan) or similar plan.  For information on how to obtain the full list contact Corey Rosen at crosen@nceo.org.

• Pilot Objectives and Procedures to Capture the Results:
  • New clients?
  • Assets under management?
  • Number of Cases?
  • Positive survey feedback?
• Pilot Scope:
  • Length of Pilot?
  • People involved in the pilot and their roles?
  • Budget (e.g. training, promotion, setup, system usage, etc.)?
• Equity Compensation Management Offering Description (required for promotion and training):
  • Workshops or seminars?
  • Periodic consultations (using reports and what-if dashboards)?
  • Nightly decision criteria monitoring?
  • Participant system usage?
• Target Market Definition:
  • Type of executives (e.g. Officers)?
  • Specific companies, departments or locations?
  • Event driven (e.g. education, seminar, marketing program)?
• Resources and Logistics:
  • Identify pilot project manager and system administrator
  • Setup system access for users
  • Customize deliverables (e.g. report templates, monitoring alerts, participant communications, etc.)
  • Create sample case for training and marketing
• Training:
  • Administrator (manages the system)
  • Planning Advisors (creates the cases)
  • Relationship Advisors (delivers reports and receives monitor alerts)
• Corporate Approvals:
  • Compliance
  • Legal
  • Vendor management
  • Data privacy and security

Bill Dillhoefer is vice president at Net Worth Strategies, Inc. a service firm specializing in personalized equity compensation management.  Bill led the development effort of the premier stock plan decision support platform: www.StockOpter.com.  This system is used by many of the major financial service firms to grow their business by assisting clients with their company stock and options.  Bill is the editor of the StockOpter University Blog which is dedicated to the topic of when to exercise employee stock options and diversify company stock holdings.  He has spoken at the NASPP conference and to numerous advisor groups.  Connect with him via email at bdillhoefer@networthstrategies.com, on LinkedIn or follow him @StockOpter.

• Some Do’s and Don’ts for Engaging Corporate Executives: Financial advisors contact us regularly to ask for ideas on how to engage and acquire additional executive clients. Having been in the personal equity compensation management space for 13 years we’ve seen what works and what doesn’t. This article describes the 2 do’s and 3 don’ts that are critical for pursuing this market.
• Managing Restricted Stock Units: A recent article on Restricted Stock Units by Dan Walter described the limitation of receiving RSUs, but it stopped short of providing any guidance for recipients. This article provides a few thoughts to help recipients get the most out of their RSUs.
• An Opportunity That May Not Last (Revisited): This article was written over a year ago but the message is as timely as ever.  Many company stock prices are at an all time high so it’s a good time to contact your clients and prospects with employee stock options and review their Insight Ratios for diversification opportunities. A good rule of thumb is that any option with an Insight Ratio of under 15% is a candidate for diversification based on client planning horizon and risk profile.
• Sample Reports: Recently we’ve had numerous requests from users for information they can give to prospective clients. There are StockOpter branded reports on the StockOpter University, but it is often more effective to create your own sample client in StockOpter.com and provide prospects with a report that includes your branding and contact info. Sample participants can have a maximum of 3 tickers so you can create 3 different cases for companies you are targeting. Tips on branding your report templates can be found on the StockOpter Forum.
• 5 Things Recipients Should Know About Stock Options: Please contact Bill Dillhoefer if you would like an editable version of this prospect marketing flyer to include your contact information.

1. The onerous processes required by IRC 409A have resulted in many companies no longer allowing participants to defer the compensation and tax liability
2. Participants can’t file an 83(b) election to accelerate income when the taxable value of their shares is low
3. Unlike with exercising Stock Options, RSU vestings trigger income and taxation so recipients don’t have tax planning flexibility

These issues have a significant effect on dealing with RSUs so here are a few thoughts to help recipients get the most out of this form of equity compensation:

First, when RSUs vest the employee will typically receive the “net” number of shares after the company sells shares to withhold 25% for federal income taxes.  Be aware that the withheld amount may not cover the tax liability so it’s a good idea to do some tax planning with an advisor to avoid surprises when filing your return.

Next, for planning purposes the net shares after vesting can be added to the other shares that a recipient “owns” outright.  To simplify the valuation of owned shares use the estimated cost basis and the long-term capital gains rate (keep in mind that vested RSU shares that have gained value since vesting need to be held for at least 1 year to qualify for the lower long-term capital gains rate).  Here’s a video that explains owned share valuation concepts.

Owned share valuation and monitoring is important because the holder will need to consider diversification at some point.  It’s a good idea to do a concentration analysis that compares the value of all company stock and options to the value of one’s other investments.  Additionally, it is prudent to know the approximate stock price needed for financial goal attainment.  To reduce risk consider selling shares when company stock concentration is high and when goal attainment is close at hand.  The reduction of a concentrated owned share position will minimize the effects of untimely decreases in company stock price.

Finally, insightful information is the key to effective equity compensation management and company stock plan administration platforms don’t generally include information on owned shares, concentration or goal attainment.  Talk to your financial advisor and ask them for a Personal Equity Compensation Profile which contains this information.  Alternatively, if you like to do-it-yourself you can do so at www.StockOpter.com.

Bill Dillhoefer is vice president at Net Worth Strategies, Inc. a service firm specializing in personalized equity compensation management.  Bill led the development effort of a web-based stock plan decision support platform: www.StockOpter.com.  This system is used by most of the major financial service firms to assist clients with company stock and options.  He is the editor of the StockOpter University Blog which is dedicated to the topic of when to exercise employee stock options and diversify company stock holdings.  Bill has spoken at the NASPP conference and to several advisor groups.  Connect with him on LinkedIn or follow him @StockOpter.

Equity Compensation – Restricted Stock Units (RSUs), Downside Protection with a Couple Downsides

Dan Walter, Performensation

Last month I covered Restricted Stock Shares (RSS), today’s post covers Restricted Stock Units (RSUs). Where RSS and Stock Options are cousins, RSS and RSUs are siblings. RSS is the older sibling, with more years and experience under its belt. RSUs are the new little sister who came by surprise and often gets more attention than seems to be required. RSUs were seldom used before they shot into the spotlight following the Dotcom crash of 1999-2000. Initially, they were used to replace underwater stock options and slow the use of plan shares approved by shareholders. They provided some protection against a decrease in stock price and used somewhere between 25-50% of the shares require to provide the same value as stock options. They quickly became a major component of the equity compensation toolbox.

RSUs are generally “full value” awards, meaning that they have no purchase or exercise cost to the participant. Unlike RSS, RSUs do not require the issuance of real shares until the units are vested. This is why they are called “units” rather than shares. Many companies use the term “Award” to refer to RSUs, RSS and any other full value instrument. This separates them from the “grant” of appreciation-only instruments like ISOs, NQSOs and SARs. Either term can be used interchangeably. RSUs live in the interesting middle ground between real restricted stock and stock options to purchase shares in the future.

It is also important to note that although the majority of RSUs are designed to settle in stock, these awards can also be designed to allow, or require, settlement in cash. Cash settlement has the upside of not diluting other shareholders’ ownership position and the downside of requiring variable accounting.

As general rule, participants do not have any income from RSUs at the time of award. The ordinary income event occurs when the units vest and shares are delivered. At the time of vest the company is obligated to withhold income and employment taxes for eligible employees.

RSUs fall under IRC 409A, the deferred income and taxation rules. Even private companies need to have a reasonable basis for the value of their stock if they wish to use these awards. It also means that one of the key potential benefits of RSUs, the elective deferral of income, is subject to restrictions that make the process onerous for both participants and companies. Because of this, many companies no longer allow participants to make deferral elections. Another downside: Unlike RSS, participants can’t file an 83(b) election to accelerate income to a time when the spread is very low. Unlike Stock Options, participants do not get to elect when, in the future, the income and tax event takes place. This lack of income and tax planning flexibility is important.

In spite of the downsides, RSUs are a great tool. Because they do not require the immediate issuance of stock, companies can avoid creating instant shareholders and paying ongoing dividends. If the individual leaves with unvested units, the company can easily cancel them rather than go through the process of forfeiture and repurchase. They are an excellent retention tool in companies with an ownership culture and can provide a simple way to provide equity to broad-based participants around the world (we will cover international aspects in a later post).

Like any equity compensation tool RSUs, do not work perfectly as the “only” equity compensation tool for any company. As we explore this equity compensation series the first Thursday of every month we will discuss other tools and way these tools can be used together to provide a complete solution to your company’s needs.

Dan Walter is the President and CEO of Performensation an independent compensation consultant focused on the needs of small and mid-sized public and private companies. Dan’s unique perspective and expertise includes equity compensation, executive compensation, performance-based pay and talent management issues. Dan is a co-author of “The Decision Makers Guide to Equity Compensation”, “If I’d Only Know That”, “GEOnomics 2011” and “Equity Alternatives.”Dan is on the board of the National Center for Employee Ownership, a partner in the ShareComp virtual conferences and the founder of Equity Compensation Experts, a free networking group. Dan is frequently requested as a dynamic and humorous speaker covering compensation and motivation topics. Connect with him on LinkedIn or follow him on Twitter at @Performensation and @SayOnPay.