Pay Me in Stock Options: Manage the Options You Have, Win the Options You Want

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Author: Carol E. Curtis

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WILEYe BOOK WILEY JOSSEY-BASS PFEIFFER J.K.LASSER CAPSTONE WILEY-LISS WILEY-VCH WILEY-INTERSCIENCE

Pay Me in Stock Options

Pay Me in Stock Options Manage the Options You Have, Win the Options You Want Carol E. Curtis

JOHN WILEY & SONS, INC. New York Chichester Weinheim Brisbane Singapore Toronto

Copyright © 2001 by Carol E. Curtis. All rights reserved. Published by John Wiley & Sons, Inc. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: [email protected]. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. This title is also available in print as ISBN 0-471-39481-5 For more information about Wiley products, visit our web site at www.Wiley.com

Contents

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xi Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xv

PART ONE—THE RISE OF STOCK OPTIONS Chapter 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 We Have Seen the Future, and It Is Stock Options . . . . . .3 Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 The New Corporate Hero . . . . . . . . . . . . . . . . . . . . . . . . .10

• • • • •

Lonnie Poole, Waste Industries . . . . . . . . . . . . . . . . . . . . . . . . . .10 Craig Barrett and Andrew Grove, Intel . . . . . . . . . . . . . . . . . . . .12 Howard Schultz, Starbucks Coffee Company . . . . . . . . . . . . . . .14 John T. Chambers, Cisco Systems . . . . . . . . . . . . . . . . . . . . . . . . .16 The Next Generation: Eric Kuhn, VarsityBooks.com . . . . . . . . .18

PART TWO—STOCK OPTIONS IN 10 EASY LESSONS Chapter 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21 Lesson 1: Stock Option Basics . . . . . . . . . . . . . . . . . . . . . .21

• •

What Is a Stock Option? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21 Example from Real Life: Mellon Financial Corporation . . . . . . .22

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• • • • • • • • • • • • •

Different Types of Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 How Was the $10 Grant Price Determined? . . . . . . . . . . . . . . . .24 How Was the $20 Market Price Determined? . . . . . . . . . . . . . . .24 Beware of Insider Trading Rules . . . . . . . . . . . . . . . . . . . . . . . . .25 Who Decides How Many Options You Get? . . . . . . . . . . . . . . . . .25 What Is Stock, Anyway? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25 Public and Private Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 What Is Your Company’s Stock Worth? . . . . . . . . . . . . . . . . . . . .26 Common and Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . .27 What Kind of Stock Do You Have? . . . . . . . . . . . . . . . . . . . . . . . .28 Stock Options and Your Company . . . . . . . . . . . . . . . . . . . . . . . .28 Dilution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .30

Chapter 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .32 Lesson 2: Different Types of Options, How They Work, and How They Are Taxed . . . . . . . . . . . . . . . . .32

• • • • • • • • •

Example from Real Life: Tim Byland . . . . . . . . . . . . . . . . . . . . .32 What Are Nonqualified Stock Options (NSOs)? . . . . . . . . . . . . . .33 What Are Incentive Stock Options (ISOs)? . . . . . . . . . . . . . . . . .35 The Alternative Minimum Tax (AMT) . . . . . . . . . . . . . . . . . . . . .37 AMT Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37 NSOs versus ISOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37 The Super Stock Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 Special Tax Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45

Chapter 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47 Lesson 3: Vesting, Expiration, and Valuation . . . . . . . . . .47

• • • • •

Types of Vesting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50 Expiration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51 Section 83(b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .53 Valuing Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .58

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Chapter 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .59 Lesson 4: Exercising Your Options . . . . . . . . . . . . . . . . . .59

• • • • • • •

Focus on Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61 Dollar Cost Averaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .62 Ways to Exercise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .62 Exercising Outside the United States . . . . . . . . . . . . . . . . . . . . . .69 Example from Real Life: Mellon Bank Corporation . . . . . . . . . .69 A Forms Checklist . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .72 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .74

Chapter 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .77 Lesson 5: What Should You Do with the Proceeds? . . . . .77

• • • • • •

The Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .78 The Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .78 An Exercise Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .81 Financial Planning for the Top Echelon . . . . . . . . . . . . . . . . . . . .84 Stock Options and Financial Independence . . . . . . . . . . . . . . .104 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .109

Chapter 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .110 Lesson 6: A Short Course in Asset Allocation . . . . . . . . .110

• • • • • • • • •

Wall Street’s Favorite Statistic: 93.6 Percent . . . . . . . . . . . . . . . .111 The Value of Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . .112 The Temptation of Concentration . . . . . . . . . . . . . . . . . . . . . . .114 Which Asset Allocation Is Right for You? . . . . . . . . . . . . . . . . . .115 Ongoing Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .119 Rebalancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .119 Where Does Company Stock Fit In? . . . . . . . . . . . . . . . . . . . . .119 Stocks or Mutual Funds? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .124 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127

Chapter 9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .128 Lesson 7: The Risks of Options . . . . . . . . . . . . . . . . . . . .128

• • •

Risks Faced by Employees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .129 Risks Faced by Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .143

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Chapter 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .145 Lesson 8: Options Overseas . . . . . . . . . . . . . . . . . . . . . . .145

• • • •

Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .146 Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .148 Stock Appreciation Rights (SARs) . . . . . . . . . . . . . . . . . . . . . . . .149 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .150

Chapter 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .151 Lesson 9: Other Types of Stock-Based Compensation . .151

• • • • •

Employee Stock Ownership Plans (ESOPs) . . . . . . . . . . . . . . . .151 Section 423 Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .152 Restricted Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .153 401(k) Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .154 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .156

Chapter 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .157 Lesson 10: Avoiding Common Mistakes . . . . . . . . . . . . .157

• • • •

Mistake 1: Not Knowing What You Own . . . . . . . . . . . . . . . . . .157

•

Mistake 5: Failing to Account for Taxes in Valuing Your Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .160

•

Mistake 6: Forgetting about the Alternative Minimum Tax (AMT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .161

• •

Mistake 7: Accepting Stock Options in Place of a Salary . . . . . .162

• • •

Mistake 9: Failing to Set Goals and Develop an Overall Plan . .164

Mistake 2: Cashing in Your Options Too Soon . . . . . . . . . . . . .158 Mistake 3: Keeping Too Much Tied up in Company Stock . . . .159 Mistake 4: Failing to Take Blackout and Lockup Periods into Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .159

Mistake 8: Failing to Learn What Happens if You Leave the Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .163 Mistake 10: Counting Your Options before They Hatch . . . . . .164 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .165

Chapter 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .167 How to Negotiate for Stock Options . . . . . . . . . . . . . . . .167

•

Where Does This Leave You? . . . . . . . . . . . . . . . . . . . . . . . . . . .168

contents

• • • • • • • • • •

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An Example from the Old Economy . . . . . . . . . . . . . . . . . . . . .170 Knowledge Is Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .171 If You Already Have Options . . . . . . . . . . . . . . . . . . . . . . . . . . .171 If You Don’t Have Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . .173 Value of Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .173 You Get What You Negotiate . . . . . . . . . . . . . . . . . . . . . . . . . . .176 A Slice of Life in the Executive Suite . . . . . . . . . . . . . . . . . . . . .176 What if You’re a Freelancer? . . . . . . . . . . . . . . . . . . . . . . . . . . . .178 Case Histories from Real Life . . . . . . . . . . . . . . . . . . . . . . . . . . .179 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .183

Chapter 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .185 Frequently Asked Questions . . . . . . . . . . . . . . . . . . . . . .185

• • • •

Stock Option Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .185 What to Do with the Proceeds . . . . . . . . . . . . . . . . . . . . . . . . . .196 Basic Financial Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .199 Your Personal Finances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .204

Appendix A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .209 Risk Tolerance Questionnaire . . . . . . . . . . . . . . . . . . . . .209 Appendix B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .219 Selected Stock Option–Related Web Sites . . . . . . . . . . . .219 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .221 Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .225 Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .247

Preface

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elcome to the stock options revolution. The market may be up, the market may be down, but one type of growth has remained relentless over the past decade: ownership of stock options. An estimated 12 million Americans now own stock options, or more than 1 out of every 10 private-sector workers. From their first appearance as a perk for corporate executives a half century ago to their pervasive use in the new economy and now the old economy, stock options are rapidly becoming a kind of corporate currency—not the same as cash in your hand, certainly, but with a lot more potential. No matter what industry you work in, or what level you are on, stock options are likely to play some part in your working life. How do I know this? In a phone survey of more than 1,000 people, here’s what Oppenheimer Funds turned up:

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two-thirds said that options would be a “some• Nearly what important” consideration in looking for a new job. two-thirds said that options would play an impor• Nearly tant role in planning for their financial security. a third—28 percent—said that if they were look• Almost ing for a new job today, they would consider taking a lower base salary in exchange for stock options. “Increasingly, employees are looking at stock options as a way to secure their financial future,” Oppenheimer concluded.1 But a curious thing happened on the way to this revolution. Knowledge failed to catch up with reality. Despite the fact that stock options are one of the most complex and powerful tools ever devised for making money, and despite the fact that more people than ever before are getting them, it turns out that employees, whether they own options or not, are spending little or no time learning about them. Nearly 40 percent of options holders told Oppenheimer that they know little or nothing about options, while 37 percent admitted that they know more about Einstein’s theory of relativity than they do about taxation of their stock options! Even more ominously, 11 percent conceded that they have allowed in-the-money options to expire worthless. If someone handed you a suitcase of money, would you throw it in the nearest garbage can? Of course not. Yet that’s precisely what these people were at risk of doing, because they didn’t take the trouble to understand and manage their stock options. That’s where Pay Me in Stock Options comes in. As the first book about stock options written for the layperson, it will teach you how to manage your options if you already have them, and win options if you want them. In 10 easy lessons, this book explains everything you need to know to maximize the value of your stock options, from the basics through smart strategies for exercising options, selling stock, and minimizing taxes to investing the proceeds like an expert.

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If you don’t yet own options, this book will take you step by step through strategies for getting them and give you tips on negotiating the best options package possible. Along the way, it will alert you to options minefields, like letting in-the-money options expire or exercising and selling at the wrong time. What follows won’t always be an easy read, but the effort is well worth it. In fact, if I’ve done my job, Pay Me in Stock Options could easily turn out to be one of the most profitable books you’ve ever read. CAROL E. CURTIS Darien, Connecticut January 2001

Acknowledgments

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his book would not have been possible without the generous help of a number of people. First and foremost I would like to thank Barbara Steinmetz, president of Steinmetz Financial Planning, Burlingame, California, for the time and effort she spent reviewing my manuscript and making suggestions which never failed to be helpful. I am also indebted to Jay Clasgens, executive vice president and director of Brownson, Rehmus & Foxworth, Inc., Menlo Park, California. Jay’s awesome knowledge of options and financial planning proved indispensable in researching and writing the chapters on financial planning and asset allocation. Much help was also provided by Corey Rosen, founder of the nonprofit National Center for Employee Ownership (NCEO), Oakland, California. The NCEO continues to contribute a great deal to the understanding of stock options through its worthxv

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while education and research. Mark H. Edwards, founder and managing principal of iQuantic, provided inspiration with his eloquent vision of where the new economy is headed and the role stock options will play. And finally, thank you to Debby Englander and Greg Friedman at Wiley, for putting up with me and never losing the faith. C. E. C.

part one

The Rise of Stock Options

C h a p t e r

o n e

We Have Seen the Future, and It Is Stock Options

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ark H. Edwards is one of the most seasoned compensation consultants in the business, with over 20 years of experience and a degree from Massachusetts Institute of Technology’s Sloan School of Management. Seven years ago, Edwards left his comfortable old-economy existence behind to found iQuantic, a rising consulting firm serving the new economy. From his office in San Francisco’s newly fashionable warehouse district, Edwards has built a thriving practice by advising companies on stock option grants. With hundreds of clients in every nook and cranny of the technology business, Edwards has become perhaps the most experienced observer of how stock options are transforming the high-tech business culture. Edwards, 47, also walks the walk. His own company—private, but set to go public by 2002—embodies his own vision of the future. In addition to a salary, every employee has stock options,

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ranging from 2,500 shares at the lowest level to over 200,000 for senior management. The grant price is less than $1. So far, Edwards has given away over 15 percent of iQuantic via options, and he expects to give away an additional 5 to 10 percent over the next year. The startling thing is not so much that Edwards has already given up so much of his company—it is that he is still losing employees, he says, to companies whose options packages are even more generous. Welcome to the future of compensation. Despite recent market volatility, in no other place and at no other time has so much wealth been amassed by workers in a single industry. And the driver of this wealth creation is stock option compensation. According to iQuantic’s research, more than 140,000 high-tech millionaires were created in 1999, more than triple the number created in 1998, and more than a sevenfold increase from 1997. And the good news is that this money is not just going to a select few executives at the top, as it has in the past. Over 100,000 high-tech employees below the level of vice president became stock option millionaires between 1994 and 1999. The presence of stock option wealth in the new economy is so pervasive that old-economy companies must adapt or die. According to the National Center for Employee Ownership (NCEO), close to 10 million employees now receive stock options. Over 90 percent of large public companies offer stock options. And in Silicon Valley, the birthplace of broad-based options, virtually every single start-up offers options as a major form of compensation.1 Options were first used in the 1940s and 1950s as a bonus for key executives. Until the 1980s, and the rise of Silicon Valley, they were largely limited to a firm’s top management. As recently as 10 years ago, according to the NCEO, only 1 million employees received stock options. What happened to spur this phenomenal growth and create leading-edge entrepreneurs like Edwards? While stock options offer significant benefits to the employee, a key factor is their

we have seen the future, and it is stock options

5

benefit to the employer. A company that issues stock options gets favorable tax and accounting benefits. Under present rules, the value of stock options is normally not recognized on the books of a corporation—it appears instead as a footnote on the financial statements. The value is charged against income only when the options are exercised. And in the case of the most popular type of option for nonmanagement employees, the so-called nonqualified stock option, the charges are considered a business expense that can lower a company’s tax bill. Still another company benefit is tied directly to the rise of Silicon Valley start-up firms. All these companies use stock options for the simple reason that they are all short on cash and have no profits, so their ability to pay high salaries is limited. Instead, they offer options as a promise of future gains based directly on the success of the company. This widespread use of equity ownership is a distinguishing characteristic of neweconomy companies. Firms of all types have also found that stock options increase worker loyalty and improve morale. This is in part because in most cases options need to be vested before they can be exercised. This can take up to four years, sometimes longer, so employees need to stay at least that long in order to fully profit from them. Options improve morale and spur productivity because sharing in the ownership of a company makes employees think like managers, and managers think like owners. “Options are the best compensation mechanism we have for getting managers to act in ways that insure the long-term success of their companies,” said Brian J. Hall recently in the Harvard Business Review.2 However, stock option growth has now taken on a life of its own. The recent market downdraft notwithstanding, success stories of options millionaires still abound. A peak may have been reached in mid-1999, when the July 5 cover of Newsweek proclaimed the “Whine of 1999”—Everyone’s getting rich but me! A main reason, according to Adam Bryant of Newsweek, was the

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phenomenon of the instant millionaire—Silicon Valley optionaires who cashed out big when their dot-coms went public.3 Even in the face of the recent dot-com shakeout, there is a virtual war for talent going on in many technology firms, allowing workers to move from job to job as they search for the best options package. And top management isn’t being left out: According to Pearl Meyer & Partners, a New York City–based compensation consulting firm, options now make up more than two-thirds of the average chief executive’s pay. “Stock options are such a big thing that they may actually be impacting the statistics that are used to measure the overall economy,” contends David Wray, head of the Chicago-based Profit Sharing Council. Although research has yet to confirm it, Wray believes that the recent lack of wage inflation is partly due to the replacement of a regular paycheck with stock options. In the near future, Wray believes, one-half of all compensation will be stock based. Meanwhile, stock options and the new economy have become so intertwined that it is hard to envision one without the other. And Edwards argues convincingly that it takes more than money to create that link. In a paper on stock options and the new economy, Edwards points out that employees whom Peter Drucker first called “knowledge workers” back in the 1950s are attracted by a company’s culture—its vision, leadership, and a whole host of characteristics that people may have difficulty describing, but know when they see or feel them: What has come to define culture for many skilled workers is an organization’s recognition of the wealth created by its employees, and the extent to which it shares that wealth with them. So while the high-tech culture of Silicon Valley is set apart from the Old Economy by things like a high ratio of pool tables to employees, boxes of doggie biscuits in drawers, and even (increasingly starched) khakis, in the minds of many it is defined by the availability of stock options.4

we have seen the future, and it is stock options

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Is this a good thing, and what does it mean for you? We have seen that the tax treatment of options, and the fact that options are a handy substitute for cash, makes them a very good thing for companies. We have also witnessed an unprecedented amount of wealth creation, in terms of the sheer number of new high-tech millionaires. But the boom has occurred in the midst of record economic prosperity. So much of the wealth that has been created exists merely on paper, waiting to be cashed in. What happens in the event of an ongoing economic downturn? We caught a glimpse of this during the recent dot-com meltdown. As the tech-heavy Nasdaq plunged, unvested, unexercised options were dragged down along with it. While morale plummeted at many firms, there was no mass exit from the market, or from high-tech companies. Still, one report said that as many as one-third of the San Francisco Bay area companies that had gone public during a recent 16-month period were trading at prices below their offering price, making their options worthless.5 The bright side is that companies appear to be adapting to make stock options better able to withstand a volatile market or an economic downturn. Many companies are resetting their options by issuing new grants at lower prices. One twist is to shorten the vesting period via performance-accelerated stock options (PASOs), which allow options to vest faster, pinning them to a performance goal such as share price growth or a target revenue level. Repricing, which involves issuing options at a lower price so they will no longer be underwater, used to be a popular tool for handling a sagging stock price. But new rules make repricing expensive, so companies are developing other means of dealing with underwater options, including the issuance of more options at a lower price (so-called resetting) to make up for any losses during market downturns. Still, as Edwards and other experts point out, one of the most valuable ways to make stock options a meaningful tool for retain-

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ing employees is communication: “The best position a company can take to get the full value out of its stock option program is to communicate, fully and effectively, what the grant means to employees,” he says. That’s where this book comes in. If knowledge is power, then knowledge of stock options is the power to create wealth—and it can make or break the effectiveness of any options grant. Despite the complexity of options at every level, companies have generally done a poor job of educating their employees. While top executives get free financial planning, including the services of a stock options expert who can help them value, exercise, and invest the proceeds from their stock options, most employees are left high and dry with their stock options grants, often without even the most basic information, such as what kind of options they have. Valuing stock options is no piece of cake. Neither is exercising them, or figuring out how they work, what taxes are owed, what risks to avoid, and what to do with the proceeds. Even before being hired, knowing how to negotiate for stock options can make a big difference in how generous an options package you receive. But to date, there have been no manuals on how to do this effectively. Even so, the new economy is pushing employees to new levels of sophistication in terms of understanding their compensation. As stock options take their place alongside 401(k) plans and Individual Retirement Accounts (IRAs) as tools for wealth building, employees will need to become much more informed decision makers about how they are compensated. The goal of this book is to make you an informed decision maker about stock options—getting them, making the most of them, and investing the proceeds wisely. But before classes begin, we’d like to take you on a brief journey through Optionsland. By recounting actual case histories of entrepreneurs who have shaped our options culture (and

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become millionaires—or billionaires—in the process), we hope to provide the inspiration and motivation you will need to become a diligent student of stock options. They—like you—are part of the new pay paradigm, in which smart people will demand a share of the wealth they create.

C h a p t e r

t w o

The New Corporate Hero

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ere are the stories of entrepreneurs who have shaped— and continue to shape—our options culture.

L ONNIE P OOLE, W ASTE I NDUSTRIES Lonnie Poole Jr. may be 63 years old, and his company, Raleigh, North Carolina–based trash hauler and recycler Waste Industries, may be firmly planted in an old-economy kind of business. But in every other respect, Poole is not only a new-economy type of hero, he is a stock options pioneer who has literally bet the ranch on options. Three decades ago, Poole sold his house to scrape up the $10,000 he needed to start Waste Industries. Through the years he built the business up: Today, with 2,000 employees, $213 million in sales, and net income of $12 million, the company operates in eight states as the eighth largest solid waste hauler in the country. 10

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How has Poole rewarded himself for creating such a successful business? Beginning in 1998, Poole slashed his salary, which was $220,000 a year, to zero, and also gave up his bonus, which in 1996 and 1997 had netted him another $350,000. Instead, Poole opted for stock options. In 1999, after the proxy went out, the company’s board of directors awarded Poole 50,000 stock options in lieu of a salary and bonus. While Poole’s options have a range of grant prices—from $5 to $19— they haven’t made him a lot of money recently: Since going public in 1997, at a price of $13.50 a share, the stock of Waste Industries, which trades on Nasdaq, has been as high as $27, but at this writing it is trading at just $11, down along with other firms in the waste business. But the depressed stock level doesn’t worry Poole. “In the grand scheme of risk taking, this pales in comparison to the risks I have taken since 1970,” Poole says. His belief in options is fueled, Poole says, by the tax advantages. He feels that he is much better off taking his pay in options rather than as a salary and bonus, on which he would lose 40 percent to state and federal taxes. Meanwhile, his incentive stock options are taxed at the lower capital gains rate of 20 percent, and no tax is owed on them until he actually sells the stock. His options, which don’t expire for 10 years, also allow him to take advantage of tax credits that accumulated before the company went public in 1997. Poole, who owns 5 percent of the company, also owns stock from before Waste Industries went public, some of it from stock options. While it’s fairly common for a company founder to own a lot of stock options, it’s unusual for a high-level executive to take only options and no salary at all. But Poole is not concerned: “When you’re in business there’s always an element of risk, and to me stock options are the best way. The beauty of them is that you don’t have to pay taxes on them until you exercise them.” Poole is such a believer that he has also granted options to many of Waste Management’s employees, dating back to 1970.

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And he has some definite ideas about the role options have played in Waste Industries’ success: “There is a big difference,” he says, “between thinking like an employee, and thinking like an owner. When I hire an employee, the trick is to make them feel the same sense of pride [in Waste Industries] that I have acquired over 30 years. Stock options are a way to do that, and to get that little bit extra out of people. That can spell the difference between success and mediocrity.” Another plus, he says, is that it’s easy to get bogged down in day-to-day business concerns, like whether to buy a new truck or Dumpster. Stock options make you see beyond that: “You say to yourself, ‘What did I do today that will make my options increase in value?’ ” Despite the company’s current depressed stock price, his options have made Poole a wealthy man. Poole and his family currently own 6.7 million shares of stock in the company—much of it from options—and even at $11 a share, that makes him worth $73 million. “The stock is down now,” he says. “But on the worst day of my life, I still know that I invested $10,000, and I am now worth $73 million.”

C RAIG B ARRETT AND A NDREW G ROVE, I NTEL Much has been made of the huge compensation packages of Silicon Valley billionaires like Michael Dell of Dell Computer. But not all of these executives are overpaid—in fact, according to compensation consultant Graef Crystal, writing in the San Francisco Business Times, one of the best known, Craig Barrett of Intel, has a compensation package that makes him underpaid—were it not for his stock options, that is.1 After analyzing the pay packages of 338 chief executive officers (CEOs), Crystal found that even though Barrett’s base salary in 1998 was $454,200, up 24.4 percent from 1997, Barrett was actually being paid a salary that was 63 percent under the

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market. Furthermore, after adjusting for company size and total shareholder return (stock price appreciation plus reinvested dividends), Crystal concluded that Barrett’s base salary and bonus combination put him 49 percent under the market. Barrett’s total direct compensation, including the estimated present value of his stock options grants, was $14.3 million. This turned out to be 160.2 percent more than his total direct compensation a year earlier. On the face of it, Barrett surely seemed to be overpaid. But when Crystal ran the $14.3 million figure through a model based on 338 other CEOs, he found that instead of being overpaid, Barrett’s compensation was 33 percent under the market. “It’s not often that we get to write about a CEO who performs wonderfully and is underpaid to boot!” he gushed.2 Crystal reached this conclusion even after Intel’s proxy revealed that Barrett’s stock options had increased from 120,000 shares in 1997 to 744,000 shares in 1998. What’s more, Barrett exercised his stock options in 1998 for a gain of more than $114 million—8 times his total direct compensation. Why? Stock options, among other things, are an award for performance. And Barrett’s performance had been sterling: From May 1998 to May 1999, he delivered total shareholder return of 50.9 percent, 2.4 times higher than the 21.2 percent return during the same period from the Standard & Poor’s 500 Stock Index (S&P 500). It seems Barrett was carrying on a tradition. Andrew Grove, who led Intel for 10 years before Barrett took over, also made his stock options millions the hard way. Compensation consultant Crystal figured that during Grove’s decade, $100 invested in the S&P 500 index would have grown to $353 at decade’s end. That’s a compound return of 13.6 percent per year. But if you had put your $100 into Intel stock, it would have grown to $1,801—a compound return of 33.8 percent a year. Given that caliber of performance, Crystal concludes that the $25 million Grove received from stock options from 1985 to 1996 was not unreasonable. By way of comparison, Disney’s

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Michael Eisner earned $506 million in 1996 alone from his Disney options. “Grove performed mightily, and he got his millions the hard way, out of some puny-sized option grants,” says Crystal.3 Put another way, some options millionaires earn their riches by building value—and at Intel, that’s a continuing tradition.

H OWARD S CHULTZ, S TARBUCKS C OFFEE C OMPANY Jessica Gleeson works in the corporate training department at Seattle’s Starbucks Coffee Company. She started working there in 1990, while still a student at the University of Washington. A year later, Starbucks CEO Howard Schultz announced that he would offer stock options to all full- and part-time employees who worked at least 20 hours a week. Gleeson was able to sell the stock from her options four years later at a profit of $15,000. The amount became the down payment on a house. What’s more, she was able to plan a trip to Paris to celebrate the millennium, thanks to more optionsgenerated stock that she sold. Tales like Gleeson’s abound at Starbucks, which became the first company to offer stock options to part-time employees back in 1991, when the company was still private. When it went public in 1992, the stock closed up a modest $4.50 from the opening price of $17. But that was enough to thrill Howard Schultz, who joined the company in 1982 as head of marketing, left, and returned in 1987 to purchase the company for $3.8 million. Schultz is credited with many of the innovations that have made Starbucks a legend in the retail business. Since taking over as CEO in 1987, Schultz has transformed Starbucks from a local coffee manufacturer into a big-league national retailer, with a simple growth strategy: Every dollar you invest in your employees shows up on the bottom line.

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Perhaps the biggest investment Schultz made was in broadbased stock options. As an incentive to stay with the company and have a vested interest in its success, in 1991 Schultz came up with “bean stock”—stock options structured to achieve employee and corporate goals. Each “partner,” or employee, receives options based on his or her annual wages. The target is 10 percent, but the actual percentage has recently been higher, due to the company’s profitability. The grant price is the price of the stock on the first day of the fiscal year. There is a five-year vesting schedule, which begins one year after the options are granted. To put the bean stock plan in place, Schultz had to get a special exemption from the Securities and Exchange Commission (SEC). The SEC required that any company with more than 500 shareholders had to report its financial performance publicly. Schultz thought this would be too costly and would reveal information to competitors. So Starbucks argued that the rule could be waived because its employees were receiving options rather than shares, and the SEC agreed. The first year that the options were offered, Starbucks exceeded its profit goal by 20 percent, and the board responded by increasing the percentage of salary for stock options to 12 percent. Schultz went even further: He gave the first wave of workers who were offered options the same 30 percent discount on the price that the company’s top executives received. As Schultz sees it, the options act as a kind of glue that binds workers like Gleeson to the company, creating loyalty, encouraging better service to the customer, and promoting innovation. And, in fact, Gleeson was able to devise a way to save the company $1 million a year by reducing in-store waste. “People wind up treating the organization’s money as if it were their own money,” she says. Although Starbucks has been a public company for nearly a decade, Schultz says that his bean stock idea can be duplicated by almost any type of company, public or private. Meanwhile, Star-

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bucks continues to be a sought-after place to work. “We’ve literally changed the level of communication,” Schultz says. “You can’t imagine how excited our workers were when we started explaining bean stock. All kinds of people started coming up with ways to save money and improve productivity. Now they’re invested in our future.” Schultz and other top executives at Starbucks haven’t done too badly, either. According to the Puget Sound Business Journal, Schultz rode the 1990s bull market to a gain of $32 million in 1998 alone, including the estimated future value of his options, consisting of 525,000 shares of Starbucks stock, then worth $30 million. Orrin Smith, president and chief operating officer (COO) of Starbucks, made $17 million from options in 1998 alone, while Howard P. Behar, president of Starbucks Coffee International, Inc., made $8.8 million.4 The bottom line? Schultz transformed Starbucks into a case study on the power of options to put employees and management on the same page, pulling shoulder-to-shoulder to achieve success and share in the profits of their labor.

J OHN T . C HAMBERS, C ISCO S YSTEMS Just when the technology correction was getting underway in earnest in April 2000, the New York Times took a critical look at compensation in the new economy. Its research turned up the fact that when stock options are valued in the most widely used way, the typical chief executive now makes more in a single day than the typical American worker does in a year.5 Fat as their compensation packages are, however, there is one elite group that makes even typical CEOs’ pay look unremarkable—the small number of executives at the top of young, successful new-economy technology companies. In 1999, according to Executive Compensation Advisory Services of Alexandria, Virginia, these particular executives took home an average of $27 million in 1999, much of it via stock options.6

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At the very top of this solid gold pyramid sits John T. Chambers, chief executive of legendary Silicon Valley superstar Cisco Systems. In 1999, Chambers’s exercised options yielded him a paycheck of $120.8 million, more than that of any other CEO. As of April 2000, Chambers held options worth $159 million. The estimated total value of Chambers’s stock and options at that time was a stunning $566 million. Whether this is good or bad is something that experts may agonize about, but the indisputable fact is that Cisco has been fantastically successful, due in large part to Chambers, and the gains at the top have trickled down, at least to the company’s managers. Cisco uses stock options extensively at the management level, and its employees recently held a collective total of nearly 440 million outstanding options. The company, an Internet equipment maker, is one of the most valuable firms in the world. It has also been one of the stock market’s best performers over the past decade, with its stock price rising from about $20 a share at the start of 1999 to $80 a share in April 2000. It has long been a practice at Cisco to give large options grants to managers, which Chambers believes has had much to do with the top-notch performance numbers. However, growing numbers of experts, including the likes of mutual fund guru John Bogle, say that dilution of earnings from huge options grants like these are becoming a serious problem. Bogle’s point is that because stock options are not required to be reported on a company’s books, they are invisibly diluting earnings. In the case of Cisco, for example, Bogle says earnings would be less than 80 percent of the reported figures if all the company’s stock options were counted on the books.7 Also, some experts contend that the level of overhang—the percentage of the company that options would represent if they were all exercised—is reaching a dangerous level. In 1999, for example, the average overhang hit 13.9 percent. However, to date, few companies—and clearly not Cisco—

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appear to have suffered from options overhang. Despite the 2000 technology sell-off, the gains of technology companies, and their optionaires, remain stunning. In the case of Cisco, while the stock swooned to a 12-month low of $28 in the mid-2000 sell-off, it was back above $68 by mid-July. While the jury is still out on whether Cisco gets any extra bang from making Chambers a centimillionaire (as opposed to a mere millionaire), Cisco shareholders and optionaires aren’t likely to rock the boat as long as their bank accounts keep increasing.

T HE NEXT GENERATION: E RIC K UHN, V ARSITYB OOKS.COM Like a lot of dot-com start-ups, VarsityBooks.com, an online retailer of college textbooks based in Washington, D.C., recruits student help. In fact, the company relies heavily on student sales representatives on college campuses to sell its products. But this isn’t just your run-of-the-mill part-time job. Student reps for VarsityBooks.com get—in addition to an hourly wage and a sales commission—a PalmPilot, a bonus, and trips to corporate conferences, just like full-fledged executives. That’s a lot for a student, but President and CEO Eric Kuhn is offering even more. At a meeting of 250 leading student representatives, Kuhn announced that they would also receive— you guessed it—stock options. As of mid-2000, the company had granted more than 600 student representatives options to purchase 100 shares of VarsityBooks.com stock at an exercise price of $5 a share. The options vest in one year. Company executives say they needed to make the move because options have become essential to recruit and motivate even the youngest, least-experienced employees. Are the incentives working? One student was so enthusiastic that he has already recruited three more friends to work with him as a team. Put another way, we have seen the future, and it is stock options.

part two

Stock Options in 10 Easy Lessons

C h a p t e r

t h r e e

Lesson 1: Stock Option Basics

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isten up, optionaires and would-be optionaires, because this is where the rubber meets the road. Here are the option basics that are indispensable if you have, or hope to have, options in your compensation package.

W HAT IS A STOCK OPTION? A stock option gives you the opportunity, but not the obligation, to buy the stock of a company—almost certainly the one for which you work—at a fixed price for a certain number of years in the future, regardless of changes in the price of the stock. This price is often called the grant price, but it can also be called the exercise price or the strike price. Your hope is that the share price will go up, and that you will be able to exercise the option (buy the stock) at your lower grant

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price, then sell the stock at a higher—hopefully much higher— market price. Your company can—and probably has—set limits on when your options can be exercised. These are called vesting restrictions, and they typically require that you work for the company for a minimum number of years (three to five, in most cases) before part or all of your options can be exercised. There are also lockup agreements, which can prevent you from selling your shares. In some cases, options can be exercised only if certain financial targets are met. These options are sometimes called performance options. The different types of vesting are described in detail in Chapter 5.

E XAMPLE FROM REAL LIFE: M ELLON F INANCIAL C ORPORATION Let’s look at a real-life example. In 1999, Mellon Financial Corporation, one of the country’s largest banks, decided to offer all of its 22,000 full- and part-time employees stock options. The program consisted of three separate grants, starting right away and continuing in 2000 and 2001. Each year, eligible full-time employees would receive options to purchase 150 shares of Mellon common stock, while eligible part-time employees would receive options to purchase 75 shares. Options for 1999 could be exercised beginning one year after their grant date, provided that Mellon’s stock had reached or exceeded a target share price for 10 consecutive business days. Over the past year or so, Mellon’s stock has fluctuated between a high of over $40 a share and a low of under $27. It’s safe to say that plenty of nervous Mellon optionaires are tracking financial stocks with keen interest these days, as they wait for their options to vest. That wasn’t Mellon’s primary intent, though. Executives at the bank say the program was created to reward employees who stay with Mellon and “continue to create value for sharehold-

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ers.” Whatever the reason, it’s a refreshing way for a stodgy old bank to become part of the new economy.

Now, back to the classroom. In most instances, if the market price of the stock goes up and you decide to exercise your options and purchase the stock at the grant price, you can then sell them right away at the higher market price. The difference between the two prices, minus taxes and fees, is your gain. You can also hold onto the stock, and wait for the price to go higher. Be aware, however, that what goes up can also go down, putting you at risk of wiping out your gain. Here’s an example: Suppose you received options in 1995 at a grant price, or exercise price, of $10 a share. By 1998, the stock price of your company is $20 a share. If you exercise your options at this price, you realize a $10-per-share gross gain. This is the market price of $20 minus your $10-per-share grant price. Your final profit will be this number minus taxes and fees.

D IFFERENT TYPES OF OPTIONS Taxes and fees are important, especially taxes. We discuss these in detail in Chapter 4. Meanwhile, you need to be aware that there are two different types of options, nonqualified stock options (NSOs) and incentive stock options (ISOs), and the type you have will determine the taxes you pay and when they are due. Nonqualified options are the most common type, and the kind you probably got or will get. They do not get preferred tax treatment. Incentive options, the type granted to many top executives and employees of firms that have not gone public, qualify for preferential tax treatment under some conditions. We discuss this in detail and advise you on tax strategy in Chapter 4.

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H OW WAS THE $10 GRANT PRICE DETERMINED? Most companies set the grant price at the fair market value of the stock on the day that you receive the options. If you work for a public company (one that is listed on a public exchange, such as the New York Stock Exchange or the tech-heavy Nasdaq), the price is usually determined by taking the trading price at the start of the day on which the option is granted, or by taking an average of the trading price over a number of days close to the grant date. (Companies that are not publicly traded have a different methodology for establishing a market value, but that is beyond the scope of this discussion.)

H OW WAS THE $20 MARKET PRICE DETERMINED? The price at which you can sell your options is the trading price of your company’s stock on the stock market on the day you sell. If yours is a public company, the stock price is listed in the paper, under the exchange on which your company is registered. Private companies have their own methods for pricing their shares. If you work for a private company that is not listed in the paper, you should check with the person your company has assigned to handle stock options. This may be someone in your company’s legal or human resources department. In many instances, you cannot sell unless the stock is publicly traded. Options also have a limited period during which they can be exercised. This is the period of time during which you can purchase the shares at the grant price. Most (but not all) exercise periods run for 10 years, meaning that you can purchase the shares at the grant price during this time, assuming that they are vested, except with an 83(b) election, in which case you can exercise prior to vesting. After that, they expire—a condition that makes them worthless to you.

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B EWARE OF INSIDER TRADING RULES Here’s something to keep in mind: It is against the law to buy or sell stock when you are aware of material inside information about your company. This is information that has not been disclosed to the public that may affect the price of the stock. An example is if you are aware of an unannounced upcoming merger and use that information to your advantage. As an employee, you are subject to restrictions contained in separate policies based on your level of exposure to such material inside information. To find out what restrictions apply to you, contact the person your company has designated to handle stock options issues.

W HO DECIDES HOW MANY OPTIONS YOU GET? Usually, the top management of your company will decide on the specifics of any option plan—who will get how many options, vesting, expiration, how you can exercise, and so on. Since these plans are very flexible, your company has a lot of latitude in deciding who will get options and how many options each employee will receive. Top management will usually ask for input from others within the company, including the human resources department, a compensation committee, the finance department, and shareholder services. Outside consultants may also be involved. They may include attorneys, accountants, and financial experts. The board of directors will also need to approve the plan before it is implemented.

W HAT IS STOCK, ANYWAY? Although we all talk about stock, we seldom take the trouble to define it. What is stock, anyway? When you are granted stock options, you become the owner

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of stock once you exercise them. Stock is the form of currency that companies use to represent how much they are worth. When you own stock in your company, the number of shares you own represents a percentage of the total value of your company. For example, if your company issues 1,000 shares of stock, and you own 10 shares, you own 1 percent of the company.

P UBLIC AND PRIVATE STOCK If your company is private, the company’s stock is not bought or sold on a public stock exchange, and not everyone can buy it. The owners of your company basically decide whether they want to sell stock, and to whom. The value of your company and its shares is determined by an expert. Then, if your company really takes off and needs more money to grow, it may decide to go public. When a company goes public through an initial public offering (IPO), the stock is registered with government agencies and made available through stockbrokers to anyone who wants to buy it. Buyers may then sell the stock to anyone they want. The price is simply what the buyer is willing to pay, and it is listed daily in the newspapers under the various exchanges where stocks are traded. Is there a downside to going public? Yes. It is expensive, requires a lot of financial reporting, and spreads ownership of the company around to many people.

W HAT IS YOUR COMPANY’S STOCK WORTH? Your stock is worth what willing buyers want to pay willing sellers. How this is determined depends on whether your company is publicly traded or privately held. People buy and sell shares every day, setting the price based on supply and demand. With

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private companies, the stock is often not priced at all, until someone wants to sell—and then the shares are worth whatever a buyer may offer. In companies that are owned by employees, the stock price is usually set by an outside appraiser or by a formula. Both approaches strive to approximate what a willing buyer would pay to a willing seller.

C OMMON AND PREFERRED STOCK Companies often have different kinds of stock, with different values put on each. Why? Imagine for a moment that you are the sole owner of a computer company. You have recently invented a new type of software that you think could hit the big time. But it will take time to develop and manufacture the software, so it will take some time for your investment to pay off. What you need now is patient investors—those who are willing to invest in your firm even though they will not get their return for a long time. So you decide to issue new shares, and sell them to investors. You could issue common stock, the simplest type. Each share of common stock has one vote. In most cases, no dividend is paid on these shares. Shareholders therefore get no return on their investment until they sell the stock, and if your company goes belly up, or bankrupt, they are last in line to get any money left over after other creditors are paid. You may not be able to attract investors with this type of high-risk stock. So you decide to issue preferred shares instead. Preferred stock is different from common stock in two ways: 1. Each share is entitled to a bigger dividend. 2. The holders of preferred stock get paid before the holders of common stock if the company is liquidated. Preferred stock normally costs more than common stock. Owners of preferred shares choose to get more of their money

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in the form of dividends, tying the value of preferred shares value more to current profits than to the intrinsic worth of the firm. One type of stock is not necessarily better than another. Preferred stock has less risk and higher dividends; common stock costs less, but may grow more in value because less is paid out in dividends.

W HAT KIND OF STOCK DO YOU HAVE? Most companies give employees the right to buy common stock when they receive stock options. This is because employees often do not hold onto the stock for very long, because most are interested in growth, so dividends don’t mean much. Also, preferred stock tends to be issued in smaller amounts than common stock.

S TOCK OPTIONS AND YOUR COMPANY You know why stock options are good for you. And you know the explanation your company has given for why you got them—to make you think like an owner and work harder. But there’s another reason that was probably left out of the press release: Unlike passing out paychecks, there is no immediate cost to your company when options are handed out. The cost to the company is deferred until the time when the options are exercised. While the ultimate value may prove to be very great, it is still a future expense—and as any financial expert will tell you, future expenses are worth much less in current dollars. A promise of $20,000 in 2008 is not worth as much as $20,000 next year. Even better for your company, accounting rules do not require the company to show this future expense on its current income statement. So the company can give employees something of real potential value (an option grant today), but does not have to pay for it until a later date, and then only if the price

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of the stock goes up. This is good for the company, because it makes it that much easier to attract capital and get loans. It’s also one of the primary reasons why options have in many cases taken the place of paychecks at cash-poor start-up firms. There are other financial reasons that make options attractive to your company. When you exercise a nonqualified option, your company can take a tax deduction. Plus, the cost of the options is borne in part by shareholders, rather than coming directly out of the company’s pocket.

D ILUTION Assuming that the company provides the stock for the options by issuing more shares, the existing shares will be diluted, meaning that current shareholders will wind up owning a smaller percent of the company than they would have without the issuance of the options. But the shareholders are unlikely to object. After all, the dilution will happen only if the share price goes up and the options are exercised, meaning that the shareholders will have made money along with the optionaires. So it’s a win-win proposition, right? You can buy stock at a discount. And the company reaps the benefits of increased worker motivation, plus plenty of financial incentives. Almost, but not quite. There are some costs borne by the company. When you exercise your options, the company must either issue new shares of stock or buy stock back from the other owners. Even if they don’t object, existing owners are unlikely to be thrilled if their shares are diluted. They will, after all, get a smaller piece of the pie. Also, the company will be selling the shares to you at a lower price than it could get by selling them to willing investors at the market price. If the company buys the shares, it will be buying them at a higher price than you will be paying. Still, by giving you options, your company will be able to attract and retain more top-flight people like yourself—people

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who will, like you, perform better after they have become optionaires.

K EY POINTS stock option is the right, but not the obligation, to buy • Aa fixed number of shares of stock at a specified price (the grant price). grant price is probably the market price at the begin• The ning of the day on which the option is granted, or the average of the market price over a number of days close to the grant date. price at which you exercise your options will be the • The market price of the stock on the day that you exercise them. Your gain is the market price minus your grant price, less taxes and fees. These are important, especially taxes. stock option (NSO) is the most common type. • AIt nonqualified is probably the type you have, or are likely to get. It does not get preferred tax treatment. An incentive stock option (ISO) is the type given to many • top executives. Under certain conditions, it gets preferential tax treatment. In most cases, your options must be vested before you • exercise them. Vesting restrictions are typically spread over a number of years before full vesting is complete, requiring that you work for the company for a number of years before your can exercise the options. The company wants to reward loyal employees! out for insider trading. It can trip you up if you • Watch don’t know the rules. your company issues more shares to provide stock for • Ifyour options, existing shares will be diluted. This means

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31

that existing shareholders will own a smaller percent of the company, something they are not usually happy about. there are costs to you (like taxes) and costs to your • While company (like dilution) when the company makes you an optionaire, the upside potential is still great enough to make it a win-win deal most of the time.

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Lesson 2: Different Types of Options, How They Work, and How They Are Taxed

H

ere’s where the going gets a bit rough. While there’s no real way to sugarcoat the complexity of what follows, we try to make it as easy as possible to understand, and we include real-life examples wherever we can. We are now going to get into the important details of the types of options and the taxes you will pay on each.

E XAMPLE FROM REAL LIFE: T IM B YLAND Let’s introduce the topic by looking at the real-life example of Tim Byland, a senior sales executive for Fairfax, Virginia–based Intervu, and one motivated employee. Intervu is firmly planted in the new economy: It provides Web site owners and content publishers with streaming, or real-time, content.

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To get Byland to move from Bell Atlantic, where he was the number-one salesperson in the company, Intervu offered to compensate him partly with stock options. That’s good—after all, stock options are a way of sharing the gains of the business with those responsible for the gains. In the case of Intervu, the stock had soared from $27.75 a share in September 1999 to more than $127 a share in March 2000. Byland’s options were very much in the money, meaning that the grant price was way below the market price. But when Byland looked into what he had to do to redeem the value of his options, he got a rude awakening. He discovered that when he exercised his options to convert them to shares of stock, he would be hit with an instant personal income tax liability at his already high rate. The tax was levied on the difference between the grant price of his options and the market price of the stock when he exercised them. In order to make sure that Byland paid the tax, Intervu was required to recognize his profit on the options as income on his W-2 form and withhold taxes. Had Byland been a consultant to the company, Intervu would have had to include his options profit on the Form 1099-MISC for the year. “The tax code hits me and employees like me hard,” Byland told a House subcommittee in March 2000. His problem? The type of options he received, so-called nonqualified options, are essentially taxed twice: once when you exercise them, and once when you sell the stock, when you have to pay capital gains tax on the additional profit you make between the time you exercise the options and the time you sell the stock.

W HAT ARE NONQUALIFIED STOCK OPTIONS (NSO S ) ? Nonqualified options (NSOs) are the type that Byland received, and they are also the most common type given to rank-and-file employees. This is in part because the grant is deductible to the

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company when it is exercised by the employee. About 87 percent of companies granting stock options give NSOs, according to Arthur Andersen, LLP, the well-known accounting firm. At the present time, there are no rules or regulations that govern how companies grant NSOs. The duration of the option, the exercise period, who can get them, and how the grant price is set are all pretty much up to the senior executives. Most commonly, NSOs are granted at fair market value on the day they are given. The one thing that is set in stone is the tax treatment. As Byland discovered, he owed personal income tax on the difference between the price at which he was granted the options and the actual price of the stock on the day he exercised the options. If he had held onto the stock any longer, he would also have owed capital gains taxes on any additional gain, that is, the difference between the stock’s price on the day of exercise and the price at which he eventually sold the stock. For example, let’s suppose Byland got 10,000 options at a grant price of $1 a share. When he exercises his options, the stock’s market price is $10 a share. So he pays $1 for each share, or $10,000, for stock that is worth $100,000 (10,000 × $10). Byland makes a profit of $90,000 ($100,000 − $10,000), on which he now owes personal income tax, in addition to Social Security and Medicare taxes. All these are subject to withholding, just like Byland’s regular income. Another problem is that the default withholding amount may not be sufficient to cover his tax liability. There is an additional complicating factor. If Byland chooses to hold the stock, rather than selling it after he exercises his options, he is still subject to withholding of all these taxes. So Byland has to pay not only the $10,000 for the stock, but also the required withholding taxes. Byland had a problem with this: “Imagine the receptionist or the mailroom staffer in a high-tech company who earns far more in options than in salary. Say that person wants to buy a house, send a child to college, or retire. The way his nonquali-

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fied options work are that they are exercised, converted to stock, and then promptly sold—because the staffer needs money to pay his tax liability, he can’t afford to hold the stock in order to qualify for long-term capital gains treatment. The tax code thinks the mail room staffer is rich, and taxes accordingly.”

W HAT ARE INCENTIVE STOCK OPTIONS (ISO S ) ? Meanwhile, in the boardroom, let’s suppose that a senior executive of Intervu has been awarded incentive stock options (ISOs). While these are not deductible to the employer, they get more favorable tax treatment. In fact, the senior executive owes no tax when he or she exercises the options. Instead, the executive is taxed only when the stock is sold, and if it is held until either two years from the grant date of the option or one year plus one day from its exercise (it must be the later of these two dates), it is taxed at the long-term capital gains rate of 20 percent. “Is this fair?” Byland asked the subcommittee. Fair or not, a substantial number of companies continue to grant ISOs. But besides the favorable tax treatment, ISOs also carry some restrictions: price at which the options are granted must be at • The least 100 percent of the fair market value on the day they are given. grant price increases to 110 percent if the executive • The owns 10 percent or more of the company’s stock. • The exercise period may not exceed 10 years. fair market value of stock bought by exercising ISOs • The cannot exceed $100,000 in a calendar year. qualify for an ISO, the executive must hold onto the • To stock for at least one year and one day after the exercise date or two years after the grant date, whichever is later.

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INDEXED OPTIONS As options packages proliferate, often with little or no connection to the performance of a company, there is a new type of option that has been slowly—very slowly— gaining ground. That is the indexed stock option, which has no value unless the company’s stock outperforms a designated peer group or market index. Unlike NSOs or ISOs, whose value depends on a rising stock price, the value of indexed options is pegged to a preset index. In a rising market, the standard is a high one. But in a declining market, an optionaire can still cash in, as long as the company’s decline is less steep than that of its peers. The difference in payouts can be dramatic. Take the case of a 1,000-share options grant at $10 per share that is tied to the performance of the Dow Jones Industrial Average (DJIA). If the company’s stock rose by 10 percent to $11, while the Dow Jones rose by 30 percent, the options would have no immediate value, since the company underperformed the index. With a standard option, the grant would have been worth $1,000. However, if the DJIA fell 30 percent while the stock dropped, say, 10 percent to $9, the indexed grant would be worth $2,000, which is the difference between the DJIA and the company’s performance. The standard option, at $10, would be underwater and therefore worthless. So far, this type of option has few supporters in the executive suite—it seems that the time for pay for outperformance has not yet arrived.

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T HE ALTERNATIVE MINIMUM TAX (AMT) If all of the ISO rules are not met, an ISO automatically becomes an NSO. This is called a disqualifying disposition. There’s another wrinkle, too: Even if our executive meets all of the appropriate requirements with the ISOs, he or she may still owe additional taxes relating to the alternative minimum tax (AMT). The AMT is a tax that the IRS uses to get you to pay some of the taxes it would have received if you did not get tax-favored options. Here’s how it works: When you exercise your ISO options, you need to include the gain on exercise in your income as a preference item for ATM calculation. This can trigger the ATM. Other factors that can trigger this tax include the size of your state income tax deductions, mortgage interest, and property tax.

AMT RATES There are currently two different AMT rates. On the first $175,000 of income, the rate is 26 percent. Above that, the rate is 28 percent. Like long-term capital gains rates, these rates may change annually, and other state and local taxes may apply. On capital gains, the maximum AMT rate can be 39.6, 20, or 18 percent. To see which rate applies, see Figure 4.1. If you are in the upper income brackets, or have ISOs that are extremely valuable, you may want to consult a tax specialist. Still, even with the AMT hanging over their head, plus all the additional qualifiers, plenty of executives are more than happy to get ISOs instead of NSOs. Let’s look at another example and see why.

NSO S VERSUS ISO S Let’s suppose that Tim Byland’s personal income tax rate is 28 percent, he has ISOs with a grant price of $10,000, and the stock

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Figure 4.1 Incentive stock options and the AMT. (Courtesy of Bugen Stuart Korn & Cordaro, Inc.)

is selling for $100,000. If he exercises the options and sells the stock immediately, he will be subject to the same tax consequences as with an NSO—that is, he will have to pay $25,200 in taxes (his $90,000 gain times the 28 percent personal income tax rate, assuming the sale does not move him into a higher tax bracket). But if he holds onto the stock for a year or more, meets the ISO requirements, and then sells, he will only have to pay $18,000 in tax (his $90,000 profit times the 20 percent capital gains tax rate), assuming he is not subject to the ATM. That’s a difference of $7,200 in taxes. Now, let’s suppose that Byland holds NSOs with a grant price of $10,000. He exercises them for $100,000, and owes 28 percent of his $90,000 profit, or $25,200, to the IRS. This is true even if he chooses to hold onto the stock, which he does. The stock goes up, and after two years, Byland sells it for an additional profit of $10,000. He then owes $2,000 more in taxes ($10,000 times the 20 percent capital gains tax rate). Byland has still made $72,800 (his total profit of $100,000

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minus his total taxes of $27,200). That’s a tidy sum. But if he had ISOs, and had realized a total profit of $100,000, he would have made $80,000 after taxes, since he would have paid just $20,000 in capital gains tax ($100,000 times 20 percent). The calculation is complicated by the performance of the stock, of course. If it goes down, ISOs become less valuable. Still, from Byland’s viewpoint, it’s not fair that the executive with ISOs can qualify for a lower tax rate than the mailroom staffer.

T HE SUPER STOCK OPTION The subject of NSOs versus ISOs has drawn the interest of lawmakers. One representative, John A. Boehner (R-Ohio), has introduced a bill, H.R. 3462, that would create a new kind of option combining the tax features of NSOs and ISOs. It’s part of the so-called Wealth through the Workplace Act of 1999. This option, which Boehner calls the super stock option, would offer an immediate deduction to the employer, as NSOs now do. There would be no taxation until the employee sells the shares purchased by exercising the option, as with an ISO, and the sale would qualify for capital gains treatment. Will the bill get anywhere? Right now, its future is uncertain. But it would make Byland and a lot of other optionaires much happier. “These new options will dramatically increase the value of options to employees,” Byland says. The new type of stock option created by H.R. 3462 would combine elements of NSOs and ISOs in order to lighten the tax burden on nonexecutive optionaires. Specifically, it would provide the following benefits: to the employer, as with today’s nonquali• Deductibility fied stock options. taxation until the employee actually sells the shares. • No Today, as we have seen, employees are often forced to sell

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their stock immediately after they exercise their options, in order to pay taxes. When they do this, the effectiveness of the option as a team-building incentive expires. protections to make sure that the stock for • Employee which options are granted can be easily traded, and that employees have the information they need to buy or not, and that existing cash compensation is not affected by the issuance of options. Of course, very few of the bills introduced in Congress actually pass and are signed into law. Meanwhile, what’s an optionaire or would-be optionaire to do about the heavy tax burden?

S PECIAL TAX STRATEGIES With or without legislative relief, there are some strategies you can use now to minimize the tax bite on your options. Used properly, such strategies could cut your taxes by up to 50 percent. But they also carry risk, and are best used by those with both extensive knowledge of their company and a healthy dose of confidence that the stock price will go up.

If You Have Nonqualified Options Here’s another real-life example, for optionaires with NSOs. Margaret Whitman is the president of eBay, Inc., an Internet auction site. After exercising her NSOs, she held stock in eBay that was worth $900 million as of June 1999. If she were to cash in her shares immediately, she would owe the IRS the tidy sum of about $342 million, since these options are taxed at regular personal income tax rates. But in reality, she wound up owing about $220 million, a savings of roughly $122 million. How? eBay arranged for certain key executives, including Whitman, to receive options that can be exercised immediately. But the resulting stock can’t be

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sold for several years, or is subject to repurchase if the executive leaves. In Whitman’s case, eBay retained the right to repurchase a gradually declining portion of her shares over four years. The key to the tax savings is the fact that she was able to immediately exercise her nonqualified options, with the grant price being the same as the exercise price. To maximize tax savings this way, the optionaire with NSOs must exercise the options before the stock increases in value, and immediately recognize any income for tax purposes. If the grant price and the market price are the same, there’s no income. When the stock does go up, realized gains are taxed at the lower capital gains rate. The optionaire’s cash outlay is relatively low, because the exercise price is no more than a few cents or a few dollars per share. Whether to use a strategy like this is not an easy decision, however. That’s because Whitman’s profit, as well as her actual tax savings, depend on the price of eBay’s stock when she sells her shares. At the time she made her decision, she had to feel confident that the shares of eBay were not going to decline, causing her to lose money. A similar strategy can also be applied to ISOs. In this case, an executive who exercises his or her ISOs early may avoid triggering the alternative minimum tax, provided that the exercise and the share price are the same. Although AMT payments are often credited against taxes in later years, the tax can produce an immediate hit in the year the options are exercised.

Charitable Lead Trusts There’s another way to cut taxes on NSOs, one that is almost always used by executives with personal financial advisors. It’s the time tested charitable lead trust. By creating such a trust, you can reduce your taxes by as much as 30 percent and invest in things other than company stock. Such a trust can also fulfill any charitable instincts you may have and allow you to pass the money on, free of estate and

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probate taxes (although it may be subject to gift taxes if it is passed on to someone other than yourself). Here’s how it works: 1. You exercise your stock options, and sell the stock at the same time. 2. You transfer all or some of the cash from the sale of the stock to a charitable lead trust. The trust reinvests the cash into stock or other securities that can be managed tax efficiently, such as municipal bonds or bond funds. 3. You then receive an up-front tax deduction for the present value of the income stream that is given to the charity. This is calculated by multiplying the dollar amount for the first year by the number of years and applying the present value rate that is specified in the IRS code. 4. You then use the up-front charitable deduction to offset taxable income from exercising your options, which is limited to 30 percent of your adjusted gross income. Any unused portion of the charitable deduction can be carried forward for up to five years. Gift taxes are owed up front when you set up the trust. 5. The trust then distributes a predetermined amount to the charity for a designated term—an annuity trust. The income earned each year is normally taxable to you, the grantor, regardless of whether it is distributed to charity. This means that it is a good idea to consider using taxadvantaged investments inside the trust. At the end of the trust’s life, the remaining assets revert to you or your designated beneficiaries, such as your children or grandchildren, free from probate and estate taxes. Clearly, setting up a trust like this involves careful planning and many details. If you are considering one, you will need a tax expert or an attorney, or both.

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If You Have Incentive Options There’s an interesting tax strategy for holders of incentive options, one that is used by some of the richest and most powerful individuals in corporate America. It’s called zero-basis stock, and it’s the way that many top executives are minimizing their taxes and maximizing their options gains these days. We learned about this courtesy of Joseph H. Clasgens III, executive vice president and director of Brownson, Rehmus & Foxworth, Inc., a financial advisory firm based in Menlo Park, California. Clasgens works only with top executives of large companies, all of whom have stock options, and many of whom have ISOs. Here is his example of how he uses zero-basis stock to help his affluent clientele. Say a client has an incentive option for which the grant price is $10. The client decides to exercise the option when the market price of the stock is $40. So the client takes the $10, buys a share, and holds onto the stock. (Remember, incentive options are not taxed at this stage.) After a year, the stock is still selling at $40 a share. The client then takes the share, sells it back to the company for $40, and tenders it for more options, each at $10 a share. The client has given the company one share worth $40 and has gotten three back, each at $10. The first share has a tax basis of $10, and the others have a tax basis of zero. Our executive now has three shares, which are 100 percent capital gain. So if the executive sold them, he or she would owe 20 percent capital gains taxes. Instead, however, the executive gives the stock to charity and gets a deduction based on the market value of the stock. The charity can then sell it and pay no tax, because it is tax exempt. This neat transaction ends up being tax efficient for both parties. Obviously, the wealth that options represent can be severely decreased by taxes. So your strategy for exercising your own options should be formulated with tax management in mind. Should your own options be considerable—say, worth more

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than $250,000—it may well be worth your while to hire a financial planner or tax attorney who specializes in options.

What if You Work Overseas? As onerous as the tax burden is on optionaires who work for U.S. companies, it can seem light compared to the burden of working overseas. This is because many countries have been slow to accept the concept of options as the new corporate currency. In much of Europe, for example, options are still viewed as something shady, even immoral. Consequently, many governments have placed heavy tax burdens on optionaires. For example, Kevin J. Delaney and David Wessel of the Wall Street Journal reported on December 21, 1999, that some companies in France were being forced to move in order to attract top talent in high technology.1 For example, Business Objects SA, a French maker of software, moved much of its top brass to the United States and optionsfriendly Britain. The reason? France routinely collects three times as much as an employee nets from options. Under a 1995 law, the French government collects $92.50 in taxes from a profitable employer and employee for every $100 a French citizen makes on options held less than five years. The employee nets only $31.50. Table 4.1 shows the grim reality. In Germany, Daimler-Benz AG, as it was known in 1997, had to fight off a shareholder lawsuit before it could even proceed with option grants. While changes to the law subsequently made options more attractive, it’s still much more difficult to make money from options in Germany: The company’s stock price must do more than just increase; it has to rise by a preset percentage, or by more than a predesignated index. Other European countries, including Switzerland and Belgium, are taking a different approach. They impose an up-front tax that is collected at the time options are awarded, rather than a tax on profits, as in the United States. The result is that some employees—notably the Swiss-based employees of Hewlett-

lesson 2: different types of options

Ta b l e

4.1

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A Taxing Story

A French employee gets options to buy 100 shares at a grant price of $10. Within five years, he or she exercises the options and sells the shares for $20 each. Employee’s pretax profit

$1,000

Company pays net tax

−240

Employee pays tax

−685

Government’s take

925

Employee’s net profit

$ 315

Source: Ernst & Young.

Packard—have actually refused stock options, rather than pay the up-front tax penalty. While some countries are moving rapidly to lift burdens like this, it is likely to be a long time before the tax treatment of options granted abroad is roughly comparable to that of options granted here at home. The indicated action for optionaires who work overseas is clear: The first order of business when you are offered options as part of your compensation package is to consult a specialist in the tax rules that operate in the country where you are working. Armed with that knowledge, you can decide whether they are worth it. (For a more detailed discussion of negotiating a foreign options package, see Chapter 10.)

K EY POINTS stock options (NSOs), the type most often • Nonqualified granted to nonmanagement employees, are taxed just like personal income when they are exercised. When the

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stock is sold, any additional gain is also subject to capital gains tax. stock options (ISOs), granted mostly to top • Incentive executives or pre-IPO employees, are not taxed when they are exercised. When the stock is sold, the gain is subject to capital gains tax. However, ISOs are subject to restrictions. out for the alternative minimum tax (AMT), which is • Watch a tax used by the IRS to capture taxes you would have paid without tax-advantaged ISOs. If you are in the upper brackets, or have ISOs that are extremely valuable, consult a tax specialist. is considering changes that would give NSOs • Congress the same tax treatment as ISOs, but it is uncertain when or if these changes will pass. there are some strategies you can use to min• Meanwhile, imize taxes. These include implementing immediate exercise of your NSOs, establishing a charitable lead trust, and using a zero-basis stock strategy. All are complicated and require the help of a professional.

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Lesson 3: Vesting, Expiration, and Valuation

T

he first part of this lesson deals with vesting, a topic you know at least something about if you’ve been granted stock options. Vesting refers to the time period that must expire before you can exercise your options. Unvested options hold only the potential for future rewards. The vesting rules for your stock options may appear in your option agreement, or in your stock option plan. Figure 5.1 may help you find out which vesting schedule you have. Vesting schedules vary greatly, depending on a company’s goals for its stock option plan. If options are intended as a reward for past performance, immediate vesting might make sense. If the options are intended to stimulate performance, a longer vesting schedule would be more appropriate. If the options are intended as a reward for company loyalty, a graduated vesting schedule would be logical.

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Figure 5.1 Which vesting schedule do you have? (Courtesy of Westward Pay Strategies.)

Let’s look at a real-life example, and revisit the case of Mellon Bank Corporation. In 1999, the big Pittsburgh-based bank decided to award options to all of its full- and part-time employees. A key reason, according to the bank’s chairman and chief executive officer, Martin G. McGuinn, was to build “a motivated and determined workforce.” In McGuinn’s view, the key to building such a workforce was to persuade employees to remain with the bank rather than jump ship—which might have been tempting, given the tight market for qualified employees in the banking industry at the

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time. So McGuinn divided Mellon’s options awards into three separate grants, starting right away and continuing into 2000 and 2001. This type of vesting, called straight vesting, is structured to reward employees who remain with the company. Most companies use some form of gradual vesting akin to Mellon’s, with a vesting schedule that rarely exceeds five years. If you work for a technology company, the odds are that your options will be fully vested in four years. This was the finding of a recent study by Westward Pay Strategies, a compensation consulting firm based in San Francisco. In a survey of stock option practices in 50 technology IPOs, Westward found that the median rate of vesting for these firms was 4 years, with rates ranging from 2.5 years to 5.0 years.1 Figure 5.2 shows the vesting schedules of the companies in the survey. The length of your vesting schedule is not the only thing your company has to consider. Figuring out when within those years an option should vest is also important. Many companies will provide straightforward annual vesting of the shares on the anniversary of the grant date. This is the easiest schedule to keep track of, and it cuts back on the amount of time needed to track each employee’s vesting requirements. But other companies may wish to draw frequent attention to the plan, as an added performance incentive. These companies create vesting schedules in which options vest every quarter, every month, or even every day. This is a very effective way to make employees think like owners on a regular basis.

T YPES OF VESTING Vesting is usually done in one of four basic ways. Briefly explained, they are as follows: 1. Straight vesting. In this case, the same percentage of options becomes exercisable each year, as in the case of Mellon bank. If you had, for example, four-year vesting

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5.0 Median Vesting (4 Years)

4.5

4.0

Years to Full Vesting

3.5

3.0

2.5

2.0

1.5

1.0

IINT

TCGI

SYKE

TEAL

WHIT

TTEC

SGIC

SMCI

SAPE

SAWS

PUMA

JPMX

PGEX

INLK

JDAS

FRTE

VST

CYMI

VSNT

VSGN

SIPX

VRLX

SEAC

PTI

IMRS

AFCI

0.0

CLMT

0.5

Figure 5.2 Stock option vesting. The median vesting rate of stock options at the surveyed companies is four years, which mirrors the practice of going-concern publicly traded technology firms. The rates range from 2.5 years to 5.0 years for those companies reporting their vesting. (Courtesy of Westward Pay Strategies.)

and options to buy 2,000 shares of stock, 500 options, or 25 percent, would vest each year. Another example from real life is the case of Pioneer Natural Resources, an oil and gas exploration company. All 1,000 employees of Pioneer receive options grants, which become vested using three-year straight vesting. This means that one-third of the options vest each year for a period of three years. 2. Cliff vesting. This is the case in which all of your options become exercisable at one time, and on one date.

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For example, if you received options to buy 2,000 shares in 2001, all 2,000 shares would become exercisable in 2005, or in four years. In real life, this is the schedule used by AT&T, the well-known telecommunications giant. If you have AT&T options, they vest using a three-year cliff schedule, meaning that they all vest three years from the grant date. 3. Performance vesting. In this situation, your options would vest in the year that your company achieves a particular goal, such as a revenue or share price target. For example, your 2,000 options would become vested when your company’s revenue reaches $1 billion. In real life, this was the method used by Conoco, a large integrated oil company that is a subsidiary of Du Pont. Back in 1991, all employees of Conoco received 100 options each. All the options vested when the stock price hit $75 a share for five consecutive days. 4. Step vesting. In this vesting scenario, the percent of options exercisable each year varies. An example would be if you received options to buy 2,000 shares in 2001, with 40 percent, or 800, becoming vested in 2002; 25 percent, or 500, in 2003; 20 percent, or 400, in 2004; and 15 percent, or 300, in 2005. San Jose National Bank uses step vesting for its employees, who all receive periodic grants based on their grade level within the bank. The options vest in four years, with 40 percent exercisable in Year 1, and 20 percent in Years 2, 3, and 4.

E XPIRATION Your options also expire after a certain date, which is commonly 10 years after they are granted. Sometimes, the period is shorter.

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If it is 10 years, this means that you have 10 years to exercise your options, starting from the day they are granted to you. This includes the vesting period. So, for example, if your options become fully vested in four years, you will have six years after this date to exercise your options. Again, it’s important for you to carefully read your options agreement or stock option plan to find out when the options expire.

If You Leave the Company What happens to your NSOs if you leave the company or get fired? If your options are not vested, you are not normally entitled to exercise them, and you can probably kiss them good-bye. If your options are vested, you will usually have a specific period of time in which to exercise them. This posttermination exercise period usually ranges in length from one to three months, depending on the terms of your company’s plan. If you are disabled, the posttermination exercise period is longer, typically 6 or 12 months. The bottom line is that if you are leaving the company on amicable terms, you will probably have longer to exercise your options, though probably not longer than one year. In the event of your death, your estate will frequently have a certain period during which it can exercise your vested options. The treatment of ISOs is somewhat different. In order to qualify for capital gains tax treatment, you need to stay with the company during the qualification period, which is the latter of two years after the grant or one year after the exercise. If you leave, the event will become a disqualifying disposition, meaning that the incentive option will become a nonqualified option, and will therefore be taxed as ordinary personal income.

You May Get a Statement While it’s not required, many companies will provide a written statement to you if and when you leave the company. Typically,

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the statement will tell you the number of options that are available to exercise and the amount of time you have to exercise them following your departure. You may also get a statement regarding restrictions on your ability to exercise your options. What kind of restrictions? Some privately held firms impose rules on transferring or disposing of vested options shares following the exercise of a stock option. These rules are intended to discourage employees from leaving and to allow the company to maintain some control over who owns its shares. A common type of restriction is called the right of first refusal. This entitles a company to repurchase shares of stock from the employee after the option is exercised on the same terms offered and at the current fair market value, if the employee wants to sell or transfer the options to a third party. The right of first refusal usually ends if and when the company goes public. As with many things about stock options, there is a qualifier to what we have just said. In some cases, the courts are getting involved, and are granting exceptions to the general rules for what happens to options after termination. For a detailed discussion of recent court rulings and their implications, see Chapter 9.

S ECTION 83 (b) Is there ever a case in which you are able to exercise options that have not vested? Yes, and you may want to be aware of it. It applies mainly to highly compensated employees and involves an arcane section of the Internal Revenue Code, Section 83(b). This section requires that notification be forwarded to the IRS within 30 days of the exercise. Exercising stock options before they vest is called an early exercise option. It is really a kind of tax strategy in which the stock acquired by the exercise of the option is subject to a substantial risk of forfeiture, and is also not transferable on the date the option is exercised.

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The optionaire exercises the unvested option and makes a so-called Section 83(b) election to recognize ordinary income on the date of the exercise, not when it vests. The value of the stock is determined when you receive it, and there is nothing to report when it vests. Here’s an example: Suppose you receive 2,000 options in your company. They aren’t vested, and the value is $1 per share. When your shares vest two years later, they are trading at $100. Without the 83(b) election, you will not report anything when you are granted the options. When they vest and you exercise them, they are worth $200,000, and you report that much as ordinary income. You could pay as much as $80,000 in federal income tax as a result. If you choose an 83(b) election, you would report only $2,000 of compensation income (2,000 × $1) when you exercise the options. You have nothing to report when they vest. You can continue to hold the stock without paying any more tax. Then, if you sell it for $200,000, you will have a long-term capital gain of $198,000, on which the tax rate will be 20 percent. Your total tax could wind up being close to half the amount you would have paid without the election. Of course, there’s a risk to this strategy. If the stock does not go up after you’ve made the election, you have paid the tax sooner, without receiving any benefit. Even worse, if it goes down, you’ve paid more tax than necessary. Try getting a refund of that money! Experts say that the 83(b) election makes sense mainly in the following circumstances: amount of income that you report when you make • The the election is small, and the potential growth in value of the stock is considerable. expect growth in the value of the stock, and the like• You lihood of a forfeiture (as, for example, if you leave before the options are vested) is very great.

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By the same token, you would be wise to forget the 83(b) election if you would pay a great deal of tax at the time of the election, the stock has only modest prospects for growth, and the likelihood of a forfeiture (leaving before shares are vested) is small. The risk in such a strategy, of course, is that after the unvested option is exercised, the price of the stock stays the same or declines. Meanwhile, the optionaire’s money is tied up in the amount of the exercise price, and he or she has also paid withholding taxes on the recognition of ordinary compensation income.

V ALUING STOCK OPTIONS How do you put a value on a stock option before it is exercised? This is a crucial question, especially for companies. After all, how can they communicate what the grant means to employees if they are unable to put a value on it? Furthermore, according to rules established by the Financial Accounting Standards Board (FASB), companies must establish the current “fair value” of their options when they are granted. There are so many variables that enter into stock option valuation that it cannot be made simple. But valuation can make a big difference. Consider this example, from a paper by Mark H. Edwards, founder and CEO of compensation consultant iQuantic, Inc.2: There are two companies, A and B. Company A’s stock price is $50. Company B’s is $10. Company A grants 100 shares of options at $50 a share. Company B grants 250 shares at $10 a share. Assuming equal growth rates of 15 percent annually, after five years Company A’s stock is worth $100, and Company B’s stock is worth $20. If you do the math, you see that while Company A granted less than half the number of shares granted by Company B, its employees realized a gain of $5,000, while Company B’s employees realized a gain of $2,500.

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The difference is relevant at a time when low-value options are being handed out so freely and described in terms of allocating percentages of a company. The company needs to convey the fact that 10 percent of a start-up is probably worth a fraction of a percent of an established company, even if the start-up is growing rapidly. So, how do you accurately value an option? The FASB requires companies to use an option-pricing model that takes into account six different variables. The most common model used by public companies is something called the Black-Scholes method, after Fischer Black and Myron Scholes, scholars who developed the method in the early 1970s to price put and call options traded on the newly formed Chicago Board Options Exchange. While you will most likely never need to use it, it may be useful to know what went into valuing the options you now have, or may someday have. Here is the Black-Scholes option formula: c = Se−q(T − t) N(d1) − Xe−r(T − t) N(d2) where

c = value of the call option S = current stock price X = grant price of the option q = expected dividend yield T − t = time to expiration r = expected risk-free rate N(dx) = probability that a random draw from a standard normal distribution is less than dx

The complicated formula incorporates both the intrinsic value and the time value of the option, to determine the market value. Six factors enter into the determination:

• Expiration date of the option. • Grant or strike price of the option.

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• Current value of the underlying security. • Expected future volatility of the underlying security. future dividend yield of the underlying secu• Expected rity, if any. risk-free rate, represented by the corresponding • The length-to-expiration treasury bond. Each of these factors has an impact on the value of your stock option, making valuation one of the most complex calculations a company must make. One way to make it easier to understand is to focus on the final payoff. The final payoff is always the fair market value of the stock minus the grant (or exercise, or strike) price, taxes, and fees. For different values of the stock, your option would have different payoffs. Table 5.1 shows payoffs based on different stock values. If you knew for certain that the market value in, say, five years would be $130, you would discount the $30 final payoff to

5.1 Option Payoff Values at Different Stock Values Ta b l e

STRIKE PRICE

MARKET VALUE AT EXPIRATION

FINAL PAYOFF VALUE OF OPTION

$100

$ 80

$ 0

100

90

0

100

100

0

100

110

10

100

120

20

100

130

30

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determine the net present value of the final payoff in today’s dollars. Using a discount rate of 7 percent, the value of the option on a current basis would be $21.39. So, for any option for which you knew the final payoff—which, alas, you don’t—you could determine the value using a relatively simple net present value approach. While it’s not perfect, experts agree that incorporating such variables as the expected future volatility of the stock makes the Black-Scholes formula the best model currently in existence for option valuation. For most companies, almost certainly including yours, it continues to be the tool of choice.

K EY POINTS

• There are four basic types of vesting schedules:

1. Straight vesting. The same percentage of options becomes exercisable each year. 2. Cliff vesting. All options become exercisable at one time, and on one date. 3. Performance vesting. The options become vested in the year that a company achieves a particular goal, such as a revenue or share price target. 4. Step vesting. The percentage of options exercisable each year varies.

you work for a technology company, the odds are that • Ifyour options will be vested in four years. most popular term for options is 10 years. After that, • The they expire and are worthless to you. stock options before they are exercised is highly • Valuing complex and involves a number of variables. The most widely accepted valuation method is the Black-Scholes option-pricing formula.

C h a p t e r

s i x

Lesson 4: Exercising Your Options

Just to update you, I exercised and sold 1,000 shares from the February 1999 grant. As you rightly predicted, greed took over when the price fell from $140 to $120—I thought I’d wait for the price to go back up, ha! ha! Then fear took over when the price dropped to $45 and started to creep back up. In the end I sold at $65, giving me a profit of just under $63,000 after fees etcetera. Since the main objective was to generate enough cash to cover my new car, I’m not really unhappy. This actual e-mail, from a client of a Silicon Valley financial planner, deals with the most critical issue you will face as an optionaire—deciding when to exercise your options and sell the stock. This decision can be difficult. Just how difficult is made clear by Corey Rosen, founder of the National Center for Employee Ownership (NCEO), a nonprofit group in Oakland, California, that specializes in research on broad-based stock options. Rosen 59

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started the NCEO in his basement in 1980 as an information source on employee stock ownership plans (ESOPs). Since then it has grown into the only research institute devoted to stock options, and Rosen has become a widely quoted options expert. Despite the complexity of tax issues as they relate to stock options, Rosen thinks they are straightforward compared to the exercise issue. “The key to options is exercising them at the right time,” he says. Rosen says there are three factors you need to consider in making this decision. This assumes that your options are fully vested, of course, since you can’t exercise them until they are. 1. What do you think is going to happen to the stock? 2. How much time is left before your options expire? 3. Do you need to exercise the option for a specific purpose, such as paying for a house or a car? If the answer to the last question is yes, it’s probably better to raise the money by exercising your options than by borrowing it. If the answer is no, then, as a general rule, the longer you are able to wait, the better. This is because a stock option is the right to buy stock up to 10 years in the future, and, historically, stocks increase in value over time. Over the past 100 years, stock price gains have averaged about 10 to 12 percent per year. So, by waiting, you have the best chance to enjoy all the upside potential without any cash investment. The problem with this, particularly in today’s frenzied media environment, is the constant bombardment of information on the direction of the stock market and advice on what to do as a result. Self-styled financial experts are on television all the time, spouting recommendations and warnings. Should you let this affect you? Absolutely not, says Rosen: “Pay no attention to what the stock market analysts are saying. They are not talking to you. Don’t watch business shows on television, except as entertainment. The turmoil in the market is sound and fury, signifying nothing.” Instead, he advises, think about your company. How well are

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things going? Is there any possibility of a merger or acquisition? How old is the CEO? Use your insider’s knowledge to weigh the prospects, and make an educated guess about the direction of the stock price. Then, give up the idea that success is achieved only by picking the peak price. Success is being in the money when you exercise the option. If you can do something useful with the money, you’ve won. Going back to the e-mail, the gentleman who exercised and sold at $65 may have missed the peak, but he still wound up with enough to buy a car, and a luxury vehicle at that.

F OCUS ON PERFORMANCE The lesson, of course, is that while few of us can achieve perfection, a lot of us can still make a substantial amount of money from our options. The key is to try to leave your emotions out of the equation and to focus instead on the performance of the stock. And remember—if the price falls, you always have the opportunity of not exercising. But after you exercise, you own the stock and therefore incur greater risk, since you may lose money if the price goes down. You haven’t lost a penny by waiting to exercise. Despite this rule, you may hear the argument that if you have nonqualified options, which you probably do, you can minimize the taxes you pay by exercising your options when the difference between the grant price and the exercise price is not that great. This is because you will pay higher personal income taxes on the difference between that grant price and the market price, and lower capital gains taxes on the difference between the market price at the time of exercise and the time when you sell the stock. While it is tempting to focus on minimizing taxes, because paying them is onerous, it is much more fruitful to pay attention to the price of the stock. And if you think about it, if your inten-

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tion is to hold onto the shares, why not just wait to exercise the option? Let’s suppose for the sake of argument that you have options at $10 per share, and the price goes to $14. You exercise the option and have a gain of $4 per share. Now you have to pay taxes on the $4 difference. If the shares go down to $9, you have lost money and paid tax as well. Had you chosen not to exercise the option, you would have lost nothing and paid nothing. But what if you exercise at $14 and the price goes to $20? Even in this case, you would have been better off by waiting to exercise, because you could still get the $10-per-share gain by exercising your option. In sum, the most important thing is to monitor your firm and its prospects so that you can develop a strategy based on your projections for future performance. And to maximize your gains even more, you can work within the company to increase its value, a win-win situation for you and your employer.

D OLLAR COST AVERAGING Another method for exercising options that is recommended by some financial planners is dollar cost averaging. This refers to an investment strategy in which the client invests a set amount at regular intervals, regardless of the direction of the market. If you are working with a financial planner who is experienced with dollar cost averaging, or if you have long-term goals that you plan to save for gradually, you may want to consider this strategy—assuming, of course, that you are optimistic about the future of your company.

W AYS TO EXERCISE Once you’ve decided to exercise your options, which methods are open to you? There are four basic ways to exercise your

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options: (1) cashless exercise, (2) cash purchase and hold, (3) sell to cover, and (4) a stock swap. Let’s look at them one by one.

Cashless Exercise for Cash The most common way for employees to exercise their options is known as a cashless exercise. With this type of exercise, you do not need to use your own money to buy the stock. Instead, a broker—perhaps one designated by your company—will lend you the money, purchase the shares for you, and immediately sell them, for a fee. Let’s look at an example. Suppose you have 5,000 options with a grant price of $5, and the stock is selling for $100 (lucky you!). To exercise all of them, you would instruct your broker to buy 5,000 shares for the grant price of $5 ($25,000), then sell them at $100 per share, for a total price of $500,000. Assuming that you have nonqualified options, your taxable gain is $475,000 (the selling price of $500,000 minus your purchase price of $25,000). Say that your total taxes add up to 40 percent. This means that you will have to pay $190,000 in taxes. The broker will then sell enough shares to pay the taxes, plus enough shares to cover the brokerage fees, which typically run between 5 and 15 cents per share. The rest, or $285,000 minus the broker’s commission, is cash that goes directly to you. Figure 6.1 is designed to walk you step by step through cashless exercise for cash.

Cash Purchase and Hold As we have seen, there is no requirement that you sell your stock after you have exercised your options. You may choose to exercise your options as soon as possible to actually own your shares and qualify most of their profits as capital gains, in order to pay less tax. If you choose to exercise and hold onto the shares, you return a check to your broker for the amount of the purchase,

FACTOR

ESTIMATED VALUES

FACTOR

Options exercised

Options exercised

Fair market value (current price per share)

Your shares were sold at this fair market value (current price per share)

Total fair market value

Total fair market value

Total exercise (option) cost

Total exercise (option) cost

Taxable income amount

Taxable income amount

Federal income tax

Federal income tax

State income tax

State income tax

Local 1 income tax

Local 1 income tax

Local 2 income tax

Local 2 income tax

Social Security tax (FICA tax)

Social Security tax (FICA tax)

Medicare tax

Medicare tax

Total taxes

Total taxes

Transaction fee

Transaction fee

SEC fee (1¢ per $300 of total fair market value) and brokerage fee

SEC fee (1¢ per $300 of total fair market value) and brokerage fee

ACTUAL VALUES

If your shares were sold at this price, funds for $ would be issued to you.

Figure 6.1 Cashless exercise for cash worksheet. (Courtesy Mellon Financial Corporation.)

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plus applicable commissions on the spread between the grant price and the market price. If you have nonqualified options, you will owe personal income taxes on this spread. You will also have to pay capital gains taxes on the difference between the price on the date of exercise and the price at which you eventually sell the stock. The upside? If you decide to hold onto the stock, you will have chosen a path that has made many optionaires very wealthy. In addition, if you hold onto the stock, you will receive any dividends that your company pays on its common shares. Using the same example as with cashless exercise—5,000 options, a grant price of $5, and a market price of $100—you would instruct your broker to buy 5,000 shares for the grant price of $5 ($25,000), then hold onto the stock. You still need to pay taxes and fees, of course. Figure 6.2 can help you with this exercise method.

Sell to Cover (Cashless Exercise for Stock) This brings us to the third method, which is basically a blend of these two methods. Sell to cover is when you exercise all of your options, then sell enough shares to cover the purchase price and perhaps applicable taxes and fees as well. You then walk away with shares in the company, instead of cash to invest. In this case, if you have 5,000 options and a grant price of $5, and the stock is selling for $100, you instruct your broker to buy 5,000 shares for $25,000. Your gain at this point is $500,000. Your broker then sells enough shares to cover the purchase price of $25,000, leaving you with stock worth $475,000. Assuming that you have a 40 percent tax rate, the broker then sells enough to cover taxes, which total $190,000. This leaves you with stock worth $285,000. Your broker then sells enough to cover the commission, and the rest remains invested in your company’s stock. Figure 6.3 can help you with this type of exercise. As with a cashless sale, you do not have to advance any money up front. The difference is that you walk away with

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FACTOR

ACTUAL VALUES

Options exercised Fair market value (current price per share) Total fair market value Total exercise (option) cost Taxable income amount Federal income tax State income tax Local 1 income tax Local 2 income tax Social Security tax (FICA tax) Medicare tax Total taxes Transaction fee Total amount due for this transaction (total exercise (option) cost + total taxes + transaction fee)

Figure 6.2 Cash purchase worksheet. (Courtesy Mellon Financial Corporation.)

shares in the company instead of cash to invest. Figures 6.4 and 6.5 summarize the first three methods of exercising options.

Stock Swap The fourth method is known as a stock swap. This method is used mainly by top executives rather than nonmanagement employees. It involves exchanging previously owned shares for option shares, and is thus available to you only if you already own a

FACTOR

ESTIMATED VALUES

FACTOR

Options exercised

Options exercised

Fair market value (current price per share)

Your shares were sold at this fair market value (current price per share)

Total fair market value

Total fair market value

Total exercise (option) cost

Total exercise (option) cost

Taxable income amount

Taxable income amount

Federal income tax

Federal income tax

State income tax

State income tax

Local 1 income tax

Local 1 income tax

Local 2 income tax

Local 2 income tax

Social Security tax (FICA tax)

Social Security tax (FICA tax)

Medicare tax

Medicare tax

Total taxes

Total taxes

Transaction fee

Transaction fee

SEC fee (1¢ per $300 of total fair market value) and brokerage fee

SEC fee (1¢ per $300 of total fair market value) and brokerage fee

ACTUAL VALUES

If your shares were sold at this price, shares would be sold and shares would be issued to you.

Figure 6.3 Cashless exercise for stock worksheet. (Courtesy Mellon Financial Corporation.)

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exercise—a broker exercises the • Cashless options and sells the stock immediately. purchase and hold—you exercise the • Cash options and hold the stock. to cover—you exercise and sell enough • Sell shares to cover the purchase price. Figure 6.4 Options can be exercised in different ways. block of stock. It can provide certain advantages if you do own stock from some previous arrangement. For example, in the case we have been using, you have options to buy 5,000 shares at a grant price of $5, and the current price of the stock is $100. Say that you also own 250 shares from a previous compensation deal. To exercise your options for 5,000 shares at $5, you would need to come up with $25,000. While you could use cash, you could also trade in your previously owned shares to cover the exercise price of the options. This is a stock swap.

• Need cash? Exercise and sell. the stock has peaked? Exercise and • Think sell. • Think the stock will go higher? Exercise and Figure 6.5 Which method should you choose?

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In essence, you are using the stock that you own as currency. After this, you would end up with 4,750 shares total. Assuming that you have nonqualified options, you will also owe tax on the difference between the grant price of $25,000 and the market price of $500,000. You can either pay this in cash or sell enough of the optioned shares to pay for the taxes, plus fees. You will most likely not use a stock swap to exercise. In the vast majority of cases, employees use cash purchase or a cashless exercise.

E XERCISING OUTSIDE THE U NITED S TATES What if you work outside the United States for a company that is based in the United States? Due to local laws, you may receive stock appreciation rights (SARs) instead of stock options. When you exercise SARs, you receive a payment equal to the difference between your grant or exercise price and the market price on the day you choose to exercise your SARs. Shares are not actually purchased when you exercise your SARs, so you do not become a shareholder in your company as a result. Generally, your cash gain from exercising SARs will be taxed in the same way as your regular wages, and it will be added to your income on your tax reporting form.

E XAMPLE FROM REAL LIFE: M ELLON B ANK C ORPORATION Beginning in 1999, Pittsburgh-based Mellon Bank Corporation gave all of its full- and part-time employees stock option awards, with the first round of grants at the grant price of $33.625 per share. Figures 6.6, 6.7, and 6.8 show three examples of how the major exercise strategies might work at a $50 market price.

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Option Exercise for Cash Let’s assume: • You want to exercise options on 200 shares of stock • The exercise price is $50 per share, and you pay by selling all of your option shares • The fair market value of stock at the time of your exercise is $60 per share

Fair market value of shares (200 options x $60)

$

12,000.00

Exercise (option) cost (200 options x $50)

$

10,000.00

Taxable income amount

$

2,000.00

Taxes due on taxable income amount*

$

833.00

Transaction fee

$

45.00

Brokerage fee

$

18.00

SEC fees

$

0.25

$

1,103.75

Fees:

Net cash proceeds (fair market value – option cost – taxes – fees)

* This tax figure is only applicable in the U.S. and assumes the following income tax rates: federal – 28%; state – 5%; local –1%; FICA – 6.2%; Medicare – 1.45%. Your actual tax rates will vary.

Figure 6.6 Option exercise for cash. You can exercise your options without spending any of your money. Essentially, you are buying shares of the stock at your exercise price and then selling them for cash. With this sale, you receive the fair market value of the shares minus the exercise price and any related taxes or fees.

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Option Exercise/Stock Transaction Let’s assume: • You want to exercise options on 200 shares of stock • The exercise price is $50 per share, and you pay by selling enough of your option shares to cover the exercise cost, taxes and fees • The fair market value of stock at the time of your exercise is $60 per share

Fair market value of shares (200 options x $60)

$

12,000.00

Exercise (option) cost (200 options x $50)

$

10,000.00

Taxable income amount

$

2,000.00

Taxes due on taxable income amount*

$

833.00

Transaction fee

$

45.00

Brokerage fee

$

15.00

SEC fees

$

0.21

$

10,893.21

Fees:

Total required payment (option cost + taxes + fees)

Shares sold to cover payment (10,893.21 ÷ $60 = 181.553 shares, rounded up to the next whole share) Number of shares deposited in your account (200 – 182)

182 shares 18 shares

* This tax figure is only applicable in the U.S. and assumes the following income tax rates: federal – 28%; state – 5%; local –1%; FICA – 6.2%; Medicare – 1.45%. Your actual tax rates will vary.

Figure 6.7 Option exercise/stock transaction. You can acquire stock without spending any of your money. You buy shares of the stock at your exercise price and then sell enough of these shares at the market value to cover all costs—your exercise price and any related taxes or fees. The shares that are not sold belong to you and are deposited into your account.

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Stock Purchase with Cash Let’s assume: • You want to exercise options on 200 shares of stock • The exercise price is $50 per share, and you pay by check • The fair market value of stock at the time of your exercise is $60 per share

Fair market value of shares (200 options x $60)

$

12,000.00

Exercise (option) cost (200 options x $50)

$

10,000.00

Taxable income amount

$

2,000.00

Taxes due on taxable income amount*

$

833.00

Transaction fee

$

45.00

Total amount due for this transaction

$

10,878.00

(option cost + taxes + transaction fee)

Number of shares deposited in your account

200 shares

* This tax figure is only applicable in the U.S. and assumes the following income tax rates: federal – 28%; state – 5%; local –1%; FICA – 6.2%; Medicare – 1.45%. Your actual tax rates will vary.

Figure 6.8 Stock purchase with cash. You can use your own money to buy shares of stock at whatever exercise price you have been granted. These shares will be deposited into your account.

A FORMS CHECKLIST Gruntal & Co., LLC, has helped many optionaires exercise and sell their options. When employees at a client company want to exercise options, Gruntal tells them to do the following:

• Complete and sign an exercise and sale form (Figure 6.9). • Complete and sign a letter of instruction (Figure 6.10). documentation provided by the company as evi• Submit dence of options, such as a copy of the stock option

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Figure 6.9 Exercise and sale form. (Courtesy of Gruntal & Co., LLC.)

agreement, statement, or grant, or the company’s internal exercise letter. and sign a stock power form (Figure 6.11). Your • Complete company will generally issue the shares in your name. and sign a margin agreement and W-9 tax cer• Complete tification.

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Figure 6.10 Letter of instruction. (Courtesy of Gruntal & Co., LLC.)

lesson 4: exercising your options

Figure 6.11 Irrevocable stock or bond power. (Courtesy of Gruntal & Co., LLC.)

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K EY POINTS of the most difficult decisions you will face is when to • One exercise your options. Generally, if you do not need the money for a specific purpose, such as buying a car, it is better to wait as long as you can. This is because stock prices have historically risen over time. on the performance of the stock in making your • Focus decision. • There are four basic ways to exercise your options:

1. Cashless exercise. A broker exercises the options and sells the shares right away. 2. Cash purchase and hold. and hold onto the stock.

You exercise the options

3. Sell to cover. You exercise and sell enough shares to cover the purchase price. 4. Stock swap. You exchange shares you already own for options shares. This is available only if you already own a block of stock. work outside the United States, you may receive • Ifstockyouappreciation rights (SARs) instead of stock options. When you exercise SARs, you receive a payment equal to the difference between the grant price and the market price on the day you choose to exercise. With SARs, you do not actually own the stock.

C h a p t e r

s e v e n

Lesson 5: What Should You Do with the Proceeds?

B

arbara Steinmetz, president of Steinmetz Financial Planning, Burlingame, California, is a successful tax professional and Certified Financial Planner whose specialty is clients with stock options. She is a “fee only” planner, meaning she is compensated on a flat-fee or hourly basis and does not sell any products. Her fee is based on the complexity of the issues covered. Besides helping her clients invest money, Steinmetz often holds their hands through the exercise and sale of their options, as well—shepherding them through the entire process with the objective of maximizing their gain and helping them hold onto it. This chapter gives you, in effect, several free consultations with Steinmetz. Although each client is different, and therefore requires a customized plan, what follows will give you a good general idea of how a financial planner works and what to expect if you decide to work with one. 77

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T HE BASICS Sitting across from Steinmetz in her office overlooking the Silicon Valley sprawl that radiates from San Francisco southward, it’s natural to wonder how she came to be one of the few financial planners specializing in stock options. Steinmetz says she never thought of options as an issue until as recently as the mid1990s, when more and more of her clients began receiving them and didn’t know what to do with them: “I guess the word spread that I gave savvy advice, and before long optionaires became the center of my practice.” Here are questions Steinmetz is commonly asked by clients in initial meetings, along with her answers: Q. Before we get down to the nitty gritty, can you give me some good general advice about investing the proceeds of my stock options? A. Get the emotion out of it, and diversify. If you’re typical of many of my clients, I will begin by discovering that after you have exercised your options, as much as 90 percent of your total portfolio is tied up in the stock of your company. This is not very bright, because you could lose everything. So we need to ask ourselves, “How much company stock do we ultimately want to hold?” Q. How much is too much? A. Even if you feel good about your company, 90 percent is way too much. Let’s say that 20 to 25 percent of your total portfolio should be in your company’s stock. We need to start diversifying, and to do that, we need to set up some sort of a plan.

T HE PLAN Q. Let’s suppose I’ve decided to hire you. What comes next? A. I need to find out exactly what I am working with. So

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I’m going to give you a financial planning checklist (see Figure 7.1). It lists the documents I will need from you in order to get a complete picture of your finances: copy of your income tax returns for the past two • Ayears (additional years may be requested, if necessary).

• A copy of any wills and trusts, if available. The following items will be required prior to commencement of a comprehensive financial plan. Copy of income tax returns for prior two years (additional years may be requested, if necessary) Copy of wills and trusts, if available Copy of insurance documents and declaration pages for each policy Copy of retirement plans and pension plan vesting schedules Copy of annuities Completed financial planning questionnaire Other

Figure 7.1 Financial planning checklist. (Courtesy of Steinmetz Financial Planning.)

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copy of insurance documents, and declaration • Apages for each policy. copy of retirement plans and pension plan vesting • Aschedules. • A copy of annuities, if any. completed copy of a financial planning question• Anaire, followed by your risk tolerance profile. Let’s suppose that you have now filled out these documents, sent them back, and are ready to review them with me. While we don’t know the specifics of your own situation, here is my strategy for guiding you at this point. After I have gone over these documents, I can put your options, and the proceeds, in the context of your entire financial picture. I know the time horizons and goals. And I put together a cash flow and net worth statement. Now, I am in your shoes. I work with you to identify your financial and personal goals and objectives. I assist in clarifying and quantifying them. Often, they include funding college educations, providing for retirement, or relieving immediate financial pressures, such as paying down a debt. Together, we identify financial problems that create barriers to achieving these goals and objectives, such as lack of diversification. At this point, I am ready to provide you, the client, with a written financial plan. Here is what is in my plan:

• A statement of your goals and objectives. • Your current and projected net worth. • Your current and projected cash flow requirements. • A standard of living and savings analysis. • A risk management analysis (insurance needs).

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plan for financing children’s education, if appli• Acable. • An income tax analysis. for stock option exercise for diversification • Aandplan tax minimization. • An investment analysis. for financial independence and • Recommendations retirement planning. • Recommendations for implementation. After this, I will help coordinate the implementation of the plan and provide periodic review to assure that the client’s goals are being achieved. Reassessing a client’s financial situation at least once a year takes into account changes in the client’s life and economic conditions. Q. Where do my stock options come in? A. Let’s say that you have not yet exercised your stock options. It’s at this point—after the plan is complete— that I will begin to focus on an options strategy. Why? Now that you’ve got a game plan, we can put the options in the context of the plan.

A N EXERCISE STRATEGY In order to avoid exercising at the wrong time, Steinmetz says that she often recommends an exercise strategy akin to the investment strategy called dollar cost averaging. This method involves investing a fixed amount of money regularly, regardless of the price of the investment or the condition of the stock market. She will, for example, advise a client to exercise 5 percent of his or her vested options each quarter, regardless of the price of the company’s stock. She may then recommend another strategy for diversifying, once the options are exercised.

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Here’s an example. Suppose a client has stock options on 7,500 shares that have to be exercised over five years, or the options will expire. She recommends exercising 1,500 a year, or about 375 every three months, with the result that all 7,500 will be exercised gradually over the five-year period. In order to diversify, she further recommends that 2,500 shares be kept in company stock, while the rest—some 5,000 shares—be sold gradually. Why? “It is very hard to get clients out of something that is going up,” Steinmetz says. This method, because it is systematic and orderly, forces them to sell and diversify in an orderly manner.

What Is Your Risk Tolerance Profile? Determine your risk tolerance from the questionnaire in Appendix A.

Selecting a Financial Planner Stock options specialists like Barbara Steinmetz are rare even in Silicon Valley, the capital of stock options. So how do you find one near where you live? (It’s best to stay local where financial advisors are concerned, since you will need to meet with them on an ongoing basis.) Here’s what to look for in making your selection: the planner registered with the state securities • Isdepartment? In California, for example, all financial planners must register with the Department of Corporations as a financial planner. There are also additional examination requirements. Advisers with control over more than $25 million are also required to register with the Securities and Exchange Commission. California regulates all other advisors, and the planner is required to make available to clients or prospective clients a copy of Form ADV—Part II. This form provides detailed information on how an advisor conducts busi-

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ness, services provided, account review procedures, fee structure, clients served, and investments offered. The form also covers the advisor’s education, licenses held, and so forth. Requirements may differ in your state. Whatever they are, make sure that the planner you are considering has met them, and ask for a copy of Form ADV—Part II, or its equivalent. is the planner’s professional education? If the • What planner is a professional, he or she will have either a Certified Financial Planner (CFP), a Chartered Financial Consultant (ChFC), or a Chartered Life Underwriter (CLU) designation. To achieve one of these designations takes at least two years of study, with national examinations required. They also require continuing education to maintain certification, which means the planner is constantly being exposed to new laws and ideas. In a rapidly evolving area like stock options, this is especially important. are the planner’s professional affiliations? Does • What the planner hold membership in a widely acknowledged association, such as the Financial Planning Association (FPA)? As a national trade group, it specifies a code of ethics for its members and advocates the financial planning process. much experience has the planner had with stock • How options? Are other clients satisfied? Often, your source for a referral to a planner will be a friend or fellow optionaire. So far, so good. You may also want to ask the planner for a list of other clients with stock options. Checking with several more clients can’t hurt. The best approach, before signing anything, is to meet face to face with the planner, to discuss fees and other important issues. Most planners encourage a free initial consultation. This helps you decide whether you can establish a comfortable work-

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ing relationship and clarifies fees before anything gets set in concrete.

F INANCIAL PLANNING FOR THE TOP ECHELON With stock options as with other things, the rich often do it differently. Not only do they frequently get a different type of option—tax-advantaged incentive options—but they also get free financial advice. What kind of advice? Meet Joseph H. Clasgens III, executive vice president and director of Brownson, Rehmus & Foxworth, Inc., in Menlo Park, California, the epicenter of Silicon Valley. Clasgens did his undergraduate work at Yale, got a JD from Stanford Law School, then went to Harvard for his MBA. His credentials were soon put to use at Dean Witter in San Francisco, where as an investment banker in the early 1980s he got first rate experience with various financial instruments. For the past 17 years, Clasgens has been with Brownson, Rehmus & Foxworth, Inc., financial and investment advisors, in that firm’s Menlo Park, California, office. If you’ve never heard of the firm, there’s a good reason: It never looks for business. All clients come via word of mouth, and they consist of the top executives at the nation’s biggest companies, in both technology and nontechnology sectors. Brownson, Rehmus is hired by these firms to remove the burden of financial planning from corporate chieftains, presumably so the executives can engage themselves more fully in getting their companies’ stock prices up, thereby making their stock options worth even more. Clasgens’s firm gives these executives the best financial planning advice that their companies can buy—and buy it they do, though the executives do not pay out of their own pockets. A typical arrangement, involving 10 executives at a single company, might cost up to $130,000 for the first year and

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$100,000 for the second year. This includes an initial start-up fee of $30,000 and a monthly retainer of $4,000. As a Rolls-Royce among financial planners, the strategies Clasgens uses offer a valuable window into the high end of options planning. While they may not always be applicable to small-fry optionaires, there is enough relevance to make his approach well worth examining. All of Clasgens’s clients have stock options, for a very good reason: At compensation levels in excess of $1 million, the firm has to pay an additional tax, so incentive-based compensation has become the rule at these levels. The majority of Clasgens’s clients have ISOs, as well as large nonqualified grants. Despite (or maybe because of) the high degree of competence of his clients, Clasgens’s biggest problem is that these executives feel they know their companies very, very well: “They think they can predict the company’s short-term stock price, and they can’t. They overestimate what they know as insiders, and underestimate the impact of market forces.” As a result, Clasgens tells clients that no matter how well they think they can forecast the stock price, options and other forms of their company’s stock should comprise only a limited percentage of their total portfolio, typically 20 percent or so. He also tells them to evaluate the performance of that portfolio over a period of five years or more, when historical averages should make its return more predictable. Options also present a special problem in the case in which an executive is confident that it’s time to exercise but is unable to do so—the blackout period. If you are a company insider, as all Clasgens’s clients are, there are certain periods, such as prior to an earnings release, when options exercise is forbidden by SEC rules. This can wreak havoc with an executive’s plans to harvest options. In one case, Clasgens says that the executive was ready to exercise when the stock price had soared from $60 to $74 a share. But since this occurred during a blackout period, the executive was unable to do so. By the time the window opened again,

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the stock price had fallen almost 25 percent, to $56. Because of their intrinsic leverage, his options lost almost two-thirds of their value in the stock price decline. To get around these problems, Clasgens stresses the following general precepts about financial planning and options. Exercise of options should have two triggers: 1. The overall concentration of assets an executive has in company stock. While a rough general guideline is 20 percent, this should be adjusted depending on the clients’ age (the younger you are, the greater your capacity for risk), existing net worth (the greater it is relative to spending, the less crucial options become), and overall appetite for risk. 2. The development of a wide spread between the grant price and the market price. To justify retaining an option rather than exercising it, the expected profit from the current spread must be at least 50 percent greater than the long-term return from the overall stock market, because the more risk there is in an asset, the more return a client should demand from it. For example, suppose an executive has options with a $10 grant price and a $40 market price. If the client doesn’t think the price is going up annually by $4.50 a share, or 15 percent of the $30 spread, Clasgens tells the client to get rid of it by exercising and selling. This rule forces the client to look beyond options to competitive investments with more predictable results. It is a concern that should be as compelling to the optionaire in the mailroom as it is to the executive in the boardroom. Clasgens notes that there are also other influences on option strategy related to the particulars of the company’s plan. If an executive owns some shares of stock outright and the plan allows him or her to buy ISOs by tendering stock, he or she can

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pyramid. In other words, the executive can obtain additional shares with no cash outlay and no income taxation. Opportunities to exercise a nonqualified option but avoid current income taxation by transferring the proceeds to a tax-deferred account may also exist.

Clasgens’s Methodology When it comes to Clasgens’s financial planning strategy, there are certain basics that also apply to optionaires across the board. All Clasgens’s clients, for example, need to fill in a detailed questionnaire and provide personal documents such as tax returns. But they do have certain perks, which you might compare to the frequent flier clubs that airlines maintain in airports to ease preferred customers through the air travel experience. Clasgens’s first contact at the company that retains him is typically not the individual executive; it is the director of human resources. This person then introduces Clasgens to the recordkeepers for the company’s benefit plans (stock options, insurance, etc.) and authorizes them to give Clasgens all the data he needs on the executives who will participate in the planning program. This allows Clasgens to get much of the information he needs without bothering the executives. “The only onerous task for the executive will be completing the initial questionnaire,” Clasgens tells his clients. “Thereafter, the burden of analysis and recommendation is ours.” What’s more, the financial plan is then structured so that many actions take place automatically, requiring merely a spot check by the executive. Most of us aren’t this fortunate. But what we can do is peer into the methodology Clasgens uses, and learn why his services are valued so highly. It may be comforting to learn that he has much in common with Steinmetz, whose clients, while affluent, aren’t necessarily CEOs. Whether we fly first class, business class, or coach, we wind up on the same plane.

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Brownson, Rehmus & Foxworth (BRF) provides the following description of Clasgens’s scope of services:

FINANCIAL COUNSELING PROCESS Our work for our clients is customized to meet their specific needs. We do not attempt to force any client’s situation into a predetermined format. Typically, however, our work includes the following functions.

Data gathering and evaluation We ask new clients to provide detailed personal financial information through the use of our questionnaire or other convenient means. Copies of tax returns, estate planning documents, insurance policies and other relevant financial records give us much of the requisite information. We then meet with the client to review the information we have gathered and to identify client objectives, preferences and attitudes, and to discuss subjects such as:

• • • • • • •

•

Cash flow requirements Career and retirement goals Attitudes about taxes, debt, and various types of investments Views on acceptable investment risk Desirability of taking a multigenerational approach to asset allocation, investments, estate planning, and other strategies Desired degree of client’s personal involvement in investment decisions and monitoring Estate planning preferences, including views on the effect of inheritance on heirs, liquidity needs, and the trade-off between estate tax savings and reduced control of assets Interest in charitable giving

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On the basis of our initial meeting and review of the client’s financial information, we give the client a summary of our understanding of his or her financial objectives and attitudes.

Preparation of financial projections We prepare a current balance sheet and project the client’s net worth, cash flow, and taxable income over a 10- to 20year time horizon. These long-term projections show the effects of inflation, spending, tax rates, and investment diversification. They provide a departure point for identifying potential problem areas and a base against which to compare the possible results of various investment strategies. The projections also illustrate likely future estate values, estate taxes, and family inheritances.

Development of investment strategies Based on the client’s objectives, we propose specific financial and investment strategies. We consider strategies in the areas of:

• • • • • • • •

Asset allocation and investments Evaluation of existing fund managers and investment advisers and consideration of alternatives (like index funds) Establishment of investment performance standards and involvement of the client in manager selection and monitoring Tax minimization through the use of particular investment approaches, retirement plans, and trusts Actions on company compensation plans, including stock options, qualified plans, deferred compensation, and phantom stock plans Education funding Retirement income planning Lifetime charitable giving

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Estate planning and insurance recommendations After reviewing the client’s existing estate planning documents, we make recommendations regarding estate and insurance matters, such as:

• • •

• • •

Plan changes which may reduce estate taxes and other expenses through gifting programs, generationskipping provisions, and special types of trusts Evaluation of the costs of estate tax minimization, particularly the loss of current or future control of assets The human element of estate planning, including the ability of heirs to handle major assets, the pattern and timing of inheritances, the selection of appropriate trustees and executors, and the role of beneficiaries subsequent to the client’s death Charitable giving strategies at death The role of life insurance Non–life insurance coverages, such as homeowners, comprehensive liability, and disability

Implementation We believe the achievement of client objectives requires the disciplined implementation of investment, tax, estate, and insurance strategies, and we use our extensive experience and resources to assist in implementation. We review existing investments to assess performance and compliance with the overall financial strategy, and we make specific recommendations for new investments. While we have a strong bias toward index funds for stock and bond investments, we seek out individual managers or investment institutions in other areas, whether real estate, energy, venture capital, or complex investments such as risk arbitrage or futures trading. We search for investment professionals who are leaders in their respective fields, have achieved proven superior performance, and charge reasonable fees.

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Ongoing advisor We expect our role as financial advisor to be ongoing and rarely accept short-term engagements. In effect, we want to be able to function as the client’s personal chief financial officer. This involves responding to financial problems as they arise. Financial strategies are reviewed regularly and adapted to changes in the executive’s situation as well as to changes in tax law or the investment environment. BRF’s ongoing services include:

• • •

•

Periodic comparison of approved strategies with actual experience Review of investments, calculation of investment returns, and comparisons of expectations with performance Recommendation of investment or strategic changes in response to changes in the economic or investment environment, the development of new investment opportunities, the need to replace underperforming investments, and changes in the client’s needs Preparation of updated balance sheets and cash flow and tax forecasts

An Actual Financial Plan Here, minus the names, is an actual financial plan prepared by Clasgens:

Introduction From our perspective, your current financial situation already looks very good. You have a net worth today of almost $6.0 million. Your financial prospects also appear quite bright, with net worth very likely to increase $3.3 million—or slightly more than 50%—in the next five years. From our understanding of your current and future financial situation, we have come to three important conclu-

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sions. First, you already approach financial independence. [That is], investment assets, net of home mortgage prepayment and adjusted for imbedded taxation, approximately equal the $4.1 million necessary to fund your annual consumption expense, rising with inflation, for your 34-year joint life expectancy. As a consequence, you could, if you chose, retire from the company in the very near future. You should certainly be able to do so by the age 58 date mentioned as earliest target. (Note, however, that your portfolio, while ample in amount, is not currently structured to provide efficiently for cash flow should you retire then.) The second conclusion we reached is that you need to exercise relatively little restraint in spending. With your expecting to continue at the company another few years, investment assets will rise enough to allow you to maintain consumption at a level 30% or more above what it is currently. Finally, you should have the ability to transfer sizable amounts to children during your lifetime. Your investment assets will exceed what is needed for financial security by a margin great enough both to utilize fully the $10,000 annual exclusion and also to make early partial use of your $1 million credit amounts. We see only two threats to this forecast. The first is the most significant—the dependency on company stock price. If it performs poorly, it will not only reduce current net worth substantially (e.g., note on Figure 7.2 your 27% concentration in it now, despite having transferred funds in June from the company stock account), but will constrain growth in net worth. The second threat concerns how you manage existing assets and, in the future, the large rollover IRA (i.e., of a forecast $2.1 million). Serious investment error could jeopardize your financial security. Our recommendations seek to reduce threats to your financial situation as well as to both increase the overall

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return from your portfolio and to broaden it. The recommendations are divided into three sections. The first states general rules which you should follow on an ongoing basis in making any significant investment or financial decisions. Most importantly, it prescribes the asset allocation you should maintain in the future. The second section outlines the approaches you should take to the compensation and benefit plans at the company. The third then lists the specific actions which we recommend you take over the next twelve months in accordance with the logic of, and to implement, the prior two sections.

Recommended basic investment rules 1. Make the fundamental assumption that inflation at some level will probably continue to occur. As corollaries: A. Choose investment assets based on the real returns that they are likely to produce. B. Avoid taking into your investment portfolio assets which do not adjust for inflation (e.g., fixed income securities) except where the asset’s tax-deferred yield substantially exceeds your long-term inflation forecast (as is sometimes the case with corporate bonds, but only within tax-deferred accounts). 2. Recognize that certain assets have produced consistent returns in the past relative to inflation: Asset Category Cash (T-bills) Precious metals Long-term corporate bonds Real estate (unleveraged) Common stocks S&P 500 Small companies

Real Historical Compound Return 0.7% 0.7% 2.5% 5.5% 8.0% 9.3% (continued)

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%

% %

$

$ $

Common stocks A. Company @ $ ,$ Vested options Owned shares [inc. 401(k)] Total company

%

Total fixed

$

%

%

Total cash

$

$

Company pension Long-term muni bonds Corporate bonds (IRA)

Fixed income

Variable cash accounts Cash and equivalents Deferred compensation 401(k) plan stable fund

Current Distribution

$

$

$

$

$

$

%

%

%

%

%

%

Projected 12/04 Distribution

10–15% 0–5% 10–20%

15–20% 0 0–5 15–20%

0–5% 15–20% 0–5% 15–25%

Recommended Distribution

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% % % 100%

$ $ $ $

Energy prices Other investments TOTAL INVESTMENT ASSETS

(Courtesy of Joseph H. Clasgens III and Brownson, Rehmus & Foxworth, Inc.)

Figure 7.2 Analysis of investment asset distribution.

%

% %

$ $ $

%

$

Real estate Home residual values Fee ownership (net) Limited partnerships/REITs Total real estate

B. Diversified portfolio (inc. IRA) Individual stocks Mutual funds [inc. 401(k)] Total diversified TOTAL STOCKS

$ $ $

$

$

$ $

$

% % 100%

%

%

% %

%

5% 0–5% 100%

5–15%

0–5% 30–40 30–40% 40–50%

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Foreign Energy prices

7.9% 4.5%

3. Distinguish between the three forms risk takes and recognize that you have a very different capacity for each: Default Illiquidity Volatility 4. Understand that a long-term portfolio strategy can allow you to take greater short-term risk in an individual investment: A. Reduced volatility risk from long-term investment Standard Deviations Asset Category Cash (T-bills) Precious metals Long-term corporate bonds Real estate (unleveraged) Common stocks S&P 500 Small companies Foreign Energy prices

One Year

Five Years

4% 30% 10% 11%

3% 21% 8% 9%

21% 35% 22% 35%

5%* 7% 6% 12%

* At its current level the S&P 500 stands two standard deviations above its historical median return. A substantial risk of near-term regression towards the historical average return exists.

B. Reduced volatility risk from balanced portfolio (1) Correlations between different asset categories: Cash Cash Precious metals

Precious Long-Term Real Common Metals Bonds Estate Stocks 0.2

0.2

0.1 (0.3)

0.4 0.7

0 (0.1) (continued)

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Long-term bonds Real estate Common stocks

0.1 0.4 0

(0.3) 0.7 (0.1)

(0.1) (0.1) 0.3

0.1

Energy prices

0.3

0.8

(0.5)

0.3

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0.3 0.1 (0.5)

(2) Correlations between segments of a single asset category—see example regarding common stocks [provided to client]. 5. Keep in mind, however, that fundamental changes in both the economic climate and the investment environment can occur more rapidly now than in the past because of political, market, regulatory, and tax influences. Re-examine your portfolio strategy (and, as part of it, verify again the relationships in the tables above) periodically, and be prepared to alter it if such changes necessitate doing so. 6. Avoid opportunism in making investment decisions, remembering that: A. The overall return from an individual investor’s portfolio will be due most influentially to how he or she allocates cash between asset categories, rather than to what securities or properties are selected within any category. B. Efficient markets exist for major asset categories, making it unlikely that you can consistently earn excess returns, either by choosing individual stocks or by employing a mutual fund manager to do so. (In that regard, see the comparisons [provided to client].) Therefore, work with a specific investment asset distribution in mind, diversifying broadly within each asset category. [Figure 7.2] sets out our recommendations for your longer-term portfolio. 7. Recognize that you must rebalance the overall portfolio periodically to ensure the expected return. In fact, rebalancing can itself add as much as 0.6% to overall

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return (or $125,000 in incremental value on an original $100,000 investment over 25 years). 8. You should maintain a variable cash concentration as high as 25% until your retirement from the company, but with these conditions: A. The account should offer an after-tax return of at least 3% above inflation. B. The account should become available at retirement for cash flow and investment needs. 9. Limit the fixed income position to no more than 20% of investment assets, including the value of your company pension. Any discretionary fixed income investments should be held exclusively (1) inside tax-deferred accounts (like your IRA), (2) using securities offering initial yields 3% or more above your expectation of future average inflation. 10. Maintain common stocks in a range of 40–50% of investment assets. Manage your position within the following constraints: A. Restrict total company stock ownership to a maximum of 20% of investment assets, consisting exclusively of (1) vested options and (2) stock contributed by the company in the 401(k) plan. B. Hold diversified stocks equal to at least 30% of investment assets, but not above 40%. In doing so: (1) For your fundamental, ongoing stock portfolio, hold positions in both U.S. and foreign stocks (recalling [document provided to client] in that regard). Maintain an allocation between the three market segments of: 35% S&P 500 stocks 35% Smaller U.S. companies 30% Large-cap foreign stocks (2) Rely primarily upon no- or low-load mutual funds, but:

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a. Make sure that they are widely diversified by company and industry. b. Recognize the strong advantage of index, rather than actively managed, funds because of their (1) lower annual management fees and, for taxable monies, (2) much longer capital gains taxation horizon. (See Figure 7.3.)

Assumptions 1. Initial investment of $100,000 in each of two stock portfolios. Portfolio I is an S&P 500 index fund, Portfolio II a managed large-cap U.S. stock fund. 2. Portfolios I and II have identical annual rates of return of 10.4%; 2.0% of it consists of dividends for Portfolio I, 1.5% for Portfolio II. 3. Capital gains are recognized annually for Portfolio II, at the end of the investment horizon for Portfolio I. 4. Dividends and recognized capital gains are reinvested annually, after tax (at federal rates of 40.8% and 21.2%, respectively). 5. The management fees and other expenses are the same for both portfolios. Calculations: Investment Horizon Portfolio I: Portfolio II:

Estate Value

Strategy

10 Years

20 Years

20 Years

Hold to term Trade annually

$218,500 214,000

$508,500 457,500

$601,000 457,500

$

$ 51,000

$143,500

4%

51%

144%

21%

115%

203%

Difference As percentage of investment Sensitivity analysis: difference at 0.8% incremental management fee

4,500

Figure 7.3 Effect of early recognition of capital gains. (Courtesy of Joseph H. Clasgens III and Brownson, Rehmus & Foxworth, Inc.)

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11. Maintain your real estate portfolio in a range of 10–15% of investment assets. Observe these rules in doing so: A. Recognize that your multiple homes constitute “investments” only to the extent that the equity exceeds the personal component (i.e., the rent you would otherwise pay over your lifetime). B. Avoid exposing yourself in the future to liability beyond the amount of your investment by purchasing REIT [real estate investment trust] shares or by acquiring limited partnership interests. (i.e., do not acquire any additional properties in fee.) C. Seek wide diversification by property type, lease term, and geographical location (which individually owned properties cannot provide.) D. Avoid properties with leverage greater than 50%. 12. Take a position in energy prices equal to about 5% of investment assets. In doing so, use the following criteria for any investment: A. Its value correlates closely with energy prices. B. Its only major risk is fluctuation in energy prices (i.e., it avoids any substantial drilling, operating, and similar risks). 13. Adopt strategies to minimize erosion of your income from taxation to the extent it would be taxed at an effective 41% federal rate. The principal strategies to accomplish this objective are (by order of preference) to: A. Make use of devices to defer income (e.g., 401(k) plan contributions and deferral of bonus income). B. Direct cash to investments which avoid annual taxation of much of their return (e.g., through depreciation deductions, like real estate, or unrecognized capital appreciation, like index funds). C. Concentrate in tax-deferred accounts those investments where much of the return constitutes ordinary income.

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D. Keep excess cash in a short-term municipal bond fund—like the Vanguard Short-Term Tax-Exempt Fund you now have—pending longer-term investment. 14. On any investment outside of an “efficient market,” make a significant financial commitment (i.e., one which will cause you to take seriously the initial decision to invest and will encourage you to spend time monitoring its performance thereafter). At present, that commitment is $ for you. As net worth continues to grow, the minimum commitment should rise, always equalling 2% of investment assets. In order to avoid overconcentration in an investment, however, none should exceed 5%. (To the extent the investment has good intrinsic diversification, however, you can raise the maximum commitment to 10%.)

Recommended actions under company compensation plans 1. With regard to the 401(k) plan: A. Defer salary equal to the maximum amount deductible under the law (which is currently $10,000). Have the contributions “front-loaded” at 7% salary. B. Retain in your company stock account only shares contributed by the company which are not yet eligible for transfer. C. Have your existing balance divided equally between the small-cap U.S. and foreign stock index funds. [That is], liquidate the S&P 500 and Stable Value Funds, directing the proceeds to the two recommended funds. D. Have future biweekly contributions added to the small-cap U.S. index fund.

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2. Each November, when you can elect to defer elements of compensation: A. Choose not to defer any salary (at least for the foreseeable future). B. With regard to annual bonuses, have them deferred 100% into the fixed account. Specify payment to begin at retirement in eight annual installments. 3. With regard to stock option awards, observe the following rules for exercising them: A. If company stock holdings (after selling owned shares and liquidating eligible 401(k) plan units), come to exceed 20% of investment assets, exercise options immediately. Choose those combining the greatest “spread” with the least years to expiration. B. At concentrations under 20%: (1) Hold a stock option until three years prior to its expiration, and then exercise it any time you think company stock price has reached a peak. (2) Exception: Exercise an option any time you come to believe that average annual appreciation on company stock to the expiration of the option will be less than 15% of the current option spread. (Under this exception, you should exercise your 1995 NQO [nonqualified option]—at the current $ price for company stock. But a price higher by $8 is required to trigger the next award).

Recommended actions during the next twelve months 1. Keep all excess cash in a short-term municipal bond fund with check-writing privileges (i.e., the Vanguard Short-Term Tax-Exempt Bond Fund you now have).

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A. Use this as the first depository for any lump sum cash payments (e.g., from option exercises) and as your principal ongoing source of liquidity. B. But maintain no more than $ (or 5% of investment assets) in it on an ongoing basis. 2. Recognize that you will build variable cash concentration to the recommended level in the future through bonus deferrals into the fixed account. 3. Note that the company pension value already gives you a satisfactory fixed income position. As corollary, sell the municipal bond fund shares you now hold. 4. With regard to company stock assets: A. Unless you expect company stock to appreciate from its current level at a rate above the overall market (i.e., more than 8% annually over five years), exercise your 1995 NQO. B. Liquidate the shares of company stock you now own outright. 5. For your diversified common stock portfolio: A. If you like, retain modest individual stock position (i.e., the Intel, Lucent, and other shares), since concentration falls short of the 5% limit. B. Liquidate your managed after-tax stock mutual fund holdings (i.e., ), noting the relatively high annual fees for the first three (i.e., 0.89% on average) and tax inefficiency (with 7.2% income distributions last year) compared with index funds. You should net about $ , which should be deposited in the Short-Term Tax-Exempt Bond Fund. C. Restructuring your 401(k) accounts gives a generally sufficient concentration in smaller-cap U.S. and foreign stocks. D. Use $ cash to add to your after-tax Vanguard S&P 500 position, having $ automatically

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transferred monthly from the Short-Term TaxExempt Bond Fund for the period of one year. E. Liquidate existing IRA investments and invest the proceeds in Vanguard’s Small-Cap Stock Index Fund (No. 48). F. Use another $ cash to invest in the Vanguard Emerging Markets Fund (No. 533). 6. Use the investment real estate owned fee for your family limited partnership, given (A) the larger unit discount allowed for vehicles holding illiquid assets and (B) the more evident business purpose in accumulating such assets within a partnership. 7. Purchase an initial $ of J.P. Morgan Oil ComPS (traded under the symbol JPW on the American Stock Exchange). 8. Prepay the $ mortgage on your home, recognizing that (A) you cannot fully deduct the interest expense in many future years and (B) you will want it repaid soon anyway, [that is], at retirement.

S TOCK OPTIONS AND FINANCIAL INDEPENDENCE Not all of us want—or need—a financial plan this complete. Most optionaires want—and need—the kind of commonsense basics that Steinmetz gives her clients. And all optionaires need to know how to make the most of their options within the context of this plan in order to become financially independent. A specialist in this arena is Chris Cordaro, with Bugen Stuart Korn & Cordaro, Inc., registered investment advisors based in Chatham, New Jersey. As part of the financial independence analyses that Cordaro prepares for clients, he provides detailed, specific recommendations on how to use stock options to help attain financial independence.

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Cordaro had a client who wanted to be financially independent by age 55, with annual after-tax inflation-protected income of $72,000. Current investments in retirement accounts totaled $955,000. Current investments in taxable accounts totaled $100,000. Although the client was 100 percent in cash, he normally directed 20 percent to fixed-income investments and 80 percent to equity investments. This lucky client was taking the next year off to travel, and expected to spend about $100,000. He planned to return to work at a salary of $150,000. He also planned to sell his home, and would have about an additional $200,000 available for investment. Table 7.1 shows the client’s stock options from AT&T. Table 7.2 shows the net before-tax proceeds of the options as cash

Ta b l e

7.1

Client’s Stock Options from AT&T

NUMBER OF SHARES

VEST DATE

VEST PRICE

2000

Current

1000

January 2000

26.2084

1500

Current

42.1042

1500

January 2000

42.1042

1500

January 2001

42.1042

1500

January 2000

59.8750

1500

January 2001

59.8750

1500

January 2002

59.8750

April 2000

24.5000

150

Source: Bugen Stuart Korn & Cordaro, Inc.

$26.2084

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7.2 Net Before-Tax Proceeds of Client’s Options in the Year They Become Vested Ta b l e

NUMBER OF COST PER SHARES SHARE

TOTAL COST

ESTIMATED PRICE OF TOTAL NET AT&T PROCEEDS PROCEEDS

3,000

$26.21

$ 78,625

$77.76

$233,294 $154,669

4,500

42.10

189,469

77.76

349,942

160,473

4,500

59.88

269,438

77.76

349,942

80,504

150

24.50

3,675

77.76

11,665

7,990 $403,636

Note: Assumes all shares exercised January 2002. Rate of return on AT&T = 11.90 percent; standard deviation = 42.90 percent. Source: Bugen Stuart Korn & Cordaro, Inc.

flows in the year they become vested. The options with an exercise price of $59.875 were not included in the analysis, because the price of AT&T at the time was $55.50, lower than the exercise price. Here is the analysis Cordaro provided for the client: The net before-tax proceeds of the options are shown as cash flows in the year that they become vested (Table 7.2). The options with an exercise price of $59.875 were not included in the financial independence analysis. The current price of AT&T of $55.50 is lower than the exercise price. A separate analysis of strategies to reduce the risk of the options was conducted. The results of the analysis will be discussed later. 1. We have assumed that inflation will average 2%. The variability of inflation could range from −0.8% to 4.8% in two out of three years.

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2. We have assumed that 75% of your investment return on nonretirement assets will be subject to income taxes. 3. We have considered the following two scenarios in our analysis: 1. You will have an after-tax annual income need of $72,000. Assuming an 80% equity allocation, a 7.9% return target is projected. The value of the stock options was included in this scenario. 2. You will have an after-tax annual income need of $72,000. Assuming an 80% equity allocation, a 7.9% return target is projected. The value of the stock options was not included in this scenario. With a 7.9% target return, annual returns in two out of three years will likely range from −5.0% to 20.9%. Based upon the above assumptions, we considered the likelihood that your assets will last through your life expectancy. This analysis considered the fact that both inflation and investment returns will vary. A computer program was used to simulate 500 different scenarios to determine your potential to achieve your financial independence objectives. Table 7.3 provides a brief summary of the analysis. Each labeled scenario in Table 7.3 corresponds to scenarios described above. The summary indicates that there is a strong possibility that your goals will be achieved. Your goals should be achievable even if your AT&T stock options proved to be worthless. This has a direct impact on the option strategy that you may want to employ. Included in this report is an analysis of your options if they are all held until 2002. The longer you hold the options the higher your potential gain and the longer you postpone taxation. The risk is that you hold your options too long and the price of AT&T drops in 2002. We had discussed the purchase of put options to provide

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Ta b l e

7.3

INVESTMENT RETURN

Summary of the Scenario Analysis ASSETS LASTING TO AGE

LIKELIHOOD OF ACHIEVING OBJECTIVE

Scenario 1 7.9%

99

95%

7.9%

148

75%

7.9%

148

50%

7.9%

91

95%

7.9%

148

75%

7.9%

148

50%

Scenario 2

Source: Bugen Stuart Korn & Cordaro, Inc.

downside protection. Currently, your $26 options would be the most likely candidate for this type of strategy. Assuming a price of 53 for AT&T, they are currently in the money by 27 points. A long-term put option (LEAP) with a strike price of 50 and an exercise date of January 2001 currently costs $6.25. Buying this put is like guaranteeing that the price of AT&T when you exercise is at least $46.75. On the upside, you give up the price of the put. If AT&T were to sell for $100 a share, you would lose the $6.25/share you paid for the put, but you would still participate in the increase in share price. The longest options available today are to 2001. Next year options will be available to 2002. The execution of an option strategy depends on your attitude toward protecting the value of the options. If your goal would be to hold onto the options until 2002, then we would recommend a strategy

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of trading up the put options as the price of AT&T increases and as we get closer to expiration.

K EY POINTS top executives often get free financial planning • While and have some special strategies available to them, the same financial planning basics apply across the board. of whether you consult a financial planner, • Regardless you will need a financial plan. The first steps in preparing one are to identify your financial and personal goals and objectives. Then, identify the problems that create barriers to meeting these goals, such as a lack of diversification. you have a plan, put your options into the context • After of the financial plan. the emotion out, and diversify. No more than 20 to • Get 25 percent of your total portfolio should be in company stock. financial planners recommend an options exercise • Some strategy akin to dollar cost averaging, in which a set percentage of vested options is exercised at regular intervals.

C h a p t e r

e i g h t

Lesson 6: A Short Course in Asset Allocation

A

s the saying goes in the real estate business, there are three important words: location, location, and location. In the field of investing, the three important words are diversification, diversification, and diversification. It is the way you can reduce market risk and increase your returns by investing in a range of different assets, either directly through stocks, bonds, and other assets such as commodities, or indirectly through mutual funds. For investors with stock options, diversification through asset allocation has a special relevance. According to a study by the International Association for Financial Planning (IAFP), Atlanta, Georgia (now the Financial Planning Association), most optionaires are putting their financial security needlessly at risk through lack of diversification—in other words, failure to allocate assets properly.1 The IAFP found that it’s not unusual for optionaires to have 90 percent of their investable assets tied up in the one investment they know best—their company’s stock. 110

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That kind of concentration is risky no matter what company you work for, says G. Joseph Votava Jr., past president of the IAFP. While you shouldn’t be scared away from owning company stock, you are also gambling needlessly if you don’t make informed decisions based on your total financial picture—in other words, if you don’t do some smart financial planning, followed by effective asset allocation. We’ve seen that top executives get free personal financial planning. This includes asset allocation. While you may not be this fortunate, you can still do a good job of allocating your own assets by hiring a financial planner—to the tune of, perhaps, a fee equal to between 1 and 3 percent of your total portfolio. If you don’t want to spend that kind of money, but still want to put an effective asset allocation program in place, read on. What follows is a short but effective course on the topic, with the object of making you as capable as any expert of doing your own asset allocation, stock options included.

W ALL S TREET’S FAVORITE STATISTIC: 93.6 PERCENT According to professional money managers, 93.6 percent is the percentage of a portfolio’s return that can be attributed to asset allocation. Figure 8.1 presents the results of a study of corporate pension plans. It shows the relative importance of activities that make up the investment management process. The primary finding is that asset allocation decisions are responsible for an overwhelming 93.6 percent of the risk and return characteristics of an investment portfolio. Why is asset allocation so important? By allocating assets among different investments, you can lower the market risk of your portfolio and create the potential for greater gains. One of the most important decisions you will make is not which stock or bond or stock fund or bond fund to buy, but which allocation makes sense among different types of stock and bond funds. As

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Market Timing 1.7% Other 2.2% Security Selection 2.5%

Asset Allocation 93.6%

Figure 8.1 Wall Street’s favorite statistic—asset allocation. (Courtesy of Oppenheimer Funds.)

Figure 8.2 shows, a diversified portfolio can balance weak performance in one investment with good performance in another, increasing yield potential and reducing risk.

T HE VALUE OF DIVERSIFICATION Wouldn’t it be great if you could forecast in advance what the stock market was going to do? Unfortunately, even the experts find it hard to tell exactly where we are in any given economic cycle, so market timing is not the best way to make investments. But that doesn’t mean you can’t benefit from understanding the cycle and spreading your investments among classes that behave differently. As the cycle changes from slowing to rising growth, stocks often benefit—until rising prices and higher borrowing rates begin to cut into profits. Then, as the economy cools off, bonds often benefit from falling interest rates. As the economy and demand heat up again, commodities often gain from the increasing cost of goods, which tends to push commodity prices up.

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$534,946 Total Return $265,329 Total Return

$100,000 Initial Investment

$327,331 15% Return

$100,000 Initial Investment

$134,549 10% Return $53,066 5% Return $20,000 0% Return $0 $20,000 lost

Figure 8.2 It’s all in the mix. Nondiversified portfolio (left): $100,000 placed in a single investment earning 5 percent a year for 20 years, with no other changes to principal. Diversified portfolio (right): the same $100,000 split into five $20,000 investments, each earning a different rate of return (in one case, showing a loss), for the same 20-year period. (Courtesy of Oppenheimer Funds.)

As the number of randomly selected assets in a portfolio increases, the risk level substantially decreases. This is an important reason for investors to diversify their portfolios. Put another way, the performance of a one-asset portfolio is contingent on the fortunes of that one investment. For example, suppose you have close to 100 percent of your assets tied up in stock options and other forms of your company’s stock. Then, suppose your company declares bankruptcy. Not only could you lose your entire portfolio, your job would probably be gone, too. Portfolios containing several assets—say, company stock, different stock funds, and several bond funds—can offset declines

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Standard deviation

20

15

10

5

0

1

2

3

4

5

6

7

8

Asset classes

Figure 8.3 Reduction of portfolio risk. (Courtesy of Oppenheimer Funds.)

in one or two assets with increases in others. If your company goes belly up in this scenario, you will still have other investments to rely on. Figure 8.3 from Oppenheimer Funds, shows how increasing the number of asset classes can reduce risk.

T HE TEMPTATION OF CONCENTRATION Many employees with stock options, along with other investors who consider themselves to be quite sophisticated, deliberately choose to invest solely in stocks. They are, in effect, going after the brass ring, betting all or nothing on those high potential returns from stocks. Even professional money managers can give in to the temptation of concentration. Robert Markman, president of Markman Capital Management, Edina, Minnesota, was so taken with the run-up in technology stocks in 1999 that he announced early in 2000 that he was telling his clients to ignore asset allocation and diversification and invest primarily in large-capitalization technology companies.2 Why? He became convinced that diversification was costing his clients too much in potential returns. He has plenty of com-

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pany in the executive suite, and elsewhere in the typical U.S. corporation. Employees—especially those near the top—frequently have so much invested in their company, and feel they know so much about it, that they become convinced they are able to forecast the direction of the stock price. Armed with this conviction, it becomes easy to justify putting all of your eggs in the company basket. What’s wrong with this picture? Investors who think they can pick 5 or 10 hot companies, or can foretell the future of their own company, are taking a huge risk that they will either pick the wrong stocks or make the wrong judgment. In this case, their choice or choices could wind up seriously underperforming the market averages, perhaps for a long period. At the very least, they are taking the risk that their highly volatile stock or stocks could expose them to some very big down years, maybe just when they need to withdraw the money. Diversification, when it is well executed, creates the optimal relationship between risk and return.

W HICH ASSET ALLOCATION IS RIGHT FOR YOU? Appendix A provides an easy test that will determine your risk profile. Based on the results, you will be able to categorize yourself roughly as a conservative, moderate, or aggressive investor. Oppenheimer Funds, the well-known New York–based fund company, prepares customized investment proposals for wealthy clients. The proposals routinely make the following asset allocation recommendations based on these three categories: CONSERVATIVE ASSET ALLOCATION 30 percent cash equivalents 25 percent income 15 percent global growth

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10 percent growth 10 percent growth and income 10 percent high income MODERATE ASSET ALLOCATION 30 percent growth and income 25 percent global growth 20 percent aggressive growth 15 percent income 10 percent cash equivalents AGGRESSIVE ASSET ALLOCATION 35 percent global growth 30 percent aggressive growth 25 percent growth and income 10 percent income Of course, since Oppenheimer is in the business of selling mutual funds, the specific funds it recommends for executing these asset allocations are all from Oppenheimer. For an unbiased view, we went to Sheldon Jacobs, founder and publisher of The No-Load Mutual Fund Investor, a newsletter from Irvingtonon-Hudson, New York, that is devoted solely to no-load mutual funds. Jacobs also manages money, and he is highly respected for his devotion to low-cost, top-performing funds. In each issue, Jacobs makes specific recommendations for three portfolios that correspond closely to the three types of investors identified by Oppenheimer. Table 8.1 shows Jacobs’s recommendations for a conservative, or retirement, portfolio, at the end of 2000. Jacobs’s recommended asset allocation for this portfolio is similar, but not identical to, Oppenheimer’s—cash or cash equivalents, such as money market funds, 35 percent; income funds, 40 percent; international funds, 10 percent; and growth stock funds or long-term equities, 15 percent.

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Ta b l e 8.1 Portfolio

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Jacobs’s Recommended Conservative

NAME OF FUND

TYPE OF FUND

Longleaf Partners International

International

Price European

International

Schwab 1000

Growth and income

Janus Balanced

Hybrid

T. Rowe Price Spectrum, Inc.

Income

Harbor Bond

Income

Vanguard Short-Term Corporate

Income

Vanguard Prime Money Market

Money market

Strong Asia Pacific

International

Source: Sheldon Jacobs.

Table 8.2 shows Jacobs’s recommended funds for a moderate asset allocation, or preretirement, portfolio. Jacobs’s asset allocation for this portfolio is cash or money market, 35 percent; income, 20 percent; international, 15 percent; and long-term growth funds, 30 percent. The main difference with Oppenheimer is that Jacobs recommends a 40 percent cash position, versus 10 percent for Oppenheimer, which prefers income and growth and income funds over money market offerings. Table 8.3 shows Jacobs’s recommended funds for the aggressive investor. Jacobs’s asset allocation for the aggressive portfolio is cash, 45 percent; international funds, 20 percent; and long-term growth stock funds, 35 percent. This is much more cash than Oppenheimer recommends, because Jacobs was convinced in mid-2000 that the market was headed lower because of rising interest rates, among other things. It turned out that he was right.

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8.2 Portfolio Ta b l e

Jacobs’s Recommended Moderate NAME OF FUND

TYPE OF FUND

Vanguard Total Stock Market Index

Growth

Longleaf Partners International

International

Vanguard Europe Index

International

Fidelity Utilities

Sector

T. Rowe Price Spectrum, Inc.

Income

Harbor Bond

Income

Vanguard Prime Money Market

Money market

Strong Asia Pacific

International

Source: Sheldon Jacobs.

8.3 Portfolio Ta b l e

Jacobs’s Recommended Aggressive

NAME OF FUND

TYPE OF FUND

Vanguard Total Stock Market Index

Growth

Longleaf Partners International

International

Scudder Greater Europe

International

TIAA-CREF Growth and Income

Growth and income

Vanguard Prime Money Market

Money market

Source: Sheldon Jacobs.

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O NGOING REVIEW A thoughtfully allocated portfolio cannot, unfortunately, be left alone. Fundamental changes in the economic climate and the investment environment can occur rapidly because of political, market, regulatory, and tax influences. In the preceding asset allocation, for example, Jacobs has a high cash position because of fears that rising interest rates could have a negative shortterm effect on the market. Rising interest rates are normally viewed as a negative because they make conservative, interestbearing investments like money market accounts and certificates of deposit look better by comparison with equities. Conversely, low interest rates are seen as a positive for stocks, since they make the yield on competitive investments like money market funds look less attractive.

R EBALANCING Part of your ongoing review is a task called rebalancing. You need to reexamine your portfolio periodically and be prepared to alter it as market conditions require. Many financial professionals recommend a twice-yearly review of your portfolio, rebalancing as necessary to keep your asset allocation intact. Allocation changes may occur if fast growth in one area throws the other percentages off kilter—making the long-term growth fund component into, say, more than 60 percent of the aggressive portfolio. Rebalancing consists of reverting back to your original asset allocation by cutting back in the areas with the biggest gains and increasing your holdings in the lagging sectors.

W HERE DOES COMPANY STOCK FIT IN? You’ve probably noticed that in the preceding asset allocation recommendations, no specific mention is made of company stock. However, your options and any other company stock you

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own—for example, in a 401(k) plan—are a key part of any asset allocation plan. To find out how to treat company stock, we went to an expert on the subject—Hewitt Associates, a benefits consulting firm based in Minneapolis. Hewitt counsels companies on employee benefits plan, including stock option programs. Lori Lucas, an associate at Hewitt, points out that just as stock options have grown, so, too, has the presence of stock in 401(k) plans. A study by Hewitt recently found that among companies that offer their own stock as an option in the retirement plan, an average of 41 percent of plan assets are invested in company stock. This means that, in many cases, employees with stock options as well as 401(k) plans may have more of their assets tied up in company stock than they are aware of. The danger here, Lucas points out, is that employers are routinely overconfident about their stock—something we have seen in our discussion of financial planning. Often, past performance is used to estimate future returns, which, in view of the recent bull market, leads employees to expect more of the same. Another problem is that model portfolios, such as Oppenheimer’s and Jacobs’s, usually consider only diversified asset classes, ignoring company stock altogether. Or, if company stock is taken into consideration, the model portfolio will assume a certain level of company stock ownership and allocate around it. Lucas advises, first of all, to make your own projections about the return on your company’s stock, using a more realistic method such as the historical risk and return, rather than basing projections on the recent past. You also need to consider the relationship of the stock to key variables like an overall market or economic decline. Lucas suggests that your deliberations should also include discussions with the management of your company about potential changes that could affect the stock going forward, such as a merger or takeover of the company.

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Lucas has created several of her own model portfolios, inclusive of company stock. In doing so, she made the following assumptions:

• Categorize the company (e.g., a large U.S. company). the unbiased return (e.g., the expected return of • Forecast large-cap U.S. stocks). risk as a factor of unsystematic and systematic • Forecast risk (e.g., 2 times the risk of the market). actual historical cross-correlation of long-term com• Use pany stock returns. Figures 8.4 to 8.6 illustrate three all-stock portfolios Lucas has created that contain between 0 and 75 percent company stock. The difference as the level goes up is that other categories of stock holdings decline. While it is unlikely that your own asset allocation will be 100 percent stock, since that is an extremely high-risk strategy, you can use these charts to calculate the stock portion of your portfolio, decreasing other categories depending on your total stock ownership as a percent of assets. The key is to understand and work with the investment risks

Large stock (34.0%) Mid-cap stock (14.0%)

Emerging markets stock (12.0%)

International stock (22.0%)

Small stock (18.0%)

Figure 8.4 Aggressive portfolio—0 percent company stock. (Courtesy of Hewitt Associates, LLC.)

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Mid-cap stock (12.0%)

Large stock (27.0%)

International stock (22.0%) Company stock (10.0%)

Small stock (17.0%)

Emerging markets stock (12.0%)

Figure 8.5 Aggressive portfolio—10 percent company stock. (Courtesy of Hewitt Associates, LLC.)

of your company stock holdings in allocating your assets. Failure to do so can have consequences that are literally disastrous. Studies of the performance of company stock plans regularly show that company stock is a highly volatile component of 401(k) plans, and as such can be either a big winner or a big loser.

International stock (11.0%)

Small stock (4.0%) Mid-cap stock (4.0%)

Company stock (75.0%)

Emerging markets stock (6.0%)

Figure 8.6 Aggressive portfolio—75 percent company stock. (Courtesy of Hewitt Associates, LLC.)

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How big? Ask the employees of Stanley Works. Stanley Works stock is the only holding in the company’s 401(k) plan. From the end of 1996 to the end of 1999, Stanley Works stock fell by 38.4 percent, or more than a third. While the company was losing its shirt, its employees were losing their pants. On average, according to recent studies, large company stock in retirement plans continues to lag the S&P 500 Index by more than 10 percentage points. The figures are a red light for companies like Stanley Works, whose plans carry a hefty percentage of company stock. They are also a red light for optionaires, since, along with stock options, optionaires may own even more stock through company retirement plans. The issue is not likely to go away, since there is a clear benefit to the company when employee contributions to retirement plans are matched with company stock. It is the only real deduction where there is no actual expense, other than the dilution of stock by issuing more shares. And the law imposes virtually no limit on the amount of company stock you can own one way or another. As long as your company’s stock goes up, all is well. But if the firm’s fortunes head south, your interests are likely to part quite rapidly with those of your firm. At some point, for example, the company may be obliged to sell stock, which can literally trigger a death spiral resulting in heavy losses to employees. Examples cited by the Financial Planning Association include Color Tile and Oxford Health, the infamous health maintenance organization. Employees of both companies held stock that became worthless when the companies failed. The lesson is to inform yourself thoroughly about company stock in your own retirement plan, and factor it into your own asset allocation along with any other stock you own through options, in a realistic way. Barbara Steinmetz, the financial planner we consulted in Chapter 7, warns that many optionaires she counsels are investors of the 1990s: Never having been through a bear market, they have not experienced the kind of losses that

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are incurred when the market declines for an extended period. They are therefore unaware of the risk posed by lack of diversification. By now, we trust you are no longer in this category.

S TOCKS OR MUTUAL FUNDS? In our examples, we have assumed that you will be investing most of your assets in mutual funds. But increasingly, brokerage firms and fund companies are betting that after individual investors reach a certain level of affluence, often via neweconomy incentives like stock options, they will opt for stocks as opposed to mutual funds as their primary investment vehicle. Brokerages are also betting that these investors will want personal advice and private asset management. So, taking a cue from major brokerage houses like Salomon Smith Barney, MFS, Dreyfus, and Oppenheimer are moving into the wrap business. In case you don’t know, wrap accounts— also known as separate accounts or managed accounts—charge one fee for asset management, rather than commissions for specific transactions. In return, investors get access to a financial professional, who helps choose money managers that pick stocks, not mutual funds.

Is a Wrap Account for You? Why not mutual funds, you ask? With assets of close to $8 trillion and some 8,000 offerings to choose from, mutual funds have become the investment of choice for the average investor, driven by the incredible popularity of 401(k) retirement plans. They are low in cost, are professionally managed, and do a good job of spreading risk out over a basket of stocks or bonds. But mutual funds are not for everyone, and their popularity has come at a cost. Rapid asset growth brings problems, including style drift and limited investment choices. Mutual funds can also carry a heavy tax burden, and while they may be modest in cost, that is due in part to the lack of advice or personal attention.

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By contrast, wrap accounts are more tax efficient, tend to be more rigorously managed, and give the individual access to a portfolio manager. They also invest in stocks, something increasing numbers of affluent fund investors say they want to do. “Wrap accounts are the logical evolution of mutual funds,” says David Oliveri, a spokesman for Boston-based mutual fund pioneer MFS Fund Distributors, Inc. “When mutual funds started, they were plain vanilla. Then came different flavors. Now that investors are comfortable with pooled assets, they want more control over their money.”3 MFS recently launched a division called Private Portfolio Services, which will offer six or seven different types of portfolios, including large-cap, small-cap and international, sold through broker-dealers. Stock selection for the portfolios will be done by MFS fund managers. While fees are set by the broker-dealer, Oliveri says they will average between 1 and 3 percent of the assets under management. To qualify for the program, an individual needs between $200,000 and $300,000 in assets. MFS made its move because wrap accounts are on a fastgrowth track. Assets in these programs reached more than $241 billion in 1999, growing by an annual average of more than 20 percent, according to Boston-based consulting firm Cerulli Associates. Oliveri says his firm’s own research shows that demand for wrap accounts is growing so rapidly that they could account for 20 percent of MFS’s total assets within five years. “As people become more affluent, they are looking for an alternative to the traditional mutual fund structure,” he says.

Tax Efficiency A major appeal of private accounts is that they offer tax advantages. In a traditional mutual fund, investors can get socked with large capital gains liabilities, even though they were not invested in the fund when the gains were generated. In a private account, taxes are owed only on capital gains actually earned by the investor.

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Another plus is the ability to set guidelines on the way the account is managed. For example, if you don’t want any tobacco stocks in your portfolio, you can so direct the manager. You also get ongoing personal advice and attention, including access to a portfolio manager. Oppenheimer Funds and Dreyfus have recently launched their own wrap programs, aimed at affluent fund investors interested in stocks. Dreyfus announced in February 2000 that it is creating a new separate account service that provides individually managed portfolios. Fayez Sarofim & Company, the Houstonbased asset management firm which also subadvises some Dreyfus funds, will work with Dreyfus’s separate account business. Oppenheimer is offering three separate portfolios—largecap value, international, and global—with stock selection to be done by Oppenheimer fund managers. “Historically, we have provided mutual funds. Now, we are providing private accounts, for optionaires and other individuals who want to invest in securities and seek management advice,” says Oppenheimer spokeswoman Jennifer Sexton.4 These programs are clearly a good deal for the fund companies. They attract the type of affluent clientele that might otherwise be lost to broker-dealers and others. And fee-based compensation provides a steadier stream of income than commissions. But are they a good deal for you? For individuals with at least $200,000 to invest who want professional help in picking stocks, the answer is a qualified yes. Even though you will pay an up-front fee of up to 3 percent of your assets, you will gain access to a financial professional who can help you with asset allocation, then follow up by choosing money managers to pick stocks and execute transactions for you. These managers are preselected and are often of high institutional quality. There is also the satisfaction of knowing that you are not paying taxes on somebody else’s profits, as you might with a mutual fund. “Back in the 1980s, the idea would have been that as you

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become more sophisticated, you want to manage your money yourself,” says Oliveri. “But the success of these programs is showing that people really do value professional money management.”

K EY POINTS

• Diversification is the key to effective asset allocation. allocation decisions are responsible for 94 percent • Asset of the risk and return characteristics of an investment portfolio. many optionaires are tempted to concentrate their • Too assets. A recent study found that it is not uncommon for employees with stock options to have 90 percent of their assets tied up in company stock. asset allocation is right for you? It depends on • Which your risk profile. Take the test in Appendix A to find out whether you are a conservative, moderate, or aggressive investor. The more conservative you are, the greater the percentage that you will invest in money market and fixed-income instruments. The more aggressive you are, the more you will invest in stocks. asset allocation you choose, you will need to • Whichever rebalance your portfolio on a regular basis. stock needs to be factored into your asset allo• Company cation. This includes stock in your 401(k) plan as well as stock you may own through stock options. In your asset allocation, use the company stock you own to fill up part or all of the stock classification, the most aggressive asset class. you have at least $200,000 to invest and are interested • Ifprimarily in stocks, you may want to consider professional money management via a wrap account.

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obody needs to be told that stock options carry risks. In light of the recent volatility of the tech-heavy Nasdaq index, the media has played up stories of optionaires whose deals went sour. Less than a year before, the news was filled with stories of options as the new economy’s route to riches. The media’s superfast reversal—shifting from positive to negative in a few months—points out the fact that while options have great potential, it can be quickly dashed when the market or the company issuing the options goes through a bad spell. For employees with stock options, a sense of balance is important. Assessing the prospect of loss along with the opportunity for gain plays a crucial role in the overall options picture and is more important than in many other areas of business, because options are exceedingly complex and therefore difficult to handle well. For companies there are also risks, and the issues are equally complex. This chapter examines—in plain language—the risks 128

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that companies and employees are facing as stock options play an ever more important role in corporate compensation, and advises optionaires on how to avoid the pitfalls.

R ISKS FACED BY EMPLOYEES The following summary of the risks optionaires face starts with those that are easiest to control, then moves to areas where there are few easy answers.

Expiration A major risk in owning stock options is holding them until they expire. The expiration period of a stock option is the time during which the option is exercisable, starting from the grant date. Expiration periods are almost never longer than 10 years, partly because the legal life of an ISO is 10 years. A 10-year term also makes sense because options are often used as a short-term compensation tool. If the period were much longer, options would look a lot more like retirement plans. The important thing to remember is that an expired option is worthless to you, so it is vital to be aware of the expiration date in your plan. This is particularly true if you are based outside the United States. A study by PricewaterhouseCoopers found that expiration of in-the-money options is common for employees working outside the United States. A key factor, said PricewaterhouseCoopers, is that communications about stock options are made available only in English, so non-English-speaking employees are unable to read them—and therefore are unable to comprehend vital information like the expiration date.1

Termination of Employment Typically, you will have a specified period of time following termination of employment during which you can still exercise

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your options, to the extent that your shares have vested. This period normally ranges from 30 to 90 days. Employees are not normally entitled to exercise shares that vest after termination. In the event that your termination results from death or disability, the termination period is often extended six months to a year. The courts are getting into this area, however. Consider the case of Charles Knox, a middle manager at Microsoft who was terminated from his job in 1995. He sued Microsoft for breach of contract, asking not only for lost salary but also for the worth of his options. Initially, the court awarded him salary but denied him the value of any options. However, a Washington State appeals court agreed with him, ruling that he could claim the value of the stock options that he lost when he left. His lawyer told the court that the options were worth tens of millions of dollars, an amount clearly worth fighting for. While at this writing the case is still pending, it raises a whole host of issues for companies and their employees, particularly technology firms where employee tenure is often short. Knox says that he was forced to give up 17,000 options that had not yet vested when he left. The stock options were a major reason that he came to Microsoft, Knox says. He claims that they were far more important than the salary or other benefits. To date, there have been a handful of similar cases, which have been settled out of court, with the outcome confidential. There are reports, however, that the court has generally supported the right of wrongfully terminated employees to recover the value of lost vested stock options. The courts have also held that, because options represent pay already received, claims need not be subject to the limits that the federal Civil Rights Act puts on compensatory damages in employment discrimination suits. Such limits range from $50,000 to $300,000, depending on the size of the company. There also seems to be a trend toward tying options payouts

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to the manner in which you leave your job and to where you go after leaving. In 1999, courts in New York and California upheld a provision in IBM’s stock option plan requiring employees to forfeit profits on any options exercised up to six months before going to work for a competitor. Since then, some other companies have added similar provisions to their plans. Since the issue is a moving target, the best advice is that if you leave a company and are forced to give up options with substantial potential value, you should probably consult a lawyer regardless of whether the options are vested. Another situation in which you might want to consult an attorney is if your company sells off your division or declares bankruptcy before your options are vested. A group of employees who worked at a division of Qualcomm that was sold to Ericsson in 1999 were so angry over options they lost that they took the company to court. They had a right to be upset: Qualcomm’s stock rose from $43 a share to over $100 after the division was sold. The group of employees claimed that even as Qualcomm was in talks with Ericsson, it was using stock options to persuade them to work for the company. Another route in a situation like this is for your new employer to make you whole. In the case of Qualcomm, for example, Ericsson did offer generous retention bonuses, plus stock options in Ericsson.

Periods When Options Can’t Be Exercised Lockup periods are periods after a company goes public when some or all of the firm’s shareholders are not permitted to sell shares. They are imposed by underwriters in order to make it easier to sell shares to the public. A blackout period is a similar period timed to coincide with the release of a company’s financial statements. Blackouts are imposed in order to prevent insiders from trading on information that is not yet available to the public, and the reason is to

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preserve the integrity of the market. They also help to avoid lawsuits from unhappy investors. How do these periods pose a risk to you, the optionaire? Consider the case of VA Linux and its 179 employees, as reported by Elise Ackerman in U.S. News and World Report on March 6, 2000.2 When the company went public in December 1999, the stock price popped 733 percent in the first 61⁄2 hours of trading. In all, employees of VA Linux owned 8.5 million options at $1.85 per share. Within hours of the red-hot IPO, a nonmanagerial employee with 10,000 options was suddenly worth over $3 million. Then the lockup factor kicked in. When the stock was at its height, VA Linux employees were prohibited from selling their shares by a six-month lockup agreement. VA Linux stock proceeded to fall by 60 percent during the following months. Employees who exercised early then were forced to wait before selling actually had tax bills that exceeded the value of the stock that they sold. The lesson is that if you exercise your options and are unable to sell, and the stock plummets, you might not even have enough money to pay the tax. So if you are employed by a company that goes public, and you hold nonqualified options, don’t by any means exercise options that you are unable to sell when and if the stock pops early in the IPO. If you are employed by a company that is already public, there is still the problem of blackout periods. While you probably can’t do much about them, you will need to take them into account in any plan you have for exercising and selling.

The Equity-for-Services Swap Rick Chase (not his real name), a consultant in Tampa, was thrilled when a client offered to give him stock options instead of cash in exchange for consulting services. With stories proliferating in the media about the instant riches that stock options can create, Chase hoped to share in the potential wealth of his client, a promising technology company. For over a year, Chase traded his expertise for options, giv-

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ing up a good portion of his fee. But he was barred from exercising them right away, and before long his cash flow began to suffer. When he went to the grocery store, they didn’t care whether he was an optionaire or not. Because he was strapped for cash, Chase was forced to cash in his options as soon as he could, making just a small amount of money. Had he been able to hold onto them longer, he could have made a hefty profit. Reality check: Options are not cash. Chase was a freelancer, not a full-time employee of the company. As such, he was not drawing a regular paycheck to which the options were attached as a benefit. By substituting options for regular pay, Chase fell into a risky situation, albeit one that can produce big profits. Consider, for example, former president George Bush, who recently was earning his living on the speaking circuit. After agreeing to accept stock options in Global Crossing, a communications company, instead of his regular $80,000 speaking fee, Bush ended up with stock worth millions. The key, financial planners say, is to view any options-forpay deal the same way as you would an investment. If you have an immediate need for cash, it is probably not the way to go. What’s more, it’s probably a good idea to become something of an expert on the company that is offering you options. To judge how good the deal is, you need to know how much stock the company has issued and how much of the total will belong to you. If the company is not public, it’s vital to know if and when the company plans to go public, who the underwriters are, and at what price the shares will be offered. You also need to have confidence in the firm’s management. Do you know the top executives and their backgrounds? Finally, how long will you have to wait before exercising your options? Ultimately, your judgment will depend on your educated assessment of where the company’s stock will be at the time your options become fully vested. If you have any serious reservations, experts advise opting for cash.

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Stock Price Volatility During the second week of April 2000, the Nasdaq stock index index fell by a whopping 20 percent. This stock dive prompted the following assessment from the Los Angeles Times: Nowhere is the consternation more direct and pervasive than among the workers of the nation’s technology companies, particularly money-losing “dot-com” concerns whose once bright futures are withering as their stock prices have collapsed as much as 80% or 90% in recent weeks. Their vast paper fortunes toppling in the face of market retreat, many young engineering and software wizards find themselves thinking of the possibilities of working for less-exciting, established companies that they viewed with disdain just weeks ago.3 Welcome to the world of dot-com instability, which contributed mightily to that Nasdaq downdraft, and which remains an ongoing fact of life for optionaires and would-be optionaires. Regardless of whether a company is well established, the risk is palpable. For example, between January 1, 1999, and July 30, 1999, household name Microsoft traded as low as $42 and as high as $96. And that was before the Justice Department announced plans to break up the technology giant. When it comes to IPOs, CommScan, a New York–based investment banking research firm, recently conducted a study that found that only 58 of the 131 Internet-related IPOs made during the first two quarters of 1999 were trading above their first-day closing prices. Eighteen were trading below their IPO prices.4 The lesson is that there is no guarantee that stock—any stock—will go up. And regardless of whether it does, it can fluctuate drastically in the interim. Instability like this can make options become worthless quickly, which is bad for the company as well as optionaires.

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Consider leading Web retailer Amazon.com, which had options vesting in April 2000 that were underwater, or below the grant price, for many of its employees. This was because Amazon’s stock was then trading at $47, down from a 52-week high of $113. The company was put in the uncomfortable position of losing valuable employees, whose consternation at holding worthless options made them prime pickings for more stable, well-established companies. Table 9.1 dramatically illustrates just how much a plunge in stock price can affect the value of options, in this case those granted to chief executives.

Repricing How are companies and employees coping with this everpresent danger? One way is by repricing. This is when the board of a company votes to lower the grant price in order to put the options in the money again. Examples of repricing in Silicon Valley abound: CD Now, Inc., an Internet retailer, repriced early in 2000. MyTurn.com, a manufacturer of low-cost computers, followed suit in April. Back in June 1999, Jonathan Steinberg, chief executive of Individual Investor Group, Inc., repriced his executive options from between $4.50 and $7.50 a share down to $1.25 per share. That was when the stock was trading at about $2. Steinberg and his fellow executives waited until the stock rose to $7, at which point his options alone were worth about $3.9 million, according to the Wall Street Journal.5 However, repricing has fallen out of favor. Because of tough new accounting rules, companies that reprice options must now take a charge on their next earnings statement. Here is an example. Suppose Worldwide Widgets.com gives workers $10 options when the stock is at $10. As the share price climbs to $100, the prospective $90 benefit to the workers appears nowhere in the company’s cost of operations. Now, let’s say that the stock drops to $5 and Worldwide Widgets reprices the

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9.1

Value Erosion

Peter J. Kight

Dwayne M. Walker

Justin L. Jaschke

David M. D’Ottavio

Gregory J. Hawkins

Robert W. Wrubel

Shopnow.com

Verio

Via Net.Works

Buy.Com

Ask Jeeves

EXECUTIVE

Checkfree Holdings

COMPANY

CHIEF

0.606

5.799

1.767

4.881

3.501

$1.481

ESTIMATED VALUE OF OPTIONS WHEN GRANTED (MILLIONS)*

15.250

46.195

40.900

23.720

2.801

$3.937

CURRENT VALUE OF OPTIONS IN EARLY 2000 (MILLIONS)†

2.465

5.314

3.500

1.388

0

$0

CURRENT VALUE OF OPTIONS ON APRIL 17 (MILLIONS)

−84

−88

−91

−94

−100

−100%

CHANGE VALUE FROM FIRST GRANT IN

The current value of stock options granted to many technology executives in 1999 remains far below where they were at year-end 1999. Here are some of the executives who saw the value of their options decline the most. Figures are through April 17, 2000.

Ta b l e

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John A. Hewitt Jr.

Charles Johnson

JoMei Chang

Versata Inc.

PurchasePro.com

Vitria Technology

23.143

2.429

1.167

0.379

0.333

0.017

0.354

0.579

1.500

54.488

24.464

3.407

23.583

2.169

35.250

22.714

10.554

225.218

*Based on one third of the options’ grant price. † Based on average of company stock prices at end of December, January, and February. Source: Executive Compensation Advisory Services.

Robert J. Davis

Peter H. Jackson

Intraware Inc.

Lycos Inc.

Ruann F. Ernst

Digital Island

Eric A. Benhamou

William L. Schrader

Psinet Inc.

3Com

Stuart H. Wolff

Homestore.com

7.294

3.394

68.325

14.951

6.100

0.850

5.953

0.481

5.719

−68

−68

−70

−73

−75

−75

−75

−78

−84

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options at $2. A recovery to, say, $12 creates a $10-an-option compensation cost for the income statement, which must include options still outstanding. Repricing is a move that can therefore be costly to the company, but even so, it could be less expensive than watching the human capital walk out the door. Microsoft is coping in another way. In April 2000, when the company was beset by market woes and under attack by the government, the stock suffered a big decline. Microsoft responded by giving out approximately 70 million new options to its employees to make up for the stock’s slide. The options were given out at a grant price of $66, the price of the stock the day they were awarded. Unlike repriced options, fixed-price options like these do not have to be charged against profits. So Microsoft was able to make the award without damaging its earnings, something that doubtless played a major role in the software giant’s decision not to reprice. At other companies, executives are offering employees the opportunity to exchange their options for shares of restricted stock. The way this works is that if a company granted options at, say, $10, and the share price is $5, the company would give employees outright ownership of a smaller number of the lowerpriced shares in return for cancelling their options. So even if the stock continues to drop, the restricted shares will still have value, unlike the underwater options. Of course, executives also use the tried-and-true jawboning tool of reassuring employees that a sudden drop in stock prices is only temporary, and jumping ship just doesn’t make sense. Other benefits also help. And, in return, company loyalty can be strong: Consider the case of Calico Commerce, based in San Diego, California. In November of 1999, Calico’s employees were paper millionaires, thanks to their stock options. Then the stock fell 80 percent from its peak, making the options almost worthless. To cope, the company tried everything it could to retain

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employees’ loyalty: It treated employees like partners, hosted monthly morale-building breakfasts and beer bashes in the lunchroom, instituted generous personal leave policies, and fostered open communication. The result was that surprisingly few employees chose to leave. Of course, in a situation when a company’s stock continues to decline, nobody’s loyalty is limitless—especially that of younger employees, who have few obligations and are more prone to job hopping. For any company to retain employees over the long haul, the compensation package must be competitive. So what is the best course of action for optionaires when faced with a plummeting stock price? As we have seen in earlier chapters, regardless of the actions your company may take, a diversified portfolio is one way you can arm yourself for a situation in which your options suddenly—if only temporarily—become worthless. If you have not bet the ranch, you can’t lose the ranch. There is also a silver lining to volatility. Some experts point out that it can actually be a good thing for optionaires, since wide up and down movements in a stock create the opportunity to buy lower and sell higher than with a stock that moves steadily upward. Figure 9.1, from a sketch by Corey Rosen of the National Center for Employee Ownership is a case in point. The figure charts two firms, Company A and Company B, each growing by 10 percent per year. Company A is moving in a straight line; Company B is moving by fits and starts. Company B is actually a better bet for optionaires, because with the proper exercise and sell strategy, the potential for gain is greater. Other than this, a wait-and-see attitude and a large tolerance for risk are valuable virtues for the optionaire, particularly if you work for a Silicon Valley company like Calico Commerce. The caveat, of course, is that if you work for a dot-com where the luster continues to fade, you may be forced to conclude that the security of a steady salary (alias an old-economy company) minus those high-stakes options is right for you after all.

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(a)

(b)

2000

2010

2000

2010

Figure 9.1 Volatility is good for options because you can buy lower—and sell higher—with a volatile stock: (a) Company A, 10 percent per year stable return; (b) Company B, 10 percent per year volatile return. (Courtesy of Corey Rosen.)

There is a middle course. If you’re looking for stability along with the excitement of a dot-com, you may want to consider a dot-com company that is linked to an old-economy firm. During the Nasdaq plunge of April 2000, many executive recruiters reported receiving inquiries about established companies like Wal-Mart, an old-line retailer that has a partnership with venture firm Accel Partners, based in Palo Alto. Ultimately, your best choice is where you will be most content. The good news, of course, is that the strong job market— especially in technology—makes job-hopping relatively easy. Roller-coaster rides can be a lot of fun, as long as you can get off when you’ve had enough.

Divorce This red flag didn’t even exist until a year or two ago. But now, as another sign of how swiftly options have become a major factor in total compensation, they are also turning up as a centerpiece in divorce negotiations—and we know how nasty those can be. If frequent-flier miles are up for grabs, it only follows that options will also fall victim.

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The area is still so new that there is little agreement among experts on how to handle options in a divorce case. One method provides for the party who owns the shares to give the other party a percentage of the proceeds when they are sold. If the couple wants no future contact, the options owner could write the other party a check for the exact amount that the shares are currently worth. But it’s best to wait until the options are sold. That way, lawyers say, both parties to the divorce share in the investment risk. But whether they are exercised and sold now or later, brace yourself for the tax. The proceeds, including the amount you may give to your ex, are treated like ordinary income. In case of default, Uncle Sam will come after you, not your ex. Experts say that the one line of defense is to persuade your company to issue your spouse a separate W-4 form for the stock proceeds. That way, you will both bear a share of the tax burden.

Unvested Options and Divorce What do you do if you have unvested options that cannot be exercised or sold? While it is common for the options owner to claim that they are worthless, that isn’t likely to work, experts say. Instead, the court may choose to divide the proceeds, possibly considering at least one-third to be marital property. Some courts are also considering unexercised shares as income for purposes of paying alimony and child support. Stay tuned.

R ISKS FACED BY COMPANIES Stock options offer undeniable advantages to the companies that grant them. As we have seen, NSOs can significantly reduce a company’s tax bill. They do this because, under IRS rules, the company receives a tax deduction that is equal to the gain when employees exercise their options, even if the gain is only on

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paper. Sometimes, the gain is great enough to wipe out the company’s entire tax bill. The New York Times reported in June 2000 that Microsoft’s options-related tax deduction of roughly $11.4 billion in the first nine months of the fiscal year saved the company $4 billion in taxes.6 So what risks could be big enough, you ask, to offset a tax advantage like this? For one thing, as employees face out-of-themoney options, they will exercise fewer of them. This means that corporate tax bills are likely to rise, without the options deduction. There is also the dilution factor. Dilution occurs when a company issues more shares of stock, possibly to compensate optionaires, as Microsoft did in April 2000. This increases the total number of shares outstanding. If the value of the company fails to increase by a corresponding amount, then the shares are diluted, meaning that they are worth less. This can put optionaires at odds with other shareholders. For example, a study by Watson Wyatt Worldwide found that companies with the greatest percentage of unexercised outstanding options produced lower returns than those with a smaller percentage of overhanging options grants.7 Even so, companies are faced with intense pressure to keep handing out options, to stay abreast of the competition. For this reason, existing shareholders, particularly those holding big blocks of stock, such as institutional shareholders, tend to be skeptical about issuing new stock as equity compensation. And shareholders—who are, after all, the ultimate bosses of the company—usually have the right to approve of these agreements. An example of why this skepticism is well founded occurred in 1999 at Acuson, a small medical equipment manufacturer. Acuson’s stock was performing poorly, and its market capitalization had fallen from $1.4 billion in 1991 to $340 million. Net profits peaked in 1991. At the annual meeting, some 3 million shares were added to the company’s stock option plan,

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and employees were allowed to buy another 2 million shares below the market price. If all the options were exercised, about one-third of the company—a controlling interest, in effect— would be in the hands of Acuson’s employees, primarily its management. While the directors may have been happy, outside shareholders were not, and they did not make a secret of their anger. “It’s a disgraceful performance, a transfer of ownership without approval,” said one fund manager who owned shares.8 Still, shareholders did not disapprove of the move, since it takes extraordinary action, and even more publicity than this one got, to block actions proposed by a company’s management. Also, shareholders know that in the long run, options are likely to be good for the company. So assuming that the equity program has been well put together, they are unlikely to vote the program down because of dilution concerns.

K EY POINTS While employees as well as corporations face many risks with options, those faced by employees are greater. They include the following: Options most commonly expire in 10 • Expiration. years. You need to know when yours expire, especially if you work outside the United States. Studies show that many foreign workers let their options expire worthless, in part because of language barriers that limit their understanding of options. of employment. You will typically have a • Termination specified term after you leave the company to exercise your vested options. However, the courts are getting involved. If you leave your company and risk forfeiting options with substantial value, consider consulting an attorney.

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and blackout periods. These are periods • Lockups when stock cannot be sold. Know how they apply to you. swaps. Some freelancers and con• Equity-for-services sultants are accepting stock options in place of a paycheck. This is dangerous if you need money, and in any event you should be very sure about the company’s prospects before you give up hard cash for the possibility of gain that options represent. The declining stock market is always a threat • Volatility. to options. While repricing used to be popular, it has gone out of favor due to stiff penalties. But companies are still issuing new options or exchanging underwater options for shares of restricted stock. Patience and a diversified portfolio will also help see you through periods of volatility. This risk is still so new that few guidelines • Divorce. exist for handling stock options during a divorce. Stay tuned, and get an experienced lawyer if you are divorcing and have options with substantial value. Risks to companies granting options include the following: When a company issues options, it increases • Dilution. the number of shares outstanding. This can make existing shares less valuable. Still, corporate boards are generally reluctant to veto options grants, since options have so far been a good thing for most companies.

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hortly after taking over as head of the Spanish telecommunications firm Telefónica in 1997, Juan Villalonga awarded the company’s top 100 executives—himself included— potentially lucrative stock options that could be cashed in after three years. As time progressed under Villalonga’s leadership, Telefónica became not only Spain’s biggest company, but also one of the most profitable: In 1999, it reported a 38 percent increase in net income. By early 2000, Telefónica’s market capitalization had doubled to $80 billion, and when Villalonga cashed in his options, he reaped a $17 million windfall. While that might seem like small change among Silicon Valley’s superrich optionaires, it provoked a firestorm of protest in Spain. Left-wing opponents of the prime minister attacked Villalonga’s relationship with Telefónica and accused him of a brazen display of corporate greed. Leftist leaders called Villalonga a bad role model and 145

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asked for a ban on stock options. The government subsequently asked Villalonga to give up the profits on his options, but he refused. But the government won in the end: It doubled the tax on gains from stock options.

E UROPE While options are the new corporate currency in the United States, in Spain and many other European countries they often inspire public outrage—and, in fact, can be considered downright immoral. In France, the Jaffre affair is a case in point. The scandal was sparked by oil giant TotalFina’s takeover of Elf Aquataine and the $35 million stock options package that Elf CEO Philippe Jaffre was given to leave. Angry French leftists responded with an unsuccessful campaign to hike the already punitive options tax rate another 10 percentage points, to 50 percent. Part of this lack of acceptance is undoubtedly due to the fact that options are even newer in Europe than they are in the United States. It is only in the last year or two, in fact, that some companies have begun to grant options to employees working outside the United States. Now, about 100 large U.S. companies offer stock options or similar equity incentives to some or all of their employees around the world, according to the National Center for Employee Ownership.1 Still, the challenges of offering a successful global stock options program remain formidable. To begin with, there is the problem of distance. It’s much easier to communicate with employees that you see every day than with those who are across the ocean in a different time zone. Currency transactions further complicate the issue. Even with the adoption of the euro, making sure that payouts in local currencies are accurate and on time can be an enormously complicated task. Reporting transactions in more than one currency is also a challenge.

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Then there is the issue of communicating something as complex as stock options in a variety of languages. It’s tough enough to understand options rules in English, let alone translate them into different languages for employees at different global locations. Last but not least is the fact that the rules and regulations for stock options vary from country to country. Therefore, any company that offers options abroad needs to be familiar with the tax and other government rules in every country in which the company operates. Generally, options remain hobbled by punitive taxes. In France, for example, any employee who makes a profit on options will be lucky to take home as much as a third of the gain. In Germany and Finland, it was illegal to pay executives in stock options until 1998, and in countries across the continent, tax laws continue to make options unappealing to managers and nonmanagers alike. However, there are reports that the intense competition for employees from options-rich firms in the United States, as well as from Internet start-ups in Europe, are beginning to change the climate. In Britain, for example, stock options now make up about half of a top executive’s salary, double the percentage five years ago. Experts say that tougher disclosure laws in places like France and Germany would help to ease public mistrust of options. It would also bring Europe more in line with the United States, where corporate practices are virtually transparent because of corporate disclosure laws. Meanwhile, the debate that rages in Europe continues to be quite different from the one at home. The larger issue for Europeans still seems to be whether anyone really deserves the vast fortunes that can be gained virtually overnight from stock options. Time quoted a local economist on the topic: “If you’re a new economy kind of guy, you would say yes—the value of the stock is a reflection of the company’s worth. If you’re more skeptical, you would say that the market is going bonkers, and over-

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estimating the value of these firms. I happen to think the market’s going bonkers.”2 Meanwhile, let the European optionaire beware. Whether you are with a new-economy start-up or an old-economy company, if you are stationed in Europe and are offered options, it’s best to discuss the offer with an expert who is wise in the ways of your company as well as the rules and regulations in the country at issue. Then, armed with your own full disclosure, you will be able to make an informed decision on whether they are worth it.

J APAN While new rules have liberalized the treatment of stock options that are offered by Japanese companies, options are not as common or as generous in Japan as they are in the United States. In 1998, Japan amended its tax laws to allow options to be treated as tax-advantaged ISOs are treated in the United States. Prior to the change, Japanese optionaires were required to count gains from the exercise of options as regular income, even before the stock was sold. For a top executive, this could mean a tax rate as high as 65 percent. Under the new rules, taxes are deferred on the gain until the stock is actually sold, then the profits are treated as capital gains and taxed at a 26 percent rate. However, the rules apply only to annual purchases of shares valued at the equivalent of $75,000, which executives say is not high enough to affect top management. For this and other reasons, the stock option phenomenon that has gripped U.S. companies by storm has been adopted to a much more limited degree in Japan. While many firms have stock option programs, the average value of stock options issued to top executives in Japan recently stood at the equivalent of about $70,000, a far cry from the millions of dollars in grants that top U.S. executives commonly receive. One reason for the disparity is that executive salaries in Japan remain far lower than they are in the United States, so

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Japanese companies are not about to offer options as a major part of compensation at the expense of salary. (In the United States, executives often receive a third or more of their total pay from stock options.) Also, rather than awarding options based on company performance, Japanese companies tend to give them out based on seniority. This detracts from the role of stock options as an incentive to improve performance. Another big difference in Japan is that stock options are good for a much shorter period. Executives often have just 4 or 5 years during which they can exercise their options, whereas 10 years is more common in the United States. The shorter holding period is due to a Japanese accounting rule that makes holding stock in an employee option plan disadvantageous for a company. So, Japanese firms have short exercise periods in order to encourage employees to buy the shares. Still, hundreds of Japanese companies offer stock options in some form. Toyota, the big automaker, was one of the first Japanese companies to offer stock options. In 1997, Toyota gave its directors options to purchase between 5,000 and 15,000 shares each. Hiroshima-based FP Corporation, a maker of plastic fruit and meat trays, decided three years ago to offer options to all of its 460 employees, a practice that is still relatively rare. While the options aren’t producing many Silicon Valley-style millionaires, they may pave the way for more Japanese companies to emulate the U.S. model and extend stock options throughout the corporate food chain. The bottom line? If you are thinking of going to work for a Japanese company, expect a much more modest part of your pay package to come from stock options, if they are offered at all.

STOCK APPRECIATION RIGHTS (SARS) To get around the problems of offering stock options abroad, some companies offer employees who work abroad stock appreci-

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ation rights (SARs) rather than stock options. With SARs, employees receive a payment equal to the difference between the stock’s grant or exercise price and its market price on the day it is exercised. Because shares are not actually purchased, the employee does not own stock as a result of the exercise.

K EY POINTS stock options abroad can be difficult for a vari• Awarding ety of reasons. In Europe, for example, stock options are made more complicated by currency translations, distance, language barriers, and different rules and regulations in each country. European countries also impose punitive taxes on • Many stock options. Japan, options exist, but the value to even the most • In senior executives is much more modest than it is in the United States. Recently, the average award for a top Japanese executive was the equivalent of a mere $70,000. of foreign difficulties, many companies grant • Because stock appreciation rights (SARs) rather than options to their foreign workers. With SARs, you receive a payment equal to the difference between the grant price and the market price of the stock when you choose to exercise.

• With SARs, you do not actually own the stock.

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Lesson 9: Other Types of Stock-Based Compensation

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tock options are not the only type of stock-based compensation. In fact, the terminology is such that some plans, such as employee stock ownership plans (ESOPs), are sometimes referred to as stock option plans even though they are not. To clear up the confusion, this chapter is designed to familiarize you with other types of stock-based compensation and tell you how they are different from employee stock options.

E MPLOYEE STOCK OWNERSHIP PLANS (ESOP S ) Although it is called a stock ownership plan, an ESOP is really a type of qualified retirement plan. This is because distribution rules generally specify that employees cannot receive any immediate benefit from the appreciation of stock held by an ESOP until retirement, disability, death, or termination of employment. 151

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ESOPs are governed by the exacting rules spelled out in the Employee Retirement Income Security Act of 1974 (ERISA). Also, as tax-advantaged plans, they must meet numerous restrictions spelled out in the tax code, including nondiscrimination. So, unlike stock options, ESOPs cannot be offered only to a select group of employees. To start an ESOP, the company sets up a trust to hold company stock. It then contributes stock to the plan, or money to buy shares of stock. It thereafter makes annual contributions to the trust on behalf of the employees. Employees are entitled to a portion of the ESOP according to a variety of factors. Most companies give out shares based on years of service. They may also award shares based on a combination of years of service and as a percentage of salary. Vesting schedules for ESOPs vary. For example, you may be vested at the rate of 20 percent per year until you are fully vested after five years. By law, you must be fully vested within seven years. What is the rationale behind ESOPs? As with stock options, some experts believe that waiting until retirement to receive the benefits will foster more of a long-term ownership attitude than plans in which employees can cash out sooner, such as employee stock options plans. There are approximately 10,000 ESOPs in existence today, according to the ESOP Association, covering some 10 million participants.

S ECTION 423 PLANS Although they are also sometimes described as stock option plans, Section 423 plans (423 refers to the relevant section of the IRS code) are more like stock purchase plans. Under these plans, the company allows employees to buy stock at up to a 15 percent discount off the stock’s fair market value either when the employee

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becomes eligible to buy the shares or when the employee actually does buy the shares. In the former case, the employee has 27 months to buy the stock; in the latter, the employee has up to five years after the grant date to purchase the shares. Section 423 plans offer preferential tax treatment if certain rules are satisfied, and they cannot be limited to top employees. Specifically, 423 plans require that all employees who have been employed for at least two years and work for a minimum of 20 hours per week have the right to purchase stock through the plan. Highly paid employees can be excluded, and any employee who owns or will own 5 percent or more of the company’s voting shares cannot participate in a 423 plan.

R ESTRICTED STOCK This is an increasingly popular method of compensation in mergers and acquisitions. It refers to the actual granting of stock to selected employees. Like stock options, restricted stock vests over time. But unlike stock options, restricted stock retains some value even if the stock plummets. While shareholder activists sometimes look down upon it as a management giveaway, companies are increasingly using restricted stock as a way to compensate newly hired employees for stock options left on the table at their former jobs. Like stock options, restricted stock is subject to punitive taxes. When the stock vests, the employee must pay tax on the market value of the shares at ordinary personal income tax rates, which can be as high as 39.6 percent for federal taxes alone. To defer taxes, some employees turn restricted stock in to the company in return for a pledge that the shares will be returned at a later date. This transforms the stock from a property interest, which triggers income tax upon vesting, to the promise of a future property interest, which does not. You will owe tax only when you receive the vested shares.

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401 (k) PLANS Like stock options, the 401(k) phenomenon has caught on like wildfire. Because many employees with stock options also participate in 401(k) plans, and because the plans often contain a high percentage of company stock, a detailed understanding of what they are and how they work is useful for every optionaire. The term 401(k) actually refers to a brief passage in the Internal Revenue Code, slipped in in 1978 to clear up a dispute over the taxation of profit-sharing plans. Several years later, pension consultant R. Theodore Benna saw the promise buried in the details and set up the first 401(k) plan at his firm, the Johnson Companies. In 1981 the IRS gave the 401(k) the green light, and the phenomenon took off. The amount of money invested in 401(k) plans soared from $55 billion in 1984 to nearly $1 trillion recently. More than 25 million people—over 75 percent of all eligible workers—currently participate in these plans. The money stored in these plans has become corporate employees’ single largest source of wealth, surpassing not only stock options but also home equity. In a 401(k) plan, you contribute a portion of your salary to the plan. Although the limit is constantly changing, in 1999 it was $10,500. This is a tax-deferred contribution, meaning that you pay no federal income taxes on the portion of your income that you put in the plan. Your investment is allowed to grow tax deferred. Your employer may match your contribution. While a company match is optional, the vast majority of companies—about 84 percent, according to a recent tally—offer some type of employer match. This brings us to the role of company stock in 401(k) plans. Many companies use their stock as a way to match employee contributions, which is tempting because it can be cost-free for the employer. It also builds employee ownership in the company. But the presence of company stock in a 401(k) plan also

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reduces diversification. Employees who are receiving their salary and their savings from the same source can be vulnerable if something happens to the company. If they also own stock options, they can literally have all of their eggs in the company basket, and they stand to lose not only their jobs but also their savings if anything happens to their employer. The issue has grown in importance as the presence of company stock in 401(k) plans continues to increase. A study by the consulting firm Hewitt Associates, LLC, based in Minneapolis, Minnesota, found that an average of over 40 percent of plan assets are invested in company stock among plans that use this type of match.1 Some companies have virtually all of the 401(k) plan assets tied up in company stock, which is possible because the law imposes no limit on the amount of company stock that employees can own one way or another. The upshot is that any employee with a 401(k) plan needs to be aware of the role that company stock plays in the plan. If it is more than, say, 10 percent, this by itself could pose a risk. But if, in addition, the employee also owns stock options, exercising them and holding onto the stock could reduce diversification in a way that could easily create an unacceptable level of risk. This is a situation that is becoming increasingly common. In a recent survey, the New York–based Institute of Management and Administration (IOMA) found that among 62 large companies with over half of their 401(k) plans in company stock, at least 13 offer broad-based stock option plans.2 If you work for one of these companies, you may own even more company stock than you are aware of. As we have seen, it’s not unusual for 90 percent or more of an employee’s investable assets to be tied up in the company, the one investment that the employee knows best. While stock has been a source of great wealth creation, forewarned is forearmed. Familiarize yourself with your own 401(k) plan, if you have one, and take any company stock in the plan into consideration in your own asset allocation program.

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K EY POINTS Stock options are not the only way for employees to own stock in the company. Other plans—which are sometimes confused with stock options—include the following: stock ownership plans (ESOPs). These are • Employee really a type of qualified retirement plan, subject to close government regulation. A company that offers an ESOP must extend it to all employees. Employees cannot receive any benefit from an ESOP until retirement, disability, death, or termination of employment. 423 plans. These are really a type of stock pur• Section chase plan, under which employees are permitted to buy stock at a discount. These plans cannot be limited to top employees. stock. This refers to the practice of granting • Restricted stock only to select employees. Granting restricted stock to executives is becoming popular in mergers and acquisitions as a way of compensating employees for lost options. plans. These are the most popular type of retire• 401(k) ment plan. They require employees to contribute a regular portion of their salary, which is often matched to some degree by the employer. The company match can be in the form of company stock, so it is vital for optionaires with 401(k) plans to know what is in the company plan. too much company stock. Whether from op• Owning tions, a 401(k) plan, or both, owning too much company stock is risky because the lack of diversification can cause employees to lose not only their savings but also their jobs if something happens to the company.

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Lesson 10: Avoiding Common Mistakes

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espite everything you have learned in Lessons 1 through 9, you will still face hard decisions as you strive to build wealth through options. Here, in the approximate order of their importance, are the 10 major mistakes experts say optionaires continue to make, along with advice on how to avoid them.

M ISTAKE 1: NOT KNOWING WHAT YOU OWN If you have gotten this far, you probably have a good idea about the specifics of your own options package. But a surprising number of optionaires remain ignorant when it comes to even the most basic facts about their stock options, such as what kind of options they own. Knowing the nuts and bolts of your own stock options package should be your first priority. These include the following: 157

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type of options you own. Are they incentive stock • The options (ISOs) or nonqualified stock options (NSOs)? your stock options are worth. This is the market • What value of the stock minus the grant price, times the num-

•

ber of shares you own. Key dates for your own options. These include the grant date, the vesting dates and type of vesting, and the expiration date.

M ISTAKE 2: CASHING IN YOUR OPTIONS TOO SOON Rick Chase (not his real name) thought he hit the jackpot when one of his consulting clients offered stock options in exchange for his consulting services. Chase was happy to forego a large part of his salary for options. But, as with most options, there was a waiting period before he could exercise them, and during this waiting period Chase found himself strapped for cash. When he was finally able to exercise the options and sell the stock he had to do so right away, realizing only a small profit. Had Chase been able to plan his finances better and hold onto his options for a longer period, they would have been worth far more. Experts agree that the single biggest decision you will face with your options is when to exercise them. Although the tax issues are complicated, they are also straightforward. Timing the exercise of options is not. Corey Rosen, founder of the National Center for Employee Ownership, is an expert on broad-based options. His advice— and most experts agree—is generally that the longer you can hold onto your options, the better. Rosen advises taking the following steps. First, make a knowledgeable assessment of the future of the company. Is it positive, meaning that the stock price is likely to rise? Next, know how much time is left on your options after they are vested. You don’t want them to expire worthless.

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Third, ask yourself if you need to exercise for a specific purpose, such as making a down payment on a house or buying a car. If so, it’s usually better to exercise the options and sell the stock, Rosen says, so that you won’t have to borrow money that must be repaid with interest. If you don’t need the money for a specific purpose, and you work for a company with a bright future, waiting is probably better. Remember that despite the stock market’s wild gyrations, the overall direction historically has always been up. Also remember that you have the luxury of not exercising your options if the price falls. Once you exercise an option, however, you own the stock and incur greater risk because you may lose money if the stock falls.

M ISTAKE 3: KEEPING TOO MUCH TIED UP IN COMPANY STOCK It is not unusual for 90 percent or more of an optionaire’s assets to be tied up in company stock. Experts agree that this level of concentration is risky, no matter what company you work for or what position you hold. This is because if something happens to the company, you stand to lose not only your job but most of your assets as well. Diversification is therefore the most important financial planning step you can take. Chapter 7 can help you decide what percentage of company stock you are comfortable with in your own portfolio, but generally speaking, it is not prudent to have more than 25 percent of your assets tied up in company stock.

M ISTAKE 4: FAILING TO TAKE BLACKOUT AND LOCKUP PERIODS INTO ACCOUNT When VA Linux made its IPO in December 1999, the stock price skyrocketed over 700 percent in the first day of trading. Employ-

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ees at the company, who owned 8.5 million options at $1.87 per share, were ecstatic. Within hours of the IPO, an employee with 10,000 options—a routine sum for original employees—was worth over $3 million. Unfortunately, VA Linux employees were prohibited from selling their shares by a six-month lockup agreement. These agreements impose restrictions on trading stock immediately after an IPO, and generally apply to the directors, officers, and principal shareholders. Blackout periods are another form of trading restriction imposed after a company goes public, and they usually follow the release of quarterly and annual reports. During the months following its IPO, shares of VA Linux fell 60 percent. The stock recently traded around $10.30. So while VA Linux optionaires still made money on their options, their hopes of becoming instant millionaires vanished with the expiration of the lockup period. To avoid having your options wealth evaporate on paper, take the time to learn about the restrictions in your own options agreement, particularly blackout and lockup periods. This could help you avoid major miscalculations about when you will be able to exercise your options.

M ISTAKE 5: FAILING TO ACCOUNT FOR TAXES IN VALUING YOUR OPTIONS No matter what kind of options you own, taxes are likely to reduce your take substantially. How much of an impact do they have? Let’s say you have ISOs with a grant price of $20,000, and the stock is selling for $30,000. If you exercise your options and sell the stock right away, your gain will be $10,000—but you will face the same tax consequences as you would with nonqualified options, since you have not met the required holding period.

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If you hold onto the stock for a year or more and then sell, meeting the required holding period, you will pay just $2,000 in taxes ($10,000 times the 20 percent capital gains tax rate), a difference of $1,960. The bottom line: In order to value your options correctly, you need to make an accurate estimate of the taxes you will pay under different exercise and selling scenarios.

M ISTAKE 6: FORGETTING ABOUT THE ALTERNATIVE MINIMUM TAX (AMT) If you have incentive stock options, beware of the AMT. This annoying tax is a separate tax that can be used by the IRS to capture some of the taxes you would have paid if you did not have tax-advantaged options, or ISOs. When you exercise your ISOs and include the gain in your income, it can trigger the AMT. Another thing that can trigger the AMT is the size of your deductions for state income tax, mortgage interest, and property taxes. There are currently two different AMT rates. On the first $175,000 of income, the rate is 26 percent. Above that, the rate is 28 percent. Like long-term capital gains rates, these can change annually, and other state and local income taxes may also apply. Lack of awareness of the AMT is a major problem among employees at all levels, including top management. One financial planner tells of a client who came in for help with his financial plan. The client had ISOs and was about to exercise them using the plan developed by his company. After exercising the options, the client returned to the advisor and was told that the exercise had triggered the AMT, and that he owed $100,000 to the IRS as a result. The client had never heard of the AMT. He went back to his company and discovered that the CEO was also unaware of the AMT and the tax consequences associated with exercising

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ISOs. As a result, the advisor wound up giving seminars to the company and focusing his entire practice on employee stock options. If you are in the upper income brackets, live in a state with a high tax rate, or have ISOs that are extremely valuable, you may want to consult a tax specialist about the AMT.

M ISTAKE 7: ACCEPTING STOCK OPTIONS IN PLACE OF A SALARY Consider the sad but all-too-common case of Bob Marks (not his real name), a business development executive for a Web site design company in San Francisco. It had a great client list, and there were plenty of smart, dynamic people working there. Marks happily accepted a fat options package in place of a high salary, figuring that his firm was destined for a hot IPO. Instead, the company merged with a London-based firm, and the new company was in turn bought out before long. Marks’s 10,000 options were converted to 36 shares, worth about $20 each. According to VentureOne, a San Francisco–based venture capital firm, only 22 percent of high-tech start-ups make it to an IPO. And contrary to the perception that optionaires working for IPOs are headed for instant riches, about 1 in 8 IPOs headed south on their first day of trading in 1999. Trading a decent salary for a large options package at a startup is a tricky proposition. A paycheck is something you can put in the bank; options are only the promise of money to come. While there are plenty of stories about optionaires who became instant millionaires when their start-ups hit it big after the IPO, this approach carries no guarantees. The best compensation package is a combination of a salary and stock options that will assure you of a steady income even if your options riches fail to materialize.

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M ISTAKE 8: FAILING TO LEARN WHAT HAPPENS IF YOU LEAVE THE COMPANY Before you jump to another job, beware. You may be forced to leave your options behind—even if they are vested. In 1999, courts in New York and California upheld a provision in IBM’s stock option plan requiring employees to forfeit profits on any options exercised up to six months before going to work for a competitor. Since then, many other employers have been adding similar provisions to their plans. The best protection against the unpleasant surprise of forfeiting your options when you change jobs is to carefully read the options agreement that you may or may not have had to sign when you were granted options. While policy in this area is still being made, it’s generally true that the circumstances of your departure dictate whether and when your options are exercisable. If you are fired, don’t count on anything. All of your options— vested or not—are likely to expire worthless. Also, if you resign, you will probably lose any unvested options, but even vested options may be at risk. If you leave due to disability or death, the rules may be more flexible, but even here, you or your heirs may have just one year to exercise any vested options. Rules in this area are becoming more strict, experts say, because in the current competitive environment, employers need to discourage employees from leaving—or, even worse, leaving and then competing with them. To protect yourself, make sure you are thoroughly aware of current company policy. Then, bear in mind that the provisions may be discretionary. If you are ultimately forced to give up your options, try to get your new employer to make you whole. As penalties grow on the firing end, employers on the hiring end may increasingly be willing to compensate for losses.

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M ISTAKE 9: FAILING TO SET GOALS AND DEVELOP AN OVERALL PLAN Top executives with stock options get financial planning for free. This is because the company brass knows how complicated stock options are and how much clarity professional help can bring to the table. Ordinary employees are often left on their own— meaning that their own financial planning efforts can be haphazard or nonexistent. You need a long-term financial plan, and all planning starts with setting goals. What do you want the money from your stock options to do for you? Is it to pay for the new car you want now, for your child’s college education 10 years down the road, or for the down payment on the new house you want? While long-term ownership of stock has proven most rewarding, any immediate need for cash will override all other considerations. So you need to think through how you will handle your options over time and integrate them into your own overall life plan. Rule 1 is that when you exercise your options, you will need to sell at least enough stock to meet your need for cash. After this, Rule 2 is to develop an orderly plan for selling, rather than simply deciding each year whether to sell, which may generate unnecessary taxes. The worst situation is to put off making a decision and be forced to sell just before the options expire. For detailed guidance, see Chapters 7 and 8, on investing the proceeds of your options and asset allocation. In addition, if you have at least $100,000 in assets, you may want to consult a professional feeonly financial planner to help you sort through these issues.

M ISTAKE 10: COUNTING YOUR OPTIONS BEFORE THEY HATCH Ask employees of San Diego–based Qualcomm about this one. In 1999 Qualcomm was having a banner year, and employees of

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its Network Equipment Manufacturing division thought they were on the way to becoming stock option millionaires. Then, in March, Qualcomm suddenly said it was selling the division to Swedish telecom giant LM Ericsson and transferring all its assets and employees. Employees weeks away from vesting their lucrative options were now faced with the reality that their options would expire worthless. The loss was made more galling by the fact that Qualcomm’s stock rocketed from $43 to over $100 after the deal was announced. Employees filed a class action suit, claiming that Qualcomm had defrauded them and owed them more than $500 million. Qualcomm countered that there was no provision in the plan document that provided for early vesting, meaning that the company was not legally obligated to vest the options. At this writing, the case is still winding its way through the courts. The lesson for you is that when you are granted stock options, you need to clarify through the plan document and discussions with company management what will become of your options in the event of a merger or takeover. Will your options vest immediately? Will the new owner of the division or company be required to make you whole? In the current volatile environment, these questions are so fundamental that no optionaire can afford to be without the answers.

K EY POINTS The 10 most common mistakes made by employees with stock options are the following: 1. Not knowing what you own. 2. Cashing in your options too soon. 3. Keeping too much tied up in company stock. 4. Failing to take blackout and lockup periods into account.

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5. Failing to account for taxes in valuing your options. 6. Forgetting about the alternative minimum tax (AMT). 7. Accepting stock options in place of a salary. 8. Failing to learn what happens if you leave the company or the company merges or is acquired. 9. Failing to set up goals and develop an overall plan for diversifying your assets. 10. Counting your options before they hatch. While learning how to avoid these pitfalls isn’t easy, it can pay off many times over as you strive to get as much as possible out of your own options package.

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How to Negotiate for Stock Options

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s any headhunter will tell you, there is a big difference between wanting a piece of the action and getting it. Even the most talented computer programmer can become docile when it comes to negotiating a pay package. The purpose of this chapter is to tell you how to maximize your own compensation package, no matter where you work or what company or industry you work for. Even after the fall of Nasdaq, the name of the game in negotiating pay packages today is still stock options. Just ask Mark Edwards. As mentioned in Chapter 1, Edwards, founder and CEO of compensation consultant iQuantic, has become a leading advocate of stock options as the centerpiece of pay packages large and small. “The pay paradigm [of stock options] is so compelling that companies in the old economy must transition, or they will die,” he states flatly.1 Edwards says that if you walk into a room full of 167

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CEOs today, to a man (or, increasingly, woman), they would agree that they can’t grow the business without stock options. Edwards believes that in the past, the key to success in the old economy, and particularly on Wall Street, was cash. The best and the brightest went to Wall Street because that’s where the pay was greatest. But in the past five years, “it has become a stock game,” he says. “The gold ring is not cash any more, it is stock options.” If you worked at iQuantic, a professional services firm that is private but likely to go public within two years, you would be offered stock options as a matter of course, whether your job was in the mail room or the corner office. The amount ranges from 2,500 shares to over 200,000, at a grant price of less than $1. As of April 2000, Edwards had given away over 15 percent of the company, and over the next 12 months, he expects to give away an additional 5 to 10 percent. If this sounds overly generous, Edwards would say that this is simply where new-economy companies, including professional services firms like his own, are inevitably heading. In 1998, the median burn rate for publicly traded technology companies was 5.6 percent. The burn rate represents the number of options created in a year divided by the total shares outstanding. So it is, in effect, the percentage of the company that these companies are giving away each year. It compares with a burn rate of 1.5 percent among old-economy companies. So despite recent strides taken by companies in the old economy, Silicon Valley is still 3.4 times more aggressive in its use of stock options than nontechnology companies in the rest of the country. This is why they are attracting the best and brightest workers, and are bound to continue to do so, in the view of Edwards and other compensation experts.

W HERE DOES THIS LEAVE YOU? All of this brings us to the $64 question: Where does this leave you? Does your own pay package land you in the new economy

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or the old? And if you’re with a company whose feet are still firmly planted in the old economy, what can you do about it? You’re not the only one asking the question. As we have seen, an estimated 10 million Americans now have stock options, up from just 1 million seven years ago. According to a new survey from Watson Wyatt Worldwide, a compensation consultant, nearly 19 percent of employees were eligible for stock option grants in 1999, up from 12 percent in 1998.2 As options have migrated down the corporate ladder, they have become something to be negotiated along with salaries, raises, and other kinds of corporate perks. Headhunters themselves—the firms with which you may be dealing during your next job switch—are among the most visible converts. In fact, if and when you get a call from an executive recruiter, he or she may well already be part of the options culture. The New York Times reported recently that Heidrick & Struggles International, which routinely recruits top executives for the country’s largest companies, has decided that it’s time to put its money where its mouth is: In return for placing an executive, Heidrick & Struggles now commonly demands equity equal to onethird of the executive’s stock and options that vest in the first year.3 How lucrative can an arrangement like this be? Consider the case of Robert Zollars. When Heidrick & Struggles found Zollars, a seasoned health care executive, and placed him as chief executive of Neoforma.com, the recruiting firm asked for and received a warrant convertible into 436,623 shares of Neoforma stock at 10 cents a share. During its first day of trading on Nasdaq, Neoforma’s stock tripled to $52.375. As of January 2000, the recruiting firm’s stake was worth $22.8 million. All told, Heidrick & Struggles has taken equity stakes in over 70 companies and has commitments for equity in literally hundreds of companies for which it is conducting searches. Taking a leaf from the book of investment banks, Heidrick & Struggles has even started a venture capital fund to invest in promising start-ups.

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Actions like these on the part of a top recruiting firm send a clear signal: Equity in a company is at least as important as cash when it comes to compensation. They also tell you that you have more clout than you may think when you negotiate your own options package, even if you work for a nontechnology company.

A N EXAMPLE FROM THE OLD ECONOMY Mellon Bank, a Pittsburgh institution that was founded in 1869, is in an industry hardly known for innovation. Banking, in fact, continues to be one of the most hidebound holdouts of the old economy. Despite being acquired by the Dreyfus Corporation in 1994, Mellon is still based in Pittsburgh, the quintessential rust belt city. So what did Mellon do in 1999? It decided to grant stock options to all its employees—not only full-time ones, but also part-time employees worldwide. The program consisted of three separate grants, starting in 1999 and continuing into 2000 and 2001. Each year, full-time employees would get options to purchase 150 shares of stock, while part-time employees would get options to purchase 75 chares. The options could be exercised beginning one year after their grant date, provided that Mellon’s stock had reached or exceeded a target share price for 10 consecutive business days. Why did Mellon feel compelled to do this? At the time, after all, broad-based stock options were still relatively rare in the banking industry. The answer lies buried in a press release on the grant: “The program is structured to reward employees who remain with Mellon,” said Martin G. McGuinn, Mellon’s chairman and chief executive officer. Simply put, Mellon needed to give stock options in order to retain its employees. If this sounds familiar, it’s also the eat-or-be-eaten strategy of new economy start-ups, now being adopted as a survival tactic

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throughout corporate America. So even if you don’t work in Silicon Valley or the technology industry, stock options may soon be part of your pay package. While Mellon’s workers aren’t going to become instant millionaires from their options, their grants could still be worth enough to pay for a major purchase, such as a car.

K NOWLEDGE IS POWER Workers at iQuantic and Mellon get options without asking for them. But in most of corporate America, stock options are still something to be negotiated for, in addition to salary and other corporate perks. And to that end, careful preparation in the form of gaining knowledge is a key factor in bargaining effectively. First and foremost is a clear understanding of how options work. If, at this point, you have not yet read the 10 lessons in Chapters 3 to 12 of this book, now is a good time to do so. Or, if you have, we suggest a quick once-over of the key points at the end of each lesson.

I F YOU ALREADY HAVE OPTIONS If options are already part of your pay package (as they will be if you work for iQuantic or Mellon), and you are thinking of switching to another job, you need to familiarize yourself with the specific options offered by the company you are considering. What is the vesting timetable? What happens if you are terminated, divorced, retire, die, or are disabled? Assuming that you have a good idea of the value of your present options, which your company should have given you, you now need to calculate the value of your possible future options to find out whether you are getting more than you are leaving behind at your old job. Use your feel for the company’s prospects to forecast its annual growth rate. Look up the track record of the

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stock. If the company is private, ask someone to give you the figures. Do as thorough a job as you can of researching this. Help is available on the Web: PeopleScape (www.peoplescape.com) has developed a compensation calculator that allows you to plug in certain data and compare your current pay package to that of the company you are considering joining. The calculator includes stock options. If you have been promised future awards in addition to the initial grant, they also need to be factored in. If the total value is less than what you are leaving on the table, you have the right— indeed, the obligation—to demand a grant that equals or exceeds your present one. Keep this in mind, too: While most companies have a method of calculating how many options employees are eligible for, there may be room for movement. Companies often compensate new employees for the value of non-vested options left at their old job with a signing bonus, or more stock options. If you are moving from a proven company to a start-up, you should also receive a premium for the risk you will be taking. Other things you may be in a position to negotiate include the following: protection that guarantees you a fixed stake in • Dilution the company, regardless of how much stock is issued. • Accelerated vesting, if the present schedule is slow. instead of options. This makes sense if you are • Stock jumping to a company whose stock has been in the doldrums. While falling stock may make options worthless, even low-priced stock has value. of options to family members to decrease estate • Transfer taxes. Remember that you will never be in a better position to maximize your options package than you are now, when the company wants to hire you and is motivated to give you what you want.

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I F YOU DON’T HAVE OPTIONS If you are looking to receive options for the first time, knowledge is once again your most powerful weapon. You need to thoroughly inform yourself about stock options practices not only at the company you may work for but also in the industry of which it is a part. To that end, a recent survey by the National Center for Employee Ownership could prove a valuable bargaining tool. In 1999, the NCEO, in cooperation with TriNet VCO, a human resources research firm, surveyed the stock option granting practices of companies receiving venture capital financing.4 Venture capital–backed companies have been central to the growth of the new economy and were also key to the high level of economic prosperity in the 1990s. They continue to be a cornerstone of growth in the technology industry, and they also tend to lead the way for other companies in terms of pay practices. The NCEO found that nearly all of the companies—some 83 percent—granted stock options to all of their new hires, while 68 percent made annual, ongoing awards determined by an employee’s performance. Another 26 percent made awards on a discretionary schedule, depending on performance and other factors.

V ALUE OF OPTIONS How much were these options worth? A lot. Table 13.1 will prove instructive on this score. For executives with a salary of more than $150,000 a year, the target value of stock options was more than 100 percent of salary, with value defined as the number of options multiplied by the grant or strike price (a very conservative method). At a salary of $111,000 to $150,000 a year, the target value of options was 70 percent of total compensation; at lower levels, the value was commensurately lower. In fact, as Table 13.1 shows, the number and value of options decreased significantly as the salary level moved down.

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98,000 $79,400

Size of ongoing grants Number of options Value of options

Source: National Center for Employee Ownership.

222,272 $308,463

Size of new hire grants Number of options Value of options

>$150

36,944 $32,477

101,504 $110,433

70%

$111–$150

19,137 $14,068

64,236 $53,392

39.75%

$91–$110

10,000 $6,436

33,964 $29,930

29.91%

$71–$90

6,375 $4,398

13,954 $21,504

13.88%

$51–$70

EMPLOYEE ANNUAL SALARY LEVEL (THOUSANDS)

Stock Option Granting Practice

101.25%

13.1

Target percentage of stock options as total value of compensation

Ta b l e

5,218 $2,815

15,292 $5,515

9.3%

$30–$50

1,041 $1,114

1,921 $1,183

6.2%

<$30

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In reality, however, the actual value of the granted options exceeded the target percentage substantially, the study found. For example, the actual value of the awards to new hires varied according to salary as follows: employees making $110,000 to $150,000, the new• For hire option value (the number of shares of stock underlying the option times the grant price) was $110,433. employees making $30,000 to $50,000, the award • For was typically worth $5,515. The most common vesting schedule in the study was fouryear straight vesting, with the same percentage of options becoming exercisable each year. Some 81 percent of the companies in the study had a four-year vesting schedule; 13 percent had a five-year schedule; 3 percent had a three-year schedule; and another 3 percent had some other type. One somewhat surprising finding was the continuing popularity of incentive stock options (ISOs). Despite a move to nonqualified stock options (NSOs) by other types of companies, 42 percent of the venture capital firms surveyed said they granted only ISOs; 35 percent granted both ISOs and NSOs. One reason is that there is intense competition for top talent at these firms, and the preferential tax treatment of ISOs makes them more desirable, despite their restrictions. Now here’s the key, even if you don’t work for a venture capital–backed company: The NCEO found that the options packages were “strikingly similar” in design. This was somewhat surprising, since these emerging companies should be setting trends that others follow. But while that may have been true years ago, the NCEO said that the data show that these options practices are in fact becoming the norm in many sectors, not just among emerging growth firms. So even if you aren’t thinking of joining a Silicon Valley start-up, these results give you an idea of what you have a right to expect.

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Y OU GET WHAT YOU NEGOTIATE Beyond this point, strategy plays a role. Network with people in your industry to find out what the best and brightest are getting. Then set your sights on the maximum, and ask—even better, insist—on that figure. Timing also plays a role. Joining a company before it goes public is better when it comes to stock options, because firms tend to give away options much more freely at the start-up stage. They do this because they are often short of cash and need to use options to attract top talent. The grant price at start-ups is also much lower, on average, than it is after companies go public. This is because the market has not yet put a value on the stock. The ideal time to join a start-up is between 6 and 18 months before the IPO, experts say. At this point, the risk of failure is minimal (though still present), and there’s still a good chance for you to get a fat options package. When you are negotiating, remember that you are not the only person in the firm. So your negotiations should be conducted in the context of what other employees are receiving. They should also be tempered by a commitment to your company and your new colleagues. And remember: Whatever deal you negotiate will become public after the IPO.

A SLICE OF LIFE IN THE EXECUTIVE SUITE Lest it should appear that we are advising you to get greedy, we would like to take you on a tour of the corner office. We’ll start with the suite occupied by the chief executive officer. According to a survey from New York–based Pearl Meyer & Partners, in 1999 the pay of the average CEO grew by 24 percent, to $9.4 million. About half of the total was stock options, meaning that the average CEO got over $4.5 million worth of stock options in 1999.5

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THE PERFECT OPTIONS PACKAGE What are the components of a first-class options package? In general, it should provide the following features: you for any options you may have • Compensate given up at your old job.

• Make a commitment to future options grants. composed of tax-advantaged ISOs rather • Be than NSOs, which are taxed like personal income upon exercise. repricing (i.e., lowering the grant • Guarantee price) if the company’s stock declines. for a speeded-up vesting schedule in • Provide the event of a takeover or your termination. for transfer of the options to family mem• Allow bers to save on estate taxes.

Chief financial officers aren’t faring too badly, either. According to the same survey, total remuneration of CFOs averaged $2.4 million last year. Again, about half came from stock options. The number-one CFO earner, according to CFO magazine,6 is James H. Hance Jr. of Bank of America Corporation, who received a whopping $26.8 million in stock options in 1999. That was over half of the $49 million in long-term incentives that Hance took home, even though Bank of America’s stock lagged behind the overall market in performance. The second most highly paid CFO, John Cecil of Lehman Brothers Holdings, Inc., got a grant worth $10.8 million. That’s

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based on the value of the options at the time they were granted, by the way, not the exercise price—which could produce gains many times higher than this figure. The fat pay packages had the magazine’s editors wondering whether “the options craze is becoming too much of a good thing.” While the CFOs interviewed for the article defended their huge grants on the grounds that they provide an incentive to maximize shareholder value, it’s worth noting that while a rising stock price benefits these executives, they are not really at risk when the price falls. That’s because they can always choose not to exercise the options, allowing them to expire worthless. They still have the rest of their compensation packages to fall back on. Shareholders are not so lucky. They experience actual losses, if they own stock and it declines in value. “This has left some CFOs scratching their heads,” reports CFO writer Ronald Fink.7 But in general, “Everybody’s fine with the trend, as long as the market goes up,” says compensation consultant David Leach of Buck Consultants in New York. Put another way, greed knoweth no bounds in the executive suite. So if you had, or have, any qualms about asking for the moon, remember that the bean counter in the corner office already has it, and the stars as well.

W HAT IF YOU’RE A FREELANCER? Consultants and freelancers who are not on a company’s payroll are increasingly asking for—and getting—stock options in exchange for their services. But there is a significant difference. Regular employees receive options in addition to their salary; outsiders often get options in place of a salary. How much of a problem this can be is illustrated by the case of a public relations consultant in Tampa, who said he was thrilled when a client offered to give him options in place of a salary. For over a year, he swapped his expertise for options, giv-

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ing up a big part of his customary $150-per-hour fee. The problem was that that the company he worked for was not yet public, so he could not exercise his options right away. But he still needed money to live on, which put him in a painful cash squeeze. When he was finally able to exercise his options and sell the stock, he was forced to do so right away, getting a smaller profit than if he had been able to wait. The lesson is that the rules for negotiating for options are different if you are not earning a regular paycheck. First and foremost, you need to know how long it will be before you are able to exercise your options. You need very fast vesting if the options are in place of, rather than in addition to, a paycheck. If the company is not yet public, you need to know how quickly it plans to become public, so your options are not placed in suspended animation for an extended period. Of course, you also want the company to be generous. To that end, you need to know many of the same things that a fulltime staffer would—what options grants the company has already given, and what is normal for the industry. The bottom line: You should aim for the same treatment as a full-time employee. Ask for options in addition to—not in place of—your fee.

C ASE HISTORIES FROM REAL LIFE Whether you’re full time, part time, or a consultant, it always helps to cite actual examples of companies where stock options have worked well for employees and management alike. Here are case histories, from three different industries, of companies with successful, broad-based options programs.

Starbucks: Bean Stock for Everyone Even if you are not a high-tech executive or a CFO with a corner office, there are plenty of reasons to expect stock options to be part of your compensation package as a new hire. There is no

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better example of why this is so than Starbucks, the 30-year-old company with coffee shops and retail stores all over the country. Since the company went public in 1992, its share price has multiplied dramatically. Starbucks began to offer broad-based stock options in 1991, with the unique concept of “bean stock” grants (as in coffee bean). The grant price was $6 a share. When Starbucks went public a year later, at $17 a share, employees were able to realize the value of their options right away. Then, a year later, the stock split, and original investors doubled their shares. The stock split again in 1995, and employees who had held onto their Starbucks stock were rewarded yet again, with another doubling of their shares. Here is the way Starbucks’ program works: All employees are called partners, and all of them, including part-timers, receive a significant benefits package, which includes stock options. Options are available to any partner who is employed from April 1 to the end of the fiscal year, works at least 500 hours during this period (an average of 20 hours per week), and is still employed when options are distributed in January. Partners receive options based on a percentage of their annual wages. The target percent is 10 percent, but because the company has been so profitable, it has been significantly higher in recent years. The grant price of the option is the market price of Starbucks stock on the first day of the fiscal year. There is a five-year vesting schedule. Apparently, the program has been an outstanding success. One partner, Toby Copeland, a district manager for a Starbucks store in San Diego, told this story on the Internet: When I received my first bean stock grant, it really surprised me to receive stock options in my name. I think my first grant was right about the time of a stock split. So I was expecting 150 shares, and all of a sudden, I had 300 shares. When I realized that I had financial security that I could build on over the years I work for Starbucks, it gave me an

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added boost to work harder at my job. I knew that if the company made money because my staff of 350 people stayed focused on our common goals—customer service, and store profitability—that would benefit my pocketbook as well. That’s a hard incentive to ignore.8 Copeland goes on to say that in his view, options are part of the reason why Starbucks has an unusually low turnover rate: “When people actually do move, frequently it’s to relocate from one store to another. College students going home for the summer may move from one Starbucks to another.” What makes the Starbucks program work so well? Communication, first and foremost. Starbucks has a benefit help line that educates employees about exercising stock options and about the value of their options. The line has an 800 number, and is open 24 hours a day. Starbucks also conducts quarterly open discussions with its employees. A member of senior management speaks to partners in each region about various issues, including the company’s financial performance for the quarter. Employees are also told that stock options do carry risk—and that by having a plan with a vesting schedule, employees can actually be protected from selling stock during very volatile periods, and can also be encouraged to think long term. In short, this is a win-win situation for the employer as well as the employee. While you may not be lucky enough to work for a company as enlightened as Starbucks, it’s a first rate example of the way stock options are becoming a routine part of pay packages up and down the corporate ladder.

Merck: Helping Workers to Commit To celebrate its 100-year anniversary in 1991, pharmaceutical giant Merck & Company, based in Whitehouse Station, New Jersey, decided to grant 100 stock options to its 37,000 employees worldwide. The shares subsequently split 3 for 1; then, in 1993,

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Merck again made an option grant of 300 shares to all employees. Since then, most employees have been eligible for grants, with more than 60 percent receiving them recently. Why such a broad-based grant? Merck announced along with the options that its intention was to “promote ownership in the company, encourage long-term thinking, and link long-term rewards to company performance.” The company recently decided to examine the impact of its stock option program and sent out a survey to its employees in 24 countries. The key finding—which was no surprise—was that employees liked the financial reward, which came as Merck’s stock price shot up from $40 per share in 1991 to $153 in 1998. Recently, its stock price was $71. While financial gains are guaranteed to make employees smile, Merck also found that its stock options promoted ownership behavior. Almost all of its employees tracked Merck’s stock price regularly, and 90 percent said that they take a greater interest in the fluctuations in the company’s stock price. Merck employees are also committed to the company: Employees’ reported intention to stay with Merck ranks 20 to 30 percent higher than the norm at other companies.

Kimberly-Clark: Handling a Downdraft with Kid Gloves When consumer products giant Kimberly-Clark merged with Scott Paper in 1997, it was also celebrating its 125th anniversary. To celebrate the landmark, it granted stock options to every employee, with the number dependent on each employee’s salary level. The move was based on a decision to focus on the past and not the future, company executives said. Along with the grant, the firm launched an ambitious program communicating how stock options work and what employees needed to do to maximize their value.

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Alas, good intentions ran smack up against stock market volatility. After the grant, the price of Kimberly-Clark’s stock fell along with that of other consumer products companies. And despite the hard work and commitment of its employees, they watched their options sink. While the jury is still out (the options are not yet exercisable), the company made a decision to step up communications through the downturn, reminding employees that their options don’t expire for years and stressing the need for patience. When several thousand employees left the company after a reorganization, the company also helped to ease the transition by vesting their stock options fully before they left. While time will tell how valuable the options are, Kimberly-Clark has retained the good will of its employees in the meantime. “We don’t go silent when there’s a downturn,” says Tina Barry, the company’s vice president for corporate communication. “If anything, it’s more of an occasion for talking to employees about the stock price.”

K EY POINTS you work for a company in the new economy or • Whether the old economy, stock options are likely to be a key part of your compensation package. is power. Before negotiating, • Knowledge yourself with stock option basics.

familiarize

yourself with what is normal in your industry • Familiarize and at your company in terms of stock option grants. To find this out, network with industry insiders as well as your own colleagues. your sights on the maximum, and ask for it—or, even • Set better, insist.

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you are negotiating, it helps to be able to cite con• When crete examples of companies in your industry, what they are awarding, and to whom. plays a role. It’s better from a stock options • Timing standpoint to work for a company that is not yet public, because such companies tend to grant more stock options at lower prices. The best time to come on board is from 6 to 18 months before the IPO. make demands as if you were the only person in • Don’t the company. Always couch your negotiations in terms of what others are getting—and temper your demands with a commitment to your new colleagues and the company as a whole. are a freelancer, negotiate for options in addition • Ifto,you not in place of, your fee.

C h a p t e r

1 4

Frequently Asked Questions

T

his chapter presents questions and answers on stock option topics in a number of basic areas.

S TOCK OPTION BASICS Q. What is a stock option? A. A stock option is the right, but not the obligation, to buy a fixed number of shares of stock at a specific price for a specific period of time. Q. What is the difference between a stock option and an actual share of stock? A. A share of stock represents an ownership interest in your company. Ownership of a public company is divided into many pieces, or shares, and it entitles the shareholders to vote on various issues. The grant of a stock option repre185

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sents an opportunity for you to become an owner of stock. But you obtain the stock only when you exercise the option and pay for the shares. Q. What is the difference between my stock options and options that are publicly traded? A. Options to buy stock (calls) and options to sell stock (puts) are publicly traded. The options granted to you by your company are not the same thing as these options. In addition, you should be aware that as an employee of your company, you are prohibited by insider-trading policy from engaging in transactions in the publicly traded options of your company. Q. How do I make money on a stock option? A. A stock option represents the opportunity to buy your company’s common stock at the grant or exercise price during a specific period of time. When you exercise an option, you buy a share of stock at the exercise price. The profit from exercising your option equals the difference between the grant price and the market price for the shares of stock underlying the option. Q. Why did my company set up a stock option plan? A. Companies grant options for a variety of reasons. One is as a performance-based incentive. Many firms offer options to give employees a financial stake in the company, giving them an added reason to improve corporate performance and increase the stock price. Companies can also increase their chances of hiring and retaining key employees if these employees are shareholders in the company. Some firms, especially technology companies in Silicon Valley, use stock options as a kind of second currency, to attract employees with special expertise. Options also factor into business succession. Often,

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the best people to continue a business are already employees of the company. By providing stock options to the most promising employees in the years before a business changes hands, a company can increase and assess its key employees’ commitment to the company as owners. This becomes very important when a successful business owner has no family members active in the business to guarantee its survival and growth. Q. Who decides what kind of options I get? A. For senior employees, the board of directors or compensation committee makes nearly all of the decisions regarding allocation and size of grants. At lower levels, the responsibility rests with individuals who have dayto-day contact with employees. Still, for most nonmanagement grants, the decision makers are senior executives. Q. What will I get from the company to show that I have stock options? A. Your stock option is evidenced by an option grant certificate. Among other things, this option grant certificate conveys the following information: number of shares of stock underlying the • The options granted to you. The number of underlying shares represents the total number of shares that you may purchase when your options are vested. your option is a nonqualified stock option • Whether or an incentive stock option. price per share of your options. This is known • The as the grant price or the exercise price. period of time before you can exercise your • The option. This is known as vesting. • The date on which your options expire.

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additional terms or conditions of the option • Any plan under which you were granted options. Q. What are the different types of options? A. Options come in two basic types: nonqualified stock options (NSOs) and incentive stock options (ISOs). NSOs, which are the most common type, are the ones that are usually granted to rank-and-file employees. These options are not tax advantaged. This means that when you exercise them you pay ordinary personal income tax at your tax rate on the difference between the grant price and the market price upon exercise whether you buy and hold or immediately sell the shares. You also pay capital gains tax (either long-term or short-term depending on the holding period) on the profit you make when you sell the stock (the difference between the exercise price and the price at which you sell the stock). ISOs, which are often granted to a company’s top management, are tax advantaged, but they carry restrictions. The tax advantage is that you do not have to pay personal income tax when the options are exercised. However, you still owe capital gains tax when you sell the shares. Restrictions are that no more than $100,000 in ISOs can be granted in any one year, and you must hold onto the stock for the latter of one year from the day of exercise or two years after the grant date. Also, the exercise period may not exceed 10 years. Q. Which type of option is better, an NSO or an ISO? A. The main difference is how much tax the optionaire pays. However, although they come with restrictions, an ISO has one distinct advantage: Employees do not have to pay any tax until the stock is sold. No tax is due when the option is exercised.

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Q. How do I know how much my options are worth? A. The value of your options is the current market price minus the grant price. For example, if the market price is $20, and your grant price is $10, your options would be worth $10 per share ($20 − $10), not counting any related tax you incur. If your company is publicly traded, the stock price will be listed in the paper under the heading of the stock exchange on which it is traded. If you work for a privately held company, check with the legal or human resources department. Privately held companies usually set a value for their shares annually, either by using a formula, hiring an outside appraiser, or asking the board of directors to determine a value. Q. What do I need to know about exercising my options? A. It is entirely at your discretion whether to exercise your options. But your options must be vested before you can exercise them, unless you make an 83(b) election. And you need to know when they expire; expired options are worthless. Q. When is the best time to exercise my options? A. Obviously, in the case of NSOs, the higher the market price, the better. For ISOs, since you may be subject to the AMT, a smaller spread may sometimes be desirable. Other than that, the right time to exercise your options depends on a number of variables. You should review your financial goals. Do you have short- or long-term financial needs? Are you young and able to wait for high gains, or are you nearing retirement and therefore in need of relatively safe investments? This can play an important role in deciding when to exercise. If you have an immediate need to purchase something, such as a house or a car, it is generally better to exercise your options and use the proceeds for the pur-

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chase, rather than borrowing money and repaying the loan plus interest. Q. What is vesting? A. Vesting refers to the amount of time that you need to hold your options before you are able to exercise them. There are four basic types of vesting: (1) straight vesting, (2) cliff vesting, (3) step vesting, and (4) performance vesting. Straight vesting, which is the most common way to vest, is when your options become exercisable by the same percentage each year. For example, with options to buy 3,000 shares and three-year vesting, one-third, or 1,000 options, would become exercisable each year over a three-year period. With cliff vesting, all of your options become exercisable at one time and on one date. For example, if you received options to buy 3,000 shares in 2001, all options would become exercisable in 2004, or after three years. With step vesting, the percentage of options that is exercisable each year varies. For example, if you were granted 3,000 options in 2001, and 10 percent vested in 2002, 30 percent vested in 2003, and 60 percent vested in 2004, that would be step vesting. In the case of performance vesting, the options become vested in the year that the company achieves a particular goal, such as a revenue or share price target. For example, your 3,000 options become vested when your company’s revenues reach $5 billion. Q. What are my tax obligations when I exercise my options? A. With NSOs, your gain, or the difference between the grant price and the market price, is treated like part of your paycheck. As with your paycheck, various taxes, including federal and state income taxes, Social Security, and Medicare, will be withheld. The percentage will

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vary, but the range is usually between 35 and 45 percent. The income will be reported on your W-2 form along with your wages. If you choose to hold onto the stock after you exercise the options, you will also pay capital gains taxes on any increase in the stock price up to and including the day you sell your shares. With ISOs, you pay no tax when you exercise the option. You pay only capital gains taxes when you sell the stock. However, you are required to meet the following restrictions: can exercise a maximum of $100,000 in the first • You year. must hold onto the stock for the latter of at least • You one year after you exercise or two years after the grant date.

• The exercise period cannot be longer than 10 years. Q. Can you give me some concrete examples of how taxes will reduce the proceeds of my nonqualified options? A. Here is an example. Assume you exercise your options and realize an immediate profit of $100,000 on the stock. Assuming that you have a 45 percent combined federal and state tax rate, you will pay $45,000 in taxes, plus the cost of exercise. Let’s suppose that you decide to hold onto the stock, and you sell it one year later at an additional profit of $100,000. This profit is subject to capital gains taxes. The holding period will determine the rate. Q. What about the alternative minimum tax? A. The alternative minimum tax (AMT) is a complicated tax that can be used by the IRS to capture some of the taxes that you would have paid if you had not received taxadvantaged options. Essentially, the AMT requires that after you figure out your taxes, you refigure them by

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adding back some preference items that you would not normally include as taxable income or that you took as deductions. Then you must pay the higher amount. When you sell the stock from your ISOs, the difference between the grant price and the market price is used in figuring the AMT. Other factors that can trigger the AMT include the size of your deductions for state income tax, mortgage interest, and property taxes. If you are in the upper income brackets or have ISOs that are extremely valuable, you may want to consult a tax expert. Q. What alternatives do I have for exercising my options? A. Options can be exercised in four different ways: (1) a cashless exercise, (2) sell to cover, (3) cash purchase and hold, and (4) a stock swap. A cashless exercise may be advisable if you think that the stock price is as high as possible. You then decide to exercise your options and sell the stock immediately. In a cashless exercise, you won’t need any cash up front. A broker will lend you the money, buy the shares, and sell them the same day. Your company may have an arrangement with a broker. You receive cash minus applicable fees and commissions. Here is an example of a cashless exercise: have 1,000 options with a grant price of $10 a • You share. • The stock is selling for $50. broker buys 1,000 shares at $10 a share • Your ($10,000) and sells them at $50 ($50,000). gain is $40 a share, or $40,000, before taxes • Your and brokerage fees. With sell to cover, you also need no cash up front. This might be advisable if you think that the stock will go

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higher, but you don’t want to come up with any cash when you exercise your options. You exercise your options, then sell enough shares to cover the purchase price, plus taxes, fees, and commissions. You are then a shareholder in your company until you sell your shares. For example: have 1,000 options with a grant price of $10 a • You share. • The stock is selling for $50 a share. • You buy 1,000 shares at $10 ($10,000). sell only enough shares to cover the cost of the • You exercise, plus taxes, fees, and commissions, and keep the rest. With cash purchase and hold, you exercise your options and hold onto the stock. This might be advisable if you think that the stock price will go higher, and you want to pay for the shares yourself. In this method of exercise, you come up with the cash to pay for the exercise, then hold onto the stock. If you have nonqualified options, you will owe payroll taxes on the profit you have made. For example: have 1,000 options with a grant price of $10 a • You share. • The stock is selling for $50 a share. • You buy 1,000 shares at $10 ($10,000). own $50,000 worth of stock, minus paytoll taxes • You on $40,000 (your gain). A stock swap is used mainly by management. In this method, you exchange stock you already own for option shares, using the stock you own as currency.

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Q. Do I have to exercise my options if the stock fails to go up? A. No, and it would be unwise to do so. This would create a situation known as an underwater option—that is, an option with a grant price that is below the market price. Since you would make no money, it would be best to let the option expire. Q. But what about repricing? Isn’t this a way to redeem underwater options? A. Yes, but. Repricing is a situation in which the stock goes down, and the company then reissues options at a new lower price. It has become more difficult to reprice recently because of tough new accounting rules, but companies are still doing it to a limited degree. Q. I work for a private company. How does this affect my stock options? A. Your options may be restricted until the company is sold or makes an initial public offering. After the IPO, you may also be prevented from exercising your shares by a lockup agreement. Q. What happens if the company I work for is sold? A. In this situation, unvested or unexercised options may lapse or expire. Or, they may fully vest and become exercisable. A third alternative is that they may transfer to the new company. This is a fluid situation in which the courts are increasingly becoming involved. Q. Can I sell or otherwise transfer my options? A. Generally, your stock options are personal to you, although in some cases, a company may allow transfers. If the company does not, then you alone may exercise your stock options. You can, however, transfer shares of stock after you exercise your options and purchase the actual shares of stock.

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Q. What happens to my options in the event of a stock split? A. If your company splits its stock, options outstanding are adjusted accordingly. For example, if you hold options on 100 shares of stock at a grant price of $10, and the company splits 2 for 1, then you would hold options on 200 shares of stock, each with an exercise price of $5. Q. Do I have to be concerned about insider trading? A. Yes. As the use of options continues to increase, the Securities and Exchange Commission (SEC) is increasing its surveillance of the markets for signs of insider trading. A trade is considered illegal when someone buys or sells securities while having material information not available to the public. Q. What is a reload grant? A. A so-called reload grant is used to provide employees with continuing options grants while they are employees of the company. Typically, the grant will provide that, upon exercise of a stock-swap option, the optionaire will receive an additional option for the same number of shares as was purchased under the original option. Such a reload option is usually priced at the fair market value of the stock on the date of its grant. Other terms, such as vesting and the term of the grant, may be the same as for the original grant, or they may be on a shorter-term basis. Reload grants are subject to the same taxes and securities rules as ordinary NSOs and ISOs. Q. What are shadow option plans? A. Sometimes, fast-growing companies that need to grant options in a hurry attempt to get around the regulations by adopting options plans without shareholder approval. Such plans strive to carefully select plan terms and participants to get around legal requirements for such approval.

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Q. What is overhang, and how does it work? A. Options overhang is the number of outstanding options as a percentage of total shares outstanding. For example, if employees hold 1,000 unexercised shares, and the company has issued a total of 10,000 shares, the options overhang would be 10 percent. In a large company, these outstanding options can add up to a very significant amount. In 1999, for example, Microsoft had roughly $60 billion in outstanding employee stock options. While an overhang can be normal, it can also become a risk if the company offers too many options, or too many employees cash in their options at one time. This is because the total number of outstanding shares increases when employees exercise their options, which dilutes the stake of existing shareholders, because optionaires are buying their shares at a discount, as opposed to full market value. This can cause earnings per share to decline.

W HAT TO DO WITH THE PROCEEDS Q. How do options fit into my overall financial picture? A. If you have stock options, you need to consider how they fit into your overall financial picture. For example, you may have a 401(k) plan which contains company stock. You may also have money invested in an employee stock ownership plan (ESOP). When you exercise stock options, you may find yourself too heavily invested in the stock of a single company, the one you work for. Studies show that lack of diversification is a mistake that optionaires often make when they decide to hold onto company stock. It’s dangerous to put all of your eggs into one basket.

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Q. What should I do with the proceeds of my options? A. If you have decided to sell the stock after you exercise your options, you will have another decision to make— what to do with the proceeds. If you have a large purchase in mind, such as a house or a car, it is probably a better idea to use the proceeds for this purpose, rather than borrowing money that must be paid back with interest. If you plan to invest the money for retirement, your childrens’ college education, or some other goal, review your asset allocation. Consider how long it will be before you need the money and your own risk tolerance, plus any short-term needs that must be met, such as an upcoming wedding. Q. What is asset allocation, and how do I do it? A. Asset allocation is a way to spread the risk of investing by dividing investments among different categories, instead of a single investment like stock in your company. Allocating assets across a selection of mutual funds, ranking from conservative bond funds to aggressive stock funds, can be an effective way to build an investment portfolio. This is because returns on these investments tend to behave differently, so that when one category is down—for example, if stocks take a hit— bonds may do better. The benefit of allocation is diversification. By spreading your assets across different investments, you can reduce the volatility associated with any single investment. Q. What are the different investments from which I can choose, and how does each fit into my asset allocation program? A. Stocks, bonds, and cash equivalents are not only the building blocks of any asset allocation program, they are also the building blocks of mutual funds. Mutual funds, which have grown enormously in popularity thanks to

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401(k) programs, are portfolios of stocks and bonds that sell shares to investors. There are also money market mutual funds, which are treated like cash equivalents. Stocks represent ownership in a company. Although stock prices can change dramatically, stocks hold the potential for appreciation and dividends as the company that issues the stock grows. Bonds represent the debt of a company or a government agency. They tend to have predictable streams of income, and are therefore more conservative than stocks. There is the potential for growth, however. Cash equivalents consist of short-term, high-quality debt of companies or government agencies. They tend to be extremely stable, which is offset by the fact that returns are lower than they are for bonds or stocks. Q. Why are mutual funds a good way to invest? A. Mutual funds offer a number of advantages over picking stocks, bonds and cash equivalents yourself: are professionally managed. It can be a • They daunting task to choose the right stock or bond. Mutual funds contain a collection of stocks, bonds, or both that are chosen by an investment professional. are low in cost. It can be very expensive to • They pick stocks and bonds yourself. selection of high-quality funds is available. • AThebroadcountry’s biggest fund families, including Fidelity, Vanguard, and T. Rowe Price, offer mutual funds at low cost in virtually every investment category. Q. How do I know what asset allocation is right for me? A. The precise mix of stocks, bonds, and cash equivalents that suits you depends on a number of factors, such as your age, risk tolerance, and comfort level. Consult

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Chapter 8 for detailed guidance on charting the mix of assets that is right for you.

B ASIC FINANCIAL QUESTIONS Q. What exactly is stock? A. Stock is a form of currency that companies use to represent on paper how much a company is worth. When you own stock in a company, the number of shares that you own represents a percentage of the total value of the company. For example, if your firm issues 10,000 shares of stock and you own 1,000 shares, you own 10 percent of the company. You can sell the shares of stock that you own to other people. Or, the company can buy them back and retire them, giving the remaining owners a higher percentage of ownership. The board can also issue new shares and sell them to investors or give them away as incentives in the form of stock options. However, when new shares are issued, each existing shareholder therefore owns a smaller percentage of the company. In return, the company has more money and, hopefully, more motivated employees. Q. What are dividends? A. Each shareholder has a claim on some part of the company. Some companies choose to pay part of this claim in the form of dividends, which are regular payments to shareholders that may go up or down based on profits. The more that is paid out in dividends, the less profit there is for the company to retain and plow back into the firm. Q. How is the price of a stock determined? A. Stock is worth what willing buyers pay willing sellers. How this is determined depends on whether the com-

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pany is public or private. Publicly traded companies are companies whose stock is traded on a stock exchange. In the United States, there are three main exchanges, the New York Stock Exchange, the American Stock Exchange, and the Nasdaq. People buy and sell the shares every day, setting a price based on supply and demand. If many people think that the company’s prospects are good, the price increases. If not, it goes down. In a privately held company, the shares are held by a small number of people, and they cannot be freely traded. Such shares are frequently not priced at all until someone wants to sell them, at which point they are worth whatever someone wants to pay. In companies owned by employees, the stock price is often set by an outside appraiser or by a formula. Either approach strives to approximate what a willing buyer would pay a willing seller. Q. What is an initial public offering? A. If a company is private, the stock is not bought or sold on a public exchange. The owners of the company decide whether they want to sell stock, and to whom. The value of the business is determined by a specialist. If the company is growing rapidly, and needs cash to expand, it may decide to go public through an initial public offering (IPO). To do this, the company needs to do the following: with the Securities and Exchange Commis• Register sion (SEC). The SEC is a federal government agency that regulates public companies in a way that protects shareholders from fraud and abuse. Each state also has its own SEC regulations. to be listed on a stock exchange. Each of • Apply the main stock exchanges—the New York Stock

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Exchange, the American Stock Exchange, and the Nasdaq—has its own rules. While a few companies are traded outside of the exchanges (the so-called pink sheets), their number is not significant. annual and quarterly reports, and disclose de• File tailed information to shareholders and the SEC about its operations, including the names of the officers and their pay. When a company decides to make an IPO, it hires one or more brokerage firms to find buyers for its shares. These buyers may purchase shares from employees who already own them, or they may purchase newly issued shares. When new shares are issued and bought, it brings in additional cash to the company. However, the issuance of new shares also reduces the shares of ownership held by the pre-IPO owners. Q. How does going public affect the owners of stock options? A. If you work for a private company that grants stock options, going public creates a market so that you can exercise your stock options. The most famous example is probably Microsoft: Founder Bill Gates has said that the main reason he took the company public was to allow Microsoft employees to exercise their options. Some IPOs succeed famously, such as those of Microsoft and Netscape. In these cases, more people want to buy stock than there are shares to buy, and scarcity drives the price up. However, an IPO can also fail. If there is not enough interest, the price can fall dramatically, or the IPO can be withdrawn. Once a company goes public, the stock becomes easier to sell. This makes the shares worth more than they were when the company was private, since the stock of private companies can be sold only under certain conditions. Going public also makes it easier to borrow money.

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Q. Why, then, would a company want to stay private? A. The owners may not want any pressure from shareholders, who tend to be more concerned with the short term than the long term. They may also feel that going public would not necessarily attract enough interest. Or, they may feel that the process is simply too expensive and complicated. If you are an optionaire, the chances are that your company is already public, or plans to go public in the not-too-distant future. Q. What is the difference between common stock and preferred stock? A. Companies can sell different kinds of shares. Common stock is used simply to sell shares in the company. Preferred stock is used to attract investors who are in a position to wait longer for their investment to pay off. Preferred stock is different from common stock in two ways: It pays a bigger dividend, and in the event that the company goes bankrupt, the holders of preferred stock get paid before the owners of common stock. Preferred stock normally costs more to buy and, in most cases, does not carry voting rights. Also, because it pays a higher dividend, it tends not to increase in value as quickly as common stock. This is because owners of preferred stock are getting more of their money as dividends, so they get less of the potential growth of the company in the form of appreciation. On the other hand, if the value of the company goes down, preferred stock will not decline as much because it is tied less to the company’s intrinsic value and more to profits. Q. Which type of stock is better, common or preferred? A. One kind is not necessarily better than the other. Preferred stock carries less risk and pays a larger dividend. Common stock costs less to buy and can grow more rap-

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idly in value. Either type can be a good investment if the company continues to grow. Q. What is a stock split, and how does it affect stock options? A. When share prices get high (typically, over $50 a share), companies often split the shares to bring the price down. This has no real effect on the value of the stock and no real effect on options. But it does have the psychological effect of making the stock seem cheaper, which appeals to some investors. In a 2-for-1 stock split, every share worth, say, $50, will be split into two shares worth $25. The total value of the shares has not changed, only the number. If you have stock options and the stock splits, your options split also. For example, if you have options on 100 shares at $50, and there is a 2-for-1 split, you now have options on 200 shares at $25 a share. Q. Why is the stock market so volatile? A. It’s true that the stock market has become more volatile, by historical standards. During the 30-year history of the Nasdaq stock exchange, for example, there were 26 days during which the Nasdaq closed with a gain or a loss of at least 5 percent. Half of them occurred during the first five months of 2000. In the long run, stocks will move up or down based on the performance of the company. But in the short run, they can be influenced by things like day trading and news events. Political anxiety, fear of a war, computerdriven trading programs—all these can have an effect on the market. Changes in interest rates can also have a large impact on the stock market. Q. Why is the impact of interest rates so important? A. Interest rates can be defined as how much borrowers have to pay when they borrow. When inflation is high,

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lenders charge a higher interest rate because the money they receive as a repayment for the loan will be worth less when it is paid back. When interest rates go up, businesses tend to think more carefully about borrowing money to expand, and consumers also tend to hold back on borrowing for things like a new car or a new house. As a result, companies tend to make less money, which shows up in the bottom line in the form of lower profits. Lower profits result in lower stock prices. There’s another reason that high interest rates negatively affect the market. As rates go up, so do the interest rates paid by bonds and cash alternatives like money market funds and certificates of deposit. This makes them relatively more attractive than stocks. Q. So why, then, would the Federal Reserve raise interest rates? A. High interest rates tend to slow economic growth. So if the Fed thinks that inflation is getting out of hand, it may decide to raise rates to slow the economy, which in turn should make prices (i.e., inflation) go down. Such moves are highly controversial, and have become even more so in the wake of the gap that has opened up between the new economy and the old economy. Some experts argue that the Fed is applying rules that worked for the old economy to the new economy, which operates according to different principles.

Y OUR PERSONAL FINANCES Q. How does stock volatility affect me? A. Volatility needs to be taken into account not only in the way you manage your stock options but also in the way you manage your portfolio. Because stocks are among the most unstable investments, they should be balanced

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by those that are most stable—bonds and money market funds, for example. The exact proportion that you should own will vary; the total mix is what makes up your portfolio. Q. How does this volatility affect me if I own stock options? A. Because stocks are volatile—including the stock of the company you work for—it is highly risky to have most of your assets tied up in your company. Moreover, recent surveys show that many employees with stock options don’t understand that their financial security could be needlessly at risk. It is not unusual for optionaires to have 90 percent or more of their investable assets tied up in the one investment they know best: their company. Your personal finances are comprised of two things: your current income stream (your paycheck) and your assets (savings, stocks, bonds, house, car, etc.). Should your income dry up, perhaps due to a job loss, you may have to rely on your assets to get you through the transitional period. If these assets are tied up in company stock, and something happens to the company, you could lose not only your income but your assets as well. Q. So, what is the proper mix of investments? A. This will vary, depending on your time horizon, investing goals, tolerance for risk, and experience. One highly experienced advisor has three different investment mixes for his clients, based on these variables. They range from a maximum-risk portfolio that is 85 percent long-term stocks and 15 percent international equities to a conservative mix that is 55 percent long-term equities, 10 percent international equities, and 35 percent bonds. In between, for the medium-risk investor, is a mix of 65 percent long-term equities, 15 percent international equities, and 20 percent bonds.

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Q. What role should mutual funds play in this? A. Many experts recommend that all of a client’s investments outside of company stock be in mutual funds. They believe that mutual funds offer the best vehicle available for diversification combined with high performance. Mutual funds themselves are pools of money that professional managers use to buy a variety of stocks, bonds, and money market instruments. There are currently over 8,000 funds to choose from, and the number grows bigger by the day. Mutual funds are liquid investments, which can be sold without difficulty at any time. Q. How do I know if I need a financial planner to help me allocate my assets and manage my money? A. Financial planning used to be reserved for the very wealthy. But increasingly, as more investors accumulate significant assets as a result of the long bull market, financial planning is available to ordinary, nonmanagement employees. Many institutions are now offering low-cost financial planning to investors with at least $100,000 of investable assets—which some experts say is about the minimum you should have to justify the services of a financial planner. Q. What can a financial planner do for me? A. According to the Financial Planning Association in Atlanta, Georgia, a financial planner can help you do the following:

• Set realistic financial and personal goals. your current financial health by examining • Assess your assets, liabilities, income, insurance, taxes, investments, and estate plan.

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a realistic, comprehensive plan to meet • Develop your financial goals by addressing financial weaknesses and building on financial strengths.

• Put your plan into action and monitor its progress. on track to meet changing goals and personal • Stay circumstances and different stages of your life. Q. How much do financial planners charge? A. The good news is that many institutions that used to specialize mainly in helping the very rich now offer privately managed accounts that include some financial planning services for a modest fee. Among these are MFS Investment Management, H. D. Vest, Inc., Oppenheimer Funds, Inc. and discount brokerage giant Charles Schwab. Fees run about 1.75 percent of total assets under management, or not much more than the average expense ratio for an equity mutual fund. Q. How can I find a financial planner? A. In addition to the institutions that offer financial planning, there are many financial planners in private practice. A good way to start is by seeking referrals from friends or business colleagues who have used a financial planner. Lawyers, accountants, insurance agents, bankers, and other financial specialists are also good sources, because they frequently work with financial planners. The Financial Planning Association (formerly the International Association for Financial Planning), a trade association based in Atlanta, Georgia, is another source. You can visit its Web site at www.fpanet.org. When you have chosen a planner, you may want to check with your local Better Business Bureau or the CFP Board at 888-CFP-MARK to make sure no complaints have been filed against the planner you are considering.

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Q. How does estate planning come into play with stock options? A. Many stock options do not pass to your heirs under the terms of your will. In addition, some plans have separate beneficiary forms that you must sign in the event of death before vesting. They may not correlate with your will and estate plan. You also need to consider the lifetime transfer of stock options. More companies are amending their stock option plans to allow some employees to transfer options to their children or to trusts or partnerships for their children. A financial planner can help you factor these issues into your estate planning.

A p p e n d i x

a

Risk Tolerance Questionnaire

P

lease answer all the questions by circling one of the options. Choose the option that best indicates how you feel about each question. If none of the options is exactly right for you, choose the option that is closest. 1. Compared to others, how do you rate your willingness to take financial risks? 1. Extremely low risk taker. 2. Very low risk taker. 3. Low risk taker. 4. Average risk taker. 5. High risk taker. 6. Very high risk taker. 7. Extremely high risk taker.

Risk Tolerance Questionnaire from ProQuest.

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2. How easily do you adapt when things go wrong financially? 1. Very uneasily. 2. Somewhat uneasily. 3. Somewhat easily. 4. Very easily. 3. When you think of the word risk in a financial context, which of the following words come to mind first? 1. Danger. 2. Uncertainty. 3. Opportunity. 4. Thrill. 4. Have you ever invested a large sum in a risky investment mainly for the thrill of seeing whether it went up or down in value? 1. No. 2. Yes, very rarely. 3. Yes, somewhat rarely. 4. Yes, somewhat frequently. 5. Yes, very frequently. 5. If you had to choose between more job security with a small pay rise and less job security with a big pay rise, which would you pick? 1. Definitely more job security with a small pay rise. 2. Probably more job security with a small pay rise. 3. Not sure. 4. Probably less job security with a big pay rise. 5. Definitely less job security with a big pay rise. 6. When faced with a major financial decision, are you more concerned about the possible losses or the possible gains? 1. Always the possible losses. 2. Usually the possible losses. 3. Usually the possible gains. 4. Always the possible gains.

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7. How do you usually feel about your major financial decisions after you make them? 1. Very pessimistic. 2. Somewhat pessimistic. 3. Somewhat optimistic. 5. Very optimistic. 8. Imagine you were in a job where you could choose to be paid salary, commission, or a mix of both. Which would you pick? 1. All salary. 2. Mainly salary. 3. Equal mix of salary and commission. 4. Mainly commission. 5. All commission. 9. What degree of risk have you taken with your financial decisions in the past? 1. Very small. 2. Small. 3. Medium. 4. Large. 5. Very large. 10. What degree of risk are you currently prepared to take with your financial decisions? 1. Very small. 2. Small. 3. Medium. 4. Large. 5. Very large. 11. Have you ever borrowed money to make an investment (other than for your home)? 1. No. 2. Yes. 12. How much confidence do you have in your ability to make good financial decisions? 1. None.

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2. A little. 3. A reasonable amount. 4. A great deal. 5. Complete. 13. Suppose that five years ago you bought shares in a highly regarded company. That same year the company experienced a severe decline in sales due to poor management. The price of the shares dropped drastically and you sold at a substantial loss. The company has been restructured under new management and most experts now expect its shares to produce better than average returns. Given your bad past experience with this company would you buy shares now? 1. Definitely not. 2. Probably not. 3. Not sure. 4. Probably. 5. Definitely. 14. Investments can go up and down in value and experts often say you should be prepared to weather a downturn. By how much could the total value of all your investments go down before you would begin to feel uncomfortable? 1. Any fall in value would make me feel uncomfortable. 2. 10 percent. 3. 20 percent. 4. 33 percent. 5. 50 percent. 6. More than 50 percent. 15. Assume that a long-lost relative dies and leaves you a house which is in a poor condition but it is located in a suburb that’s becoming popular. As is, the house would probably sell for $150,000, but if you were to spend

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about $50,000 on renovations, the selling price would be around $300,000. However, there’s some talk of constructing a major highway next to the house, and this would lower its value considerably. Which of the following options would you take? 1. Sell it as is. 2. Keep it as is, but rent it out. 3. Take out a $50,000 mortgage and do the renovations. 16. Most investment portfolios have a spread of investments—some of the investments may have high expected returns but with high risk, some may have medium expected returns and medium risk, and some may be low risk/low return. (For example, shares and property would be high risk/high return, whereas cash and term deposits would be low risk/low return.) Which spread of investments do you find most appealing? Would you prefer all low risk/low return, all high risk/high return, or somewhere in between?

SPREAD OF INVESTMENTS IN PORTFOLIO PORTFOLIO

HIGH RISK /RETURN

MEDIUM RISK /RETURN 0%

LOW RISK /RETURN

1

0%

100%

2

0

30

70

3

10

40

50

4

30

40

30

5

50

40

10

6

70

30

0

7

100

0

0

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17. You are considering placing one-quarter of your investment funds into a single investment. This investment is expected to earn about twice the term deposit rate. However, unlike a term deposit, this investment is not protected against loss of the money invested. How low would the chance of a loss have to be for you to make the investment? 1. Zero (i.e., no chance of any loss). 2. Very low chance of loss. 3. Moderately low chance of loss. 4. 50 percent chance of loss. 18. With some types of investment, such as cash and term deposits, the money value of the investment is fixed. However, inflation will cause the purchasing power of this money value to decrease. With other types of investment, such as shares and property, the money value is not fixed. It will vary. In the short term it may even fall below the purchase price. However, over the long term, the money value of shares and property should certainly increase by more than the rate of inflation. With this in mind, which is more important to you, that the money value of your investments does not fall or that it retains its purchasing power? 1. Much more important that the money value does not fall. 2. Somewhat more that the money value does not fall. 3. Somewhat more that the money value retains its purchasing power. 4. Much more important the money value retains its purchasing power. 19. In recent years, how have your personal investments changed? 1. Always toward lower risk. 2. Mostly toward lower risk.

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3. No changes or changes with no clear direction. 4. Mostly toward higher risk. 5. Always toward higher risk. 20. When making an investment, return and risk usually go hand in hand. Investments which produce above average returns are usually of above average risk. With this in mind, how much of the funds you have available to invest would you be willing to place in investments where both returns and risks are expected to be above average? 1. None. 2. 10 percent. 3. 20 percent. 4. 30 percent. 5. 40 percent. 6. 50 percent. 7. 60 percent. 8. 70 percent. 9. 80 percent. 10. 90 percent. 11. 100 percent. 21. Think of the average rate of return you would expect to earn on an investment portfolio over the next 10 years. How does this compare with what you think you would earn if you invested the money in term deposits? 1. About the same rate as from term deposits. 2. About one and a half times the rate from term deposits. 3. About twice the rate from term deposits. 4. About two and a half times the rate from term deposits. 5. About three times the rate from term deposits. 6. More than three times the rate from term deposits. 22. People often arrange their financial affairs so as to qualify for a government benefit or to obtain a tax advan-

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tage. However, a change in legislation can leave them worse off than if they’d done nothing. With this in mind, would you take a risk in arranging your affairs to qualify for a government benefit or obtain a tax advantage? 1. I would not take a risk if there was any chance I could finish up worse off. 2. I would take a risk if there was only a small chance I could finish up worse off. 3. I would take a risk as long as there was more than a 50 percent chance that I would finish up better off. 23. Imagine that you are borrowing a large sum of money at some time in the future. It’s not clear which way interest rates are going to move—they might go up, they might go down, no one seems to know. You can have a variable interest rate that will rise and fall as the market rate changes, a fixed interest rate which is 1 percent more than the then variable rate but which won’t change as the market rate changes, or a mixture of both. How would you prefer your loan to be made up? 1. 100 percent variable. 2. 75 percent variable, 25 percent fixed. 3. 50 percent variable, 50 percent fixed. 4. 25 percent variable, 75 percent fixed. 5. 100 percent fixed. 24. Insurance can cover a wide variety of life’s major risks—theft, fire, accident, illness, death, and so on. How much cover do you have? 1. Very little. 2. Some. 3. Considerable. 4. Complete.

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S CORING This questionnaire is scored on a scale of 0 to 100. In practice, however, the scores range from around 20 to around 80, with the average being 50. When the scores are graphed they follow the familiar bellshaped curve of the normal distribution (see following). About two-thirds of all scores are within 10 points of the average.

0 10 Risk Avoiding

20

30

40

50

60

70

What do you think your score will be?

80

90

100 Risk Seeking

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H OW DO YOU RATE? 60 Points and Over: Risk Taker/Acceptor The closer you are to 100 points, the more adventuresome an investor you are. You need to be careful to avoid the trap of thinking that more risk automatically means a higher return.

40 to 60 Points: Risk Minimizer/Middle of the Road You are willing to take calculated risks with your investments and realize the need for diversity.

Below 40 Points: Risk Avoider/Conservative You are conservative in your investment philosophy. If you don’t develop some tolerance for investment risk, your biggest risk will be inflation.

A p p e n d i x

b

Selected Stock Option–Related Web Sites

H

ere are select Web sites that offer information on stock options:

Financial Planning Association (FPA)—www.fpanet.org. A trade group for financial planners (formerly the International Association for Financial Planning). Has done studies on stock options and financial planning. iQuantic—www.iquantic.com. Compensation consultants who advise companies on stock option plans.

My Stock Options—www.mystockoptions.com. Help managing stock options. Free, but to use you need to register and provide personal financial information. National Association of Stock Plan Professionals— www.naspp.com. Association of employees who manage stock option plans.

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National Center for Employee Ownership (NCEO)— www.nceo.org. A nonprofit organization dedicated to researching and promoting broad-based stock options. Extensive research is available free on the Web site. National Commission on Entrepreneurship—www.ncoe .org. A Washington-based lobby for entrepreneurs. Strongly pro-options. PeopleScape—www.peoplescape.com. Features a compensation calculator that allows you to plug in data and compare your current pay package to that of a company you are considering joining. The calculator includes stock options. Stock Options Central—www.stockoptionscentral.com. Help valuing and managing stock options. Free, but you must register and provide personal financial information. Watson Wyatt Worldwide—www.watsonwyatt.com. Compensation consultants who advise companies on stock option plans. Surveys are available on the Web site. Westward Pay Strategies—www.westwardpay.com. Compensation consultants who advise companies about stock options. Some stock option studies are available on the Web site.

Notes

P REFACE 1. Survey on stock option ownership conducted by Oppenheimer Funds, Inc., New York, August 2000.

C HAPTER 1 1. Patrick von Bargen, executive director, National Center for Employee Ownership, interviewed for this book. 2. Brian J. Hall, “What You Need to Know about Stock Options,” Harvard Business Review, March–April 2000, p. 122. 3. Adam Bryant, Newsweek, July 5, 1999. 4. Mark H. Edwards, “Stock Options and the New Economy: You Can’t Have One Without the Other,” Directorship, June 2000, p. 12. 221

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5. Graef Crystal, compensation consultant, interviewed for this book.

C HAPTER 2 1. Graef Crystal, San Francisco Business Times, May 28–June 3, 1999, Executive Compensation section. 2. Crystal. 3. Graef Crystal, “Intel CEO Made $95 Million the Hard Way,” Cincinnati Business Courier, May 12, 1997, p. 25. 4. Steve Ernst, “Options Put the Pop in Exec’s Pay,” Puget Sound Business Journal, July 23, 1999, p. 1. 5. David Leonhardt, “In the Options Age, Rising Pay (and Risk),” New York Times, April 2, 2000, Money & Business section, p. 1. 6. Leonhardt. 7. Leonhardt.

C HAPTER 4 1. Kevin J. Delaney and David Wessel, Wall Street Journal, December 21, 1999.

C HAPTER 5 1. “Stock Compensation in the High-Tech Sector,” survey by Westward Pay Strategies, San Francisco, 1997. 2. Mark H. Edwards, “Stock Options and the New Economy: You Can’t Have One Without the Other,” Directorship, June 2000.

C HAPTER 8 1. “IAFP Survey of Financial Advisors,” International Association for Financial Planning, Atlanta, GA, December 1998.

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Survey results based on 250 telephone interviews. (The IAFP has since become the Financial Planning Association.) 2. Robert Markman, president of Markman Capital Management, interviewed for this book. 3. David Olivieri, MFS Fund Distributors, interviewed for this book. 4. Jennifer Sexton, Oppenheimer Funds, interviewed for this book.

C HAPTER 9 1. “NASPP/PricewaterhouseCoopers 1998 Stock Plan Design and Administration Survey,” PricewaterhouseCoopers, New York, 1999, Highlights, p. 4. 2. Elise Ackerman, “Optionaires, Beware!” U.S. News and World Report, March 6, 2000, p. 36. 3. Charles Pillar, “Dot-com Workers Watch Net Gains Fade,” Los Angeles Times, April 16, 2000, p. 1. 4. “Tapping Into Stock Option Wealth,” study by Oppenheimer Funds, Inc., New York, September 1999, p. 4. 5. Timothy Schellhardt, “Anatomy of an Unusual StockOption Windfall,” Wall Street Journal, June 2, 1999, p. B1. 6. Gretchen Morgenson, “Hidden Cost of Stock Options May Soon Come Back to Haunt,” New York Times, June 13, 2000, p. 1. 7. Ira Kay, study of 900 companies conducted for Watson Wyatt Worldwide, 1999. 8. “The Final Option,” The Economist, May 13, 2000, p. 78.

C HAPTER 10 1. Patrick von Bargen, executive director, National Center for Employee Ownership, interviewed for this book. 2. “Get Rich Quick,” Time, May 8, 2000, p. B7.

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C HAPTER 11 1. Lori Lucas, Hewitt Associates, LLC, Minneapolis, MN, interviewed for this book. 2. “Company Stock in OC Plans,” survey by the Institute of Management and Administration, New York, December 1999.

C HAPTER 13 1. Mark H. Edwards, founder and CEO of iQuantic, interviewed for this book. 2. “Survey of Top Management Compensation,” Watson Wyatt Worldwide, Bethesda, MD, 2000. 3. Patrick McGeehan, “New Economics of Recruiting Top Executives,” New York Times, January 25, 2000, Business Day section, p. 1. 4. Siobhan Hurley, “TriNet/NCEO Survey,” Appendix B in Current Practices in Stock Option Plan Design, National Center for Employee Ownership, 1999. 5. “Executive Compensation,” survey by Pearl Meyer & Partners, New York, 1999. 6. Ronald Fink, “Taking Stock: The 2000 Compensation Survey,” CFO, June 2000. 7. Fink. 8. Toby Copeland, www.fed.org/onlinemag/april97/starb .html.

Glossary

active investing A type of management strategy in which the portfolio manager picks what he or she believes are the right investments at the right time. It involves active trading of securities and is built on the belief that it is possible to produce returns in excess of the market averages by buying and selling the right mix of securities. Active investing is the opposite of passive investing, which uses an index rather than active trading as a management strategy. Costs are usually higher than with passive investing. adjusted gross income (AGI) A step in arriving at how much of your income is subject to federal income tax. The AGI consists of your gross income from taxable sources, minus certain items, such as contributions to an Individual Retirement Account. Your AGI minus deductions and personal exemptions equals your taxable income.

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alternative minimum tax (AMT) A separate tax that can be used by the Internal Revenue Service to capture some of the taxes that optionaires with tax-advantaged options, or ISOs, would have paid without the options. American Depositary Receipts (ADRs) ADRs are used as a stand-in for the shares of a foreign company to facilitate trading in the United States. The shares themselves remain in the custody of a third party, usually a bank. ADRs allow Americans to invest directly in a foreign company, while avoiding currency conversions, high fees, and other obstacles to investing abroad. American Stock Exchange (AMEX) One of the three major stock exchanges, on which the securities of small- to medium-sized companies are traded. Because the listing requirements of the AMEX are less strict than those of the New York Stock Exchange, it generally trades the securities of smaller companies. annuity A series of regular payments guaranteed to continue for a specific time, usually the lifetime of the annuity holder, in exchange for a single payment or series of payments to the company, which is often an insurance company. Annuities offer the advantage of tax-deferred compounding; the downside is that they often have high fees, especially early surrender fees. asset allocation An investment strategy that involves diversifying assets. It involves determining the right mix of stocks, bonds, and cash to maximize performance under different economic conditions, while minimizing risk. balanced funds Mutual funds that invest in a combination of stocks and bonds. A typical mix is 60 percent stocks and 40 percent bonds. These lower-risk funds are often recommended for retirees and investors who want to minimize risk. balance sheet A list of assets, liabilities, and net worth as of a certain date. Net worth is arrived at by subtracting total liabilities from total assets.

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227

basis point One one-hundredth of a percent (0.01 percent). Often used when talking about interest rates or yields; a move of 100 basis points equals 1 percentage point. blackout period A period during which the securities of a corporation cannot be traded by certain individuals, typically those who work for the corporation. The period usually runs from a predetermined time following the release of a quarterly or annual report to between two and four days after the release of the next period’s financial results. Black-Scholes options-pricing model A mathematical formula used for valuing stock options. It considers factors that include the volatility of the stock, the risk-free interest rate, the dividend rate, the relation of the grant price to the stock price, and the life of the option. It was developed by Fisher Black and Myron Scholes. blue-chip stock A term coined for stock issued by a wellknown, highly respected company with a track record of earnings and dividend payments. Such stock is usually widely held by investors and tends to be less volatile than the stock of smaller, unproven companies. The term blue chip comes from poker, in which the blue chip has the highest value. blue-sky laws State laws that regulate the offer and sale of securities within a state’s jurisdiction. They are designed to prevent fraud in connection with such offers and sales, and vary from state to state. The term blue sky comes from a federal case that described these laws as being aimed against “speculative schemes which hold no more basis than so many feet of blue sky.” bond An interest-bearing security that obligates the issuer to pay a specific amount of interest for a fixed amount of time, then repay the bondholder the face amount of the bond. Bonds issued by corporations are backed by corporate assets. In case of default, the bondholders have a legal claim on those assets. Government bonds may or may not be secured by collateral.

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bond fund A mutual fund that invests primarily in bonds. Commonly referred to as a fixed-income investment. bond rating A judgment on the likelihood that investors will receive the promised interest and principal payments on time. Bond ratings are made by independent agencies, such as Standard & Poor’s and Moody’s Investors Service. Also known as debt rating. book value The difference between a company’s assets and its liabilities, often expressed on a per-share basis. A company’s book value can be found in its annual report. broker-dealer A professional who brings together buyers and sellers of securities. Broker-dealers may also take a financial position in some securities while they are functioning as the seller of those securities. burn rate The number of stock options a company issues each year as a percentage of the common shares outstanding. call The right to buy a security at a given price within a given time. capital gain The increase in value of a capital asset, such as stock, that is realized when the asset is sold. The gain is taxed at a lower rate than ordinary income. cash equivalent A relatively stable asset that is denominated in currency terms. An example would be a money market fund or a bank certificate of deposit (CD). cash exercise The process of exercising a stock option through the use of cash to buy the stock. cashless (same day sale) exercise An options exercise in which a broker loans an optionaire the money to exercise the options. The broker will then sell enough of the shares to cover the cost of exercising the options. cash purchase and hold A method of exercising options in which the optionaire exercises the options, then holds onto the stock. Certified Financial Planner (CFP) The best-known financial planning designation, given to qualified financial planners by the CFP Board of Standards, Denver, Colorado.

glossary

229

charitable lead trust A trust that pays income to a charity from a donated asset for a number of years, after which time the principal goes to the donor’s beneficiaries. Charitable lead trusts can reduce estate and gift taxes. charitable remainder trust A trust that allows people to leave assets to a favorite charity and receive a tax break, while retaining income for life. It is recommended for people with a large appreciated asset that, if sold, would incur large capital gains taxes. Chartered Financial Consultant (ChFC) A financial planning designation given to qualified planners by the American College, Bryn Mawr, Pennsylvania. Chartered Life Underwriter (CLU) A professional designation given to qualified life insurance agents by the American College, Bryn Mawr, Pennsylvania. cliff vesting When all of the stock options from a grant vest on the same date. closed-end fund A mutual fund that sells a limited number of shares, after which it is closed and listed on a stock exchange. Following the initial offering, the only way new investors can get in is to buy shares traded on the exchange. Shares of a closed-end fund may trade for more or less than the pershare value of the portfolio’s net holdings. If a fund is trading at less than the portfolio value, it is said to be trading at a discount. If it is trading at more than the portfolio’s value, it is said to be trading at a premium. common stock Equity ownership in a company. Owners of common stock are paid dividends only after owners of preferred stock have received dividends. Their right to the company’s assets, in case of bankruptcy or liquidation, is junior to that of the owners of preferred stock. convertible bonds Interest-paying bonds that can be converted into a fixed amount of the common shares of a company. These hybrid securities derive part of their value from interest payments and part from the potential for capital appreciation.

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credit-shelter trust A trust that allows a married person (who can leave everything to his or her spouse tax free) to preserve the exemption that allows $600,000 of every estate to pass to nonspouses free of federal estate tax. deferred annuity An annuity that can be paid with a single premium or a series of installment payments. It does not begin payments until a specified date in the future. defined benefit plan Commonly referred to as a pension plan. This is a type of retirement plan in which benefits rather than contributions into the plan are specified. Pension plans provide retired employees with a fixed benefit that is based on age, years of service, and income. defined contribution plan A type of retirement plan characterized by periodic payments into the plan by an employee, such as a 401(k) plan. In contrast to a pension plan, participants in defined contribution plans are given the choice of where to invest the money they have contributed. derivatives Financial instruments with returns that move up or down in response to an underlying asset or index. disposable income The amount of money that consumers have available for spending or saving after other obligations are taken care of. disqualifying disposition An event that results in an incentive stock option (ISO) being treated like an NSO (nonqualified stock option). Such an event might be selling the stock before meeting the required holding period. diversification A strategy for reducing investment risk by spreading investments over a mix of different categories. The idea is that since different categories may move in different directions, a sudden move in one area will be balanced out by the others. dividends Earnings paid by a corporation to its shareholders. In the case of common stock, dividends fluctuate according to the fortunes of the company. Dividends of preferred stock are usually fixed.

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231

dollar cost averaging An investment strategy in which the investor buys a specified amount of stock or other security at regular intervals, regardless of price. The idea is to average out the dollar cost of the investment through high-priced and low-priced periods. Dow Jones Industrial Average (DJIA) A widely quoted stock market index, consisting of 30 actively traded stocks. Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system An automated computer system developed by the Securities and Exchange Commission for filing registration statements, periodic reports, and other material mandated under federal securities laws. Employee Retirement Income Security Act (ERISA) This 1974 act establishes the rules under which all pension and profit-sharing plans operate within the United States. It sets standards for eligibility, performance, investment selection, funding, and vesting. ERISA was designed to make sure that retirement funds like 401(k) plans would be available to workers when they retire by curbing abuses by fund managers. employee stock ownership plan (ESOP) A type of qualified retirement plan in which employees receive shares of stock, but cannot receive any benefit from the appreciation of the stock until retirement, death, disability or termination of employment. ESOPs are governed by the exacting rules spelled out in the Employee Retirement Income Tax Security Act of 1974 (ERISA). employee stock purchase plan (ESPP) Also known as a Section 423 plan, this is an employee benefit plan that allows you to purchase stock through payroll deductions, often at a discount. equity An ownership interest in a corporation represented by shares of stock. estate taxes Taxes levied by the federal and state government on the transfer of your assets after you die.

232

glossary

exercise To purchase shares of stock granted through a stock option. exercise date The date on which you exercise your options. exercise price Also known as the grant price, this is the price you pay when you exercise your options. For example, if you have an option to buy 100 shares of XYZ stock at $10, your exercise price is $10. expense ratio The figure that tells you how much a mutual fund charges each year, expressed as a percentage of the fund’s assets. For example, a fund with a 1.50 percent expense ratio charges $1.50 for every $100 under management. The expense ratio includes the management fee, servicing costs, and any annual 12b-1 fee, or marketing fee. expiration date The date on which your stock options expire and become worthless. fair market value The price at which a seller wants to sell, and a buyer wants to buy. federal funds rate The interest rate that banks charge each other on short-term loans. This interest rate, which is closely controlled by the Federal Reserve, has a significant impact on other short-term interest rates. Federal Insurance Contributions Act (FICA) FICA is familiar to employees as the term used for taxes withheld from paychecks for Social Security and Medicare. Federal Reserve System The U.S. central bank. Its sevenmember group, the Federal Reserve Board, is based in Washington, D.C. The Fed’s actions are closely watched by investors and institutions around the world, because of its ability to control key short-term interest rates, which in turn influence the amount of money and credit flowing through the economy. For this reason, the chairman of the Federal Reserve is one of the most powerful people in Washington. FICA See Federal Insurance Contributions Act. Financial Accounting Standards Board (FASB) The organization recognized by the Securities and Exchange Commission

glossary

233

as the source for generally accepted accounting principles for companies that trade securities in the United States. financial planner A financial advisor skilled in providing personal financial planning. However, no credentials are required, so anyone may call themselves a planner. Fee-only planners are paid a fixed fee by their clients; others may receive sales commissions or other compensation from outside sources. fiscal year The annual accounting period for a corporation. The 12-month period sometimes coincides with the calendar year, but can also conclude at the end of a different month. For example, some fiscal years run from October 1 to September 30. fixed annuity A steady stream of payments for a specific period or a person’s lifetime, as spelled out in the annuity contract. Fixed annuities are frequently sold by insurance companies to investors who want a fixed income. 401(k) plan Named after Section 401(k) of the IRS code, this is an employer-sponsored retirement plan that allows employees to put part of their salary into the plan and defer current taxes on that income. Employee contributions into the plan are usually matched in part by the employer. Earnings in the plan accumulate tax-deferred until they are withdrawn. 403(b) plan This refers to Section 403(b) of the IRS code. It is essentially a 401(k) program for nonprofit organizations, including schools and hospitals. Like a 401(k), it allows employees to set up tax-deferred retirement plans. The plan is set up to compensate for the absence of profit-sharing plans at nonprofit organizations. front-end load In a mutual fund, a sales commission that is paid when the fund is purchased. futures contract An agreement to buy or sell an asset, such as commodities or a U.S. Treasury bond, at a set time in the future at a fixed price.

234

glossary

gain The difference between the price at which you buy stock through an option and the price at which you eventually sell the stock. gift tax Federal taxes are owed on gifts if they exceed the annual limit of $100,000 per recipient and the $600,000 lifetime unified credit. grant The awarding of stock options. grant date The date on which your company grants you stock options. grant price The price at which you are given the opportunity to buy stock through a stock option. Also known as the strike price and the exercise price. growth investing An investing style that involves buying stocks with the potential for rapid growth, regardless of price or current earnings. guaranteed investment contract (GIC) A contract between an insurance company and a company’s profit-sharing or pension plan that assures a specific rate of return over the life of the contract. GICs are a low-risk way to lock in a specific rate of return. However, although the rate is guaranteed, the insurance company behind the GIC is not. And, in fact, insurance carriers have gone bankrupt in recent years, endangering the GICs issued by them. hard assets Also known as tangible assets, they are investments like gold and precious metals that tend to perform well when inflation is high and stocks are down. hedge An investing strategy designed to limit the potential for loss. In a hedging arrangement, the investor buys one investment, such as oil stocks, that performs in the opposite way from another, such as transportation stocks, to hedge against losses in any one sector. hedge fund A private investment partnership that may invest large sums in stocks, bonds, and currency worldwide. These little-regulated investments may not hedge, despite the name. Instead, the volatility for which they are well known

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235

may result from making heavy bets using borrowed money. Hedge funds typically require minimum investments that begin in the hundreds of thousands of dollars. index fund A mutual fund that is managed as a proxy for an index, such as the S&P 500 Stock Index. The return is close to that of the index, minus expenses. Individual Retirement Account (IRA) A tax-advantaged means of saving for retirement, used by individuals who are not employed by corporations. While allowable contributions have varied over the years, the current maximum is $2,000 per year. Penalties apply if any money is withdrawn before age 591⁄2. Taxpayers whose income falls below a certain level can deduct all or part of their IRA contributions. Individual Retirement Account rollover The reinvestment of a lump-sum distribution from an IRA when the investor has withdrawn the contents of the original IRA. To maintain its tax-advantaged status, rules specify that the money must be deposited into an IRA rollover account within 60 days of the time it was taken out of the first IRA. initial public offering (IPO) This is when a privately held company goes public and begins to sell shares. Public companies are regulated by the Securities and Exchange Commission, so an IPO can be a complicated and costly affair. While some IPOs, especially those of technology stocks, have performed famously well, others have lagged following the publicity that normally surrounds a new IPO. One reason for going public may be to allow employees to exercise their stock options, as was the case with Microsoft. insider A person who, by virtue of holding a position in a company, has access to confidential information about the company. The term is frequently used to denote officers, directors, and beneficial owners of more than 10 percent of a particular class of a company’s registered securities. insider trading Buying or selling stock in a public company when you are aware of “material inside information” about

236

glossary

that company. This is information that has not been disclosed to the public that may affect the price of the stock. Insider trading is against the law. incentive stock option (ISO) A type of stock option that qualifies for preferential tax treatment, assuming that certain rules are met. The optionaire does not pay personal income tax when the option is exercised. Instead, he or she pays capital gains taxes on the gain when the stock is sold. In return, the optionaire is required to hold onto the stock for at least one year after exercise, or two years after the grant date, whichever is later. The company is also required to follow certain rules about granting these options. ISOs are most frequently granted to top executives. in the money A phrase used to describe a stock option when the market price of the stock is higher than the grant price of the stock option. junk bonds Corporate bonds issued by firms whose financial condition is considered so unstable that there is a possibility they may default. Due to this risk, junk bonds usually offer higher yields than bonds with higher credit ratings. Also known as high-yield bonds. Keogh account A tax-sheltered retirement plan. People who are self-employed can put up to 25 percent of their earnings into the account and deduct the contributions from current income. Investments in the account grow without being taxed until they are withdrawn. As with an IRA, withdrawals before age 591⁄2 carry penalties. liability insurance Insurance that pays if you are sued or found to be legally responsible for a loss. Liability coverage is typically included in auto and home insurance policies. life annuity An annuity contract that provides a stated income for life, often payable annually. It stops automatically when the annuitant dies. liquid assets Assets that can be quickly and easily converted into cash, such as money market funds, Treasury bills or sav-

glossary

237

ings accounts. These contrast with things like real estate and art, which are difficult to sell quickly. living trust A revocable trust formed while you are alive. Such a trust is often used to avoid probate or to provide for the management of assets in the event of disability or incompetence. load In the mutual fund industry, a charge by an investment company that is paid by the investor when the fund is bought or sold. lockup period A period following an IPO when some or all of the existing shareholders are not permitted to sell shares. management fee The fee charged by a manager, often a mutual fund manager, for managing investments, often those in a mutual fund. The fee is calculated as a percentage of the net asset value of the fund, and it varies considerably according to the type of fund and the management company. Actively managed funds, such as stock funds, are generally more expensive than fixed-income funds or passively managed funds, such as index funds. marginal tax rate The tax rate that you would owe on your next dollar of taxable income. margin buying In the equities industry, the practice of buying securities partly with money borrowed from a brokerage firm. Current rules permit buying stocks up to 50 percent on margin, or up to 90 percent of the value of bonds, depending on the type of bond and its maturity. market capitalization A common way to measure the size of a company. It consists of the market price per share times the total number of shares outstanding. For example, at a price of $10 per share for each of its 1 million shares of stock, XYZ corporation would have a market capitalization of $10 million, or $10 times 1 million. market timing An investing strategy in which decisions about buying or selling are based on short-term prices, asset values, or economic factors, rather than on fundamental

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glossary

research into individual companies. Few investors manage to be consistently successful in timing the market. money market account A federally insured account available at many banks and savings and loan associations. This should not be confused with a money market fund, which is not insured. money market fund A type of mutual fund that invests only in short-term securities sold in the money markets, in order to provide current income to investors. Since there is virtually no risk of loss of capital, these funds are for extremely conservative investors with no appetite for risk. They earn current market interest and are highly liquid. municipal bonds Bonds issued by state or local governments that are exempt from federal income tax. Most states do not tax interest on municipal bonds issued within that state. Because of their tax advantages, municipal bonds tend to be popular with investors in high tax brackets. mutual fund A portfolio of stocks, bonds or a combination, purchased with a pool of money from investors. Shares of the fund consist of shares of the total portfolio of fund holdings. Nasdaq Composite Index A widely followed stock market index made up of all issues traded on Nasdaq. Nasdaq stock market A system set up for the trading of overthe-counter stocks, or those not listed on major exchanges. However, since it was set up, the Nasdaq, which is heavy with technology issues, has become just as important as the New York Stock Exchange as a widely followed index. Many dotcom companies are traded on Nasdaq. The term Nasdaq began as an acronym for National Association of Securities Dealers Automated Quotation, but now does not stand for anything but itself. Nasdaq is operated by the National Association of Securities Dealers. National Association of Securities Dealers (NASD) A membership organization for U.S. brokerage firms and under-

glossary

239

writers. It sets standards for ethics and industry practices and has a system for looking into alleged rules violations and disciplining violators. net asset value (NAV) In the fund industry, the assets of a fund minus its liabilities, divided by the total number of shares outstanding. net worth Your total assets minus your total liabilities. New York Stock Exchange (NYSE) The oldest and largest organized stock exchange on which securities are traded. Companies listed on the NYSE must meet stricter requirements than companies listed on other exchanges. no-load mutual fund A fund that does not charge a fee when the shares are purchased. nonqualified stock option (NSO) A type of stock option that is not given preferential tax treatment. This means that the optionaire must pay personal income tax when the option is exercised, as well as capital gains taxes when the stock is sold. The company takes a tax deduction equal to the difference between the grant price and the price of the stock when the option is exercised. option agreement When a company grants options, it should also provide an option agreement. This document spells out the terms of your options, including the number of shares, the grant price, and when you can exercise your options. optionaire Anyone who has been granted stock options. out of the money A phrase used to describe a stock option when the grant price of the option is higher than the market price of the stock. Also called an underwater option. overhang The number of unexercised options issued by a company as a percentage of the common shares outstanding. par value A dollar amount assigned to shares of a stock by a company’s charter. It may be used to compute the dollar accounting value of common shares on a company’s balance sheet. Par value has no relation to market value.

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passive investing The opposite of active investing, passive investing does not involve the active trading of securities. Instead, it involves using some index, such as the S&P 500, as a benchmark, and investing in a basket of securities that replicates the index. Passive investing usually costs less than active investing. The disadvantage is that because it is designed to replicate a certain index, it cannot by definition outperform the index, which active management can and often does. performance vesting A vesting schedule in which stock options become vested in the year that a company achieves a particular goal, such as a revenue or share price target. preferred stock A class of stock that provides a fixed dividend and has first claim on a company’s assets if the company is liquidated. price-to-book (P/B) ratio A company’s stock price divided by its per-share book value. If a company’s stock is trading below book value, the shares may be undervalued. price-to-earnings (P/E) ratio A company’s stock price divided by its per-share earnings over a 12-month period. The P/E ratio is the most popular method of valuing stocks; P/E information is available on a daily basis in the financial pages of major newspapers. prime rate The interest rate that is available to the best customers of a bank. The prime rate is often used as the benchmark for other interest rates. privately held company A company whose shares are not publicly traded. Also called closely held. probate The procedure used by each state to validate a will. profit-sharing plan A plan offered by many employers in which a portion of the company’s profits is put into a tax-deferred employee retirement account, often a 401(k) account. prospectus A document used as a selling piece in a securities offering. It must contain specific information about the issuer, including its financial condition, terms and conditions of the offering, and risks associated with the offering. A

glossary

241

prospectus is a condensed version of the registration statement filed with the Securities and Exchange Commission prior to the offering of securities. publicly traded company A company whose stock is held by the public and is bought and sold on an exchange, such as the New York Stock Exchange. Public companies are regulated by the Securities and Exchange Commission. put The right to sell a security at a given price within a given time. real estate investment trust (REIT) A publicly traded security. There are two types of REITs, equity and mortgage. Mortgage REITs lend money to real estate owners and pass on the interest to shareholders. Equity REITs buy real estate. Their profit or loss depends on income, usually from rent, and profits from selling property. rebalancing The reallocation of the mix of assets in a portfolio as the result of different growth rates of different asset classes. For example, a portfolio may start out as 60 percent stocks, 30 percent bonds, and 10 percent cash. Over time, the faster growth of the stock portion could make the stock part into, say, 70 percent of the portfolio. To rebalance, some stocks would be sold and other assets bought, to maintain the original asset allocation. reload options A situation in which the optionaire is granted new options each time the old ones are exercised. This commonly applies only to options that are exercised through a stock swap. repricing When a company resets the price of stock options that have already been granted. The situation that gives rise to repricing is one in which the options are underwater— that is, the grant price is higher than the market price. The company may then choose to reprice them at a lower level, so that they are in the money. The rules on repricing were recently tightened to make it much more expensive for the company.

242

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restricted stock Stock that is granted by a company subject to restrictions, such as a time limit before which the stock cannot be sold. reverse stock split A change in the capitalization of a company that decreases, rather than increases, the number of shares outstanding. risk The potential for losing your money and investments and the buying power that they provide. The causes of risk are many; a few include interest rates, a falling market, and business failure. Russell 2000 A widely followed index of small company stocks. Section 423 plan An employee stock purchase plan (ESPP) that qualifies under Section 423 of the tax code. sector fund A type of mutual fund that invests in a particular sector or industry, such as a technology fund, a financial services fund, or a health care fund. Such funds tend to carry greater risk than diversified stock funds, because their assets are concentrated in a single area, making them vulnerable to the fortunes of that sector. Securities and Exchange Commission (SEC) The federal agency that administers securities laws. It was created under the Securities Exchange Act of 1934. sell to cover A method of exercising options in which the optionaire exercises all of the options, then sells just enough shares to cover the purchase price, taxes, and commissions. short sale A bet that the price of a stock will fall. In a short sale, the seller borrows stock that he or she thinks is overvalued, then sells it, hoping that other investors will sell and drive down the price. A short seller will then cover the short (buying back shares to replace the borrowed ones) and earn the difference between the high selling price and the lower repurchase price. spread The difference between the grant price of a stock option and the market value of the stock on the date that the option is exercised.

glossary

243

Standard & Poor’s 500 Stock Index (S&P 500) A stock price index maintained by Standard & Poor’s Corporation made up of 500 stocks that represent approximately 70 percent of the total market value of all publicly traded U.S. companies. The S&P 500 is a commonly used indicator of the health of the stock market, because it represents such a broad segment of the market. standard deduction How much you can deduct from your taxable income if you elect not to itemize your deductions. Nearly three quarters of all individual income tax filers use the standard deduction. step vesting A vesting schedule in which the percentage of options exercisable each year varies. stock Part ownership of a company. The value of stock fluctuates, depending on such things as economic indicators, the direction of interest rates, the health of the company, and analysts’ reports. However, the odds are that a company’s shares will rise over time, as the company’s earnings improve. Also, shareholders often receive dividends, which can rise over time. Statistics show that of the three major classes of investments—stocks, bonds, and cash—stocks are the best long-term performers. stock appreciation rights (SARs) Due to local laws in foreign countries, SARs are often issued to foreign employees of U.S. companies in place of stock options. With SARs, you receive a payment equal to the difference between the option’s grant price and its market price when you exercise your SARs. Shares are not actually purchased when you exercise SARs, so you do not become a shareholder as a result of the exercise. stock option The right, but not the obligation, to buy a fixed number of shares of stock at a specified price for a specific period of time. stock split An increase in the total number of a company’s shares by a specific ratio, often 2 for 1 or 3 for 1. The value

244

glossary

of the company does not change, only the number of outstanding shares. stock-swap exercise A transaction in which shares of stock that are already owned are used in place of cash to pay the price for the exercise of stock options. straight vesting A vesting schedule in which the same percentage of options becomes exercisable each year. This is the most common way to vest. tax-deferred plan A tax-deferred plan, such as a 401(k) or an Individual Retirement Account, is one in which any taxes owed are deferred, usually until the time of withdrawal. total return A measure of investment performance that is calculated by adding yield (dividends or interest) to capital appreciation. transferable stock option A nonqualified stock option that allows the owner to transfer the option to one or more third parties. Because of the restrictions placed on it, an incentive stock option cannot be transferred. Treasury bill (T-bill) Short-term debt of the U.S. government that matures in one year or less. T-bills can be bought for a minimum of $10,000, and in installments of $5,000 thereafter. T-bills can be purchased through brokers, commercial banks, or the Federal Reserve. Treasury bond Long-term debt of the U.S. Treasury that matures in 10 years or more. Such bonds are interest-bearing. Treasury note Intermediate-term debt of the U.S. Treasury, maturing in 1 to 10 years. Like other forms of Treasury debt, these can be purchased from a bank, a brokerage firm, or directly from the Federal Reserve. 12b-1 fee A fee charged by a mutual fund to cover marketing costs. The fee is named after the applicable Securities and Exchange Commission regulation. umbrella insurance coverage Supplemental liability insurance that provides additional protection against lawsuits or other losses for which you may be legally responsible.

glossary

245

underwater option A stock option that has a grant price that is higher than the market value of the stock. unified credit For estate and gift tax purposes, a tax credit that permits taxpayers to exclude the first $600,000 in assets. Uniform Gift to Minors Act An act that allows a minor child to own property. Accounts set up under the act are managed by a custodian until the child reaches his or her majority. State laws govern the type of account and the age at which the child gains control of the assets. unit investment trust A portfolio of stocks or bonds with a fixed maturity date. Usually sold by brokers. unvested option A stock option that has been granted, but that cannot be exercised because it is not yet vested. value investing A type of investing akin to bargain hunting. Value investors seek beaten-down companies whose price seems cheap compared with earnings or underlying assets. Value investing contrasts with growth investing, which involves selecting stocks with the potential for rapid growth, regardless of price. The two styles tend to move in and out of favor by turns. variable annuity A type of investment contract that provides varying payments, depending on the performance of the account tied to the annuity. Variable annuities invest mainly in stocks and therefore tend to be more volatile than annuities that invest primarily in fixed income securities. vested option An option that can be exercised. vesting The amount of time before a stock option can be exercised. vesting period The time before which a stock option cannot be exercised. There are different time periods and types of vesting, including straight vesting, cliff vesting, step vesting, and performance vesting. viatical An arrangement under which a company will buy the life insurance policy of a terminally ill individual and pay a percentage of the death benefit. The company then

246

glossary

pays the premiums and collects the benefits at the time of death. volatility The up-and-down movement of an investment. Wilshire 5000 Index A broad-based index to measure stock market performance. window period A period during which employees of a corporation are allowed to trade the company’s stock. Typically, these periods run from 10 days to two months following the release of quarterly or annual reports. wrap account A type of account that “wraps” money management and brokerage services into a single package. For one inclusive fee, the investment firm provides the services of a money manager, who gives investment advice and executes trades. yield The income from an investment in the form of dividends or interest, excluding capital appreciation. zero-coupon bond A bond that makes no regular interest payments. The investor purchases the bond at a discount and receives a much greater sum when the bond matures. The return is the difference between what the investors pays for the bond and the value when the bond matures or is sold.

Index

Accel Partners, 140 Accounting benefits of stock options, 5 Accounting rules, repricing and, 135–136 Ackerman, Elise, 132 Acquisitions, effect on options, 131, 164–165, 194 Acuson, 142–143 After-tax annual income goal, planning for, 104–109 Alternative minimum tax (AMT), 37, 161–162, 191–192 rates, 37 Amazon.com, 135 American Stock Exchange, 200 Annuities, 80 Annuity trusts, 42 Ask Jeeves, 136 Asset allocation, 110–111 aggressive, 116–118 conservative, 115–117 determining right mix, 115–118 explanation of, 197 importance of, 111–112 moderate, 117–118

ongoing review of, 119 plan for, 198–199 for retirement portfolio, 116–117 returns from, 111–112 of stock options, 119–124 Assets, 205 distribution within portfolio, 94–95 (see also Asset allocation) standard deviation from median return, 96 tax-deferred yield of, 93 AT&T: stock options from, 105 vesting schedule, 51 Banking industry, 170 Bank of America Corporation, 177 Barrett, Craig, 12–14 Barry, Tina, 183 Bean stocks, 15, 179–181 Bear markets, 7–8, 123–124 Behar, Howard P., 16 Benhamou, Eric A., 137 Benna, R. Theodore, 154

247

248

index

Black, Fischer, 56 Blackout periods, 85–86, 131–132, 159–160 Black-Scholes option formula, 56–58 Boehner, John A., 39 Bogle, John, 17 Bonds: market timing and, 112 portfolio allocation to, 197–198 Bonuses: deferring to fixed accounts, 102–103 replacement with options, 10–11 signing bonuses, 172 Borrowing, versus exercising, 159, 197 Britain, treatment of options, 147 Brownson, Rehmus & Foxworth, Inc., 43, 84–88 Bryant, Adam, 5 Buck Consultants, 178 Bugen Stuart Korn & Cordaro, Inc., 104–109 Burn rate, 168 Bush, George, 133 Business expenses, options as, 5 Business Objects SA, 44 Business succession, and stock options, 186–187 Buy.Com, 136 Byland, Tim, 32–34, 37–39 Calico Commerce, 138–139 Calls, 186 Capital gains, early recognition of, 99 Capital gains tax, 33 on ISOs, 35 on NSOs, 33–34 Cash: allocation of, 97–98, 116–119 versus options, as compensation, 132–133, 162, 178–179 short-term investment of, 101–103 Cash equivalents, portfolio allocation to, 197–198 Cash flow requirements, 80 Cashless exercise: for cash, 63–64, 70, 192 for stock, 65–67, 71 Cash purchase and hold exercise, 63, 65–66, 72, 193

CD Now, Inc., 135 Cecil, John, 177–178 Certified Financial Planner (CFP), 83. See also Financial planners Cerulli Associates, 125 Chambers, John T., 16–18 Change, JoMei, 137 Charitable lead trusts, 41–42 Charles Schwab, 207 Chartered Financial Consultant (ChFC), 83. See also Financial planners Chartered Life Underwriter (CLU), 83. See also Financial planners Checkfree Holdings, 136 Chief executive officers (CEOs). See also Executives average pay of, 176 compensation packages of, 12–13 Chief financial officers (CFOs). See also Executives average pay of, 177–178 Children, transfer of wealth to, 92 Cisco Systems, 16–18 Clasgens, Joseph H., III, 43, 84–91 Cliff vesting, 50–51, 190 Color Tile, 123 Commodities, market cycles and, 112 Common stock, 27–28 versus preferred, 202–203 CommScan, 134 Communication, 8, 16 in different languages, 147 over distances, 146 with employees, 181, 183 Company: advantages of options, 28–29 assessment of, 158 bankruptcy of, 131 costs of options, 28–30 financial performance reporting, 15 loyalty to, 138–139, 182 risk of overhang, 196 risks of, 141–143 sale of divisions, 131 (see also Acquisitions; Mergers) Company culture, 6–7 Company management, effect on options, 120

index

Company stock: in 401(k) plans, 154–155 restricting ownership in, 98 too much of, 159 Compensation calculator, 172 Compensation package: deferring parts of, 102 ideal, 177 knowledge of, 157–158 stock option granting practices, 173–175 with stock options, 4 Concentration: risks of, 159, 196 temptation of, 114–115 Conoco, vesting schedule, 51 Consultants, stock options for, 178–179 Consumption levels, 92 Copeland, Toby, 180–181 Cordaro, Chris, 104–109 Crystal, Graef, 12–14 Currency transactions, and accuracy of payouts, 146 Daimler-Benz AG, 44 Davis, Robert J., 137 Death: effect on options, 163 exercise period after, 52 Default risk, 96 Delaney, Kevin J., 44 Dell, Michael, 12 Dell Computer, 12 Digital Island, 137 Dilution, 29–30, 142–143 protection against, 172 Discounting, 57–58 Disqualifying disposition, 37, 52 Distance, physical, and communication about options, 146 Diversification, 78, 82, 85, 97–98, 101, 110–111, 197 advantages of, 112–114 importance of, 113–114, 159 as protection against price declines, 139 Dividends, 27–28, 65 explanation of, 199 Divorce, 140–141 unvested options and, 141

249

Dollar cost averaging, 62, 81–82 Dot-coms. See also Technology companies instability of, 134–135 linked with old-economy companies, 140 Dot-com shakeout, 6–7 D’Ottavio, David M., 136 Downside protection, 108 Dreyfus Corporation, 170 wrap accounts from, 126 Drucker, Peter, 6 Early exercise option, 53–55 Earnings, dilution of, 17 EBay, Inc., 40–41 Economic downturns, 123–124 effect on stock options, 7–8 Economic growth, slowing, 204 Education, financing, 81 Edwards, Mark H., 3–4, 6, 8, 55, 167–168 Efficient markets, 97 Eisner, Michael, 14 Elf Aquataine, 146 Emotions, ignoring, 61, 78, 97 Employee Retirement Income Security Act of 1974 (ERISA), 152 Employees. See also Ownership behavior educating about options, 8, 181 loyalty of, building, 139 morale of, 5 reload grants for, 195 retaining, stock options for, 139, 170, 186 rewarding performance with options, 173 risks of stock options to, 129–141 turnover rate, stock options and, 181 Employee stock ownership plans (ESOPs), 60, 151–152 Employers. See also Company benefits of stock options to, 5 compensation of employees for lost options, 131, 163 deductions for super stock options, 39 Employment discrimination suits, 130 Energy prices, investment in, 100 Equity-for-pay swaps, 132–133, 162, 178–179 Ernst, Ruann F., 137

250

index

Estate planning, 90 stock options and, 208 Europe, treatment of stock options, 44–45, 146–148 Executives: average pay of, 176–178 compensation packages of, 6, 16 financial counseling process, 88–91 financial planning for, 84–88 Exercise period, 24 in Japan, 149 upon leaving the company, 52 Exercise price, 21 Exercising the options, 21–22, 189 blackout periods, 85–86, 131–132 versus borrowing, 159, 197 delaying, 60 dollar cost averaging method, 62, 81–82 early exercise, 41, 53–55 exercise and sale form, 73 focusing on performance for, 61–62 forms for, 72–74 letter of instruction for, 74 lockup periods, 131 methods of, 62–69, 192–193 minimizing taxes and, 61–62 at price higher than grant price, 23 profits from, 186 rules for, 102 for specific purposes, 159 stock power form, 75 strategy for, 81–84 tax obligations upon, 190–191 timing of, 59–61, 158–159, 189–190 trading restrictions on, 85–86, 131–132, 159–160 triggers for, 86 outside of the United States, 69 for unvested options, 53–55 Expiration, 24, 51–53 risks posed by, 129 Fair value, 55 Family members, transferring options to, 172 Fayez Sarofim & Company, 126 Federal Reserve, 204 Fees, 23

Financial Accounting Standards Board (FASB), 55–56 Financial goals, setting, 164 Financial independence, 92 analysis for, 104–109 Financial performance, public reporting of, 15 Financial plan, 80–81 example of, 91–104 importance of, 164 options role in, 196 Financial planners: educational background, 83 experience of, 83 fees of, 207 locating one, 207–208 need for, 206 professional affiliations, 83 registration with state securities department, 82–83 selecting one, 82–84 services of, 206–207 Financial planning: counseling process, 88–91 data gathering and evaluation, 88–89 estate planning recommendations, 90 for executives, 84–88 financial projections, 89 implementation of plan, 90 insurance recommendations, 90 investment strategy development, 89 ongoing, 91 to reach after-tax annual income goal, 104–109 Financial Planning Association (FPA), 83, 110, 206 Financial planning checklist, 79–80 Fink, Ronald, 178 Finland, tax treatment of options, 147 Fixed income position, 98 Form ADV—Part II, 82–83 401(k) plans, 154–155 company stock in, 120–123, 154–155 investment strategies for, 101 restructuring, 103 tax-deferred contributions to, 154 FP Corporation, 149 France, tax treatment of stock options, 44–45, 147

index

Freelance workers, stock options for, 178–179 Future expenses, 28 Gain, 23 Gates, Bill, 201 Germany, tax treatment of stock options, 44, 147 Gleeson, Jessica, 14–15 Global Crossing, 133 Grant price, 21, 23 determination of, 24 repricing, 135, 138–140 tax deductibility of, 33–34 Grove, Andrew, 12–14 Growth: expected, 54 rising, 112 Gruntal & Co., forms checklist from, 72–74 Hall, Brian J., 5 Hance, James H., Jr., 177 Hawkins, Gregory J., 136 H. D. Vest, Inc., 207 Headhunters, 169 Heidrick & Struggles International, 169 Hewitt, John A., Jr., 137 Hewitt Associates, 120, 155 Historical risk and return analysis, 120 Homestore.com, 136 H.R. 3462, 39 IBM, option exercise plan, 131, 163 Illiquidity risk, 96 Incentive stock options (ISOs), 23, 188 AMT and, 161–162, 191–192 definition of, 35 disqualification of, 37 versus NSOs, 37–39, 188 popularity of, 175 qualification period, 52 restrictions on, 35 tax obligations on, 191 tax strategies for, 43–44 timing of exercise, 189 Income stream, 205 Income tax analysis, 81 Income tax returns, 79

251

Indexed stock options, 36 Individual Investor Group, Inc., 135 Inflation: effect on investments, 93 and increased interest rates, 204 rate of, 106 Initial public offerings (IPOs), 26 effect on stock options, 201 exercising options and, 132 explanation of, 200–201 failures of, 201 joining companies prior to, 176 profitability of, 162 stock price volatility and, 134 Insider trading rules, 25, 186, 195 Institute of Management and Administration (IOMA), 155 Insurance coverage: recommendations for, 90 review of documents, 80 Intel, 12–14 Interest rates: effect on markets, 203–204 falling, 112 low, 119 rising, 117, 119, 204 International Association for Financial Planning (IAFP), 110 Intervu, 32–33 Intraware Inc., 137 Investment analysis, 81 Investment strategies, 89, 93–101 iQuantic, 3–4, 167–168, 171 Jackson, Peter H., 137 Jacobs, Sheldon, 116–119 Jaffre, Philippe, 146 Japan, treatment of stock options, 148–149 Jaschke, Justin L., 136 Johnson, Charles, 137 Johnson Companies, 154 J.P. Morgan Oil ComPS, 104 Kight, Peter J., 136 Kimberly-Clark, 182–183 Knowledge of options, 171, 173 Knowledge workers, attraction to workplace, 6–7

252

index

Knox, Charles, 130 Kuhn, Eric, 18 Leach, David, 178 Lehman Brothers Holdings, Inc., 177–178 Letter of instruction for exercising the options, 74 Liquidation, payout to shareholders upon, 27 Liquidity, 103 LM Ericsson, 165 Lockup agreements, 22, 131–132, 159–160, 194 Long-term perspective, 12 Long-term put option (LEAP), 108 Los Angeles Times, 134 Loyalty to company, 5, 138–139, 182 Lucas, Lori, 120 Lycos, Inc., 137 Managed accounts, 124 Management, stock options for, 17 Management advice, for private accounts, 124–127 Market cycles, 112–113 Market price, determination of, 24 Market segments, asset allocation between, 98 Markman, Robert, 114 Markman Capital Management, 114 Material inside information, 25. See also Insider trading rules McGuinn, Martin G., 48–49, 170 Mellon Financial Corporation, 22–23 exercise strategies, 69–72 stock options plan, 170 vesting schedules, 48–49 Merck & Company, 181–182 Mergers: easing transition, 183 effect on options, 131, 164–165, 194 MFS Fund Distributors, Inc., 125 MFS Investment Management, 207 Microsoft: options-related tax deduction, 142 public offering of, 201 reissue of options, 138 stock price of, 134

Millionaires, high-tech, 4 Mutual funds, 98–99, 103, 124 benefits of, 198 for diversification, 206 no-load, 116 portfolio allocation to, 197–198 tax burden of, 124–125 versus wrap accounts, 124–125 MyTurn.com, 135 Nasdaq, 128, 200 April 2000 decline of, 7, 134, 140, 167 volatility of, 203 National Center for Employee Ownership (NCEO), 4, 59–60, 139, 146, 158, 173 Negotiation for options, 167–170 knowledge of options, 171, 173 for new jobs, 171–172 strategy for, 176 Neoforma.com, 169 Net before-tax proceeds, 106 Net present value, 57–58 Netscape, IPO of, 201 Net worth statement, 80 New-economy companies. See also Dotcoms; Technology companies equity ownership in, 5 options-granting practices, 173–175 venture capital–backed, 173–175 New York Stock Exchange, 200 New York Times, report on CEO compensation packages, 16 The No-Load Mutual Fund Investor, 116 Nonqualified stock options (NSOs), 5, 23, 188 exercise period upon leaving the company, 52 explanation of, 33–35 versus ISOs, 37–39, 188 tax obligations on, 33, 190–191 tax strategies for, 40–41 timing of exercise, 189 Old-economy companies: burn rate of, 168 dot-coms linked with, 140 use of stock options, 170–171 Oliveri, David, 125–127

index

Oppenheimer Funds, 207 asset allocation recommendations, 115–117 wrap accounts from, 126 Option grant certificates, 187–188 Option-pricing model, 56–58 Options, publicly traded, 186 Options millionaires (optionaires), 5–6 Overhang, 17, 196 Overseas workers, 44–45. See also Europe; Japan Ownership behavior, 12, 182, 187 Oxford Health, 123 Part-time employees, options for, 14 Payoff, final, 57–58 Pearl Meyer & Partners, 176 Pension plan vesting information, 80 PeopleScape, 172 Performance: focusing on, 61–62 weak, balancing, 112 Performance-accelerated stock options (PASOs), 7 Performance incentives, stock options as, 14–16, 49, 173, 186 Performance options, 22 Performance vesting, 51, 190 Personal income tax, due on NSOs, 33–34 Pink sheets, 201 Pioneer Natural Resources, vesting schedule, 50 Poole, Lonnie, 10–12 Portfolio: asset distribution in, 94–95 (see also Asset allocation) cash allocation, 97–98, 103, 115–119 company stock in, 121–122 diversification of, 85 effect of volatility on, 204–205 fixed income position, 98 investment mixes for, 205 ongoing review of, 119 real estate investments in, 100 rebalancing, 97, 119 Preference items, 192 Preferred stock, 27 versus common, 202–203

253

PricewaterhouseCoopers, 129 Privately held companies, 200 decision to go public, 26 versus going public, 202 restrictions on options of, 194 share pricing techniques, 24 Proceeds, allocation of, 197 Productivity, increasing with stock options, 5. See also Performance incentives Psinet Inc., 136 Public companies, 200 grant price determination, 24 Publicly traded options, 186 Public mistrust of options, 44, 146–147 PurchasePro.com, 137 Puts, 107–109, 186 long-term put options, 108 Pyramiding, 87 Qualcomm, 131, 164–165 Real estate investments, 100 Real estate investment trust (REIT) shares, 100 Rebalancing, 97, 119 Reload grants, 195 Reports, annual and quarterly, 15, 201 Repricing, 7, 135, 138–140, 194 versus fixed-price options, 138 Resetting, 7 Resignation from company, effect on options, 53, 129–131, 163 Restricted stocks, 153 Restrictions: blackout periods, 85–86, 131–132, 159–160 lockup agreements, 22, 131–132, 159–160, 194 right of first refusal, 53 Retirement plans, 80–81 asset allocation for, 116–117 company stock holdings in, 120–123 employee stock ownership plans, 151–152 Returns: from asset allocation, 111–112 projected, 120 Right of first refusal, 53

254

index

Risk management analysis, 80 Risks: of blackout periods, 131–132 of common stocks, 27 of companies, 141–143 of company stock in 401(k) plans, 154–155 of concentration, 159 decreasing, through asset allocation, 111, 113–114 of dilution, 142–143 of divorce, 140–141 of equity-for-services swaps, 132–133 of exceeding expiration date, 129 of lockup agreements, 131–132 of overhang, 196 of preferred stocks, 28 premiums for, 172 of repricing, 135, 138–140 short-term versus long-term, 96 of stock price volatility, 134–135 of termination of employment, 129–131 types of, 96 Risk tolerance: exercising options and, 86 and investment mix, 205 profile of, 80, 82 Rosen, Corey, 59–61, 139, 158 Salary, replacement with options, 10–11, 132–133, 162, 178–179 San Jose National Bank, vesting schedule, 51 Savings analysis, 80 Scholes, Myron, 56 Schrader, William L., 136 Schultz, Howard, 14–16 Scott Paper, 182 Section 83(b) election, 24, 53–55 Section 423 plans, 152–153 Securities and Exchange Commission (SEC): company registration with, 200 exemption from, 15 Sell to cover exercise, 65–67, 71, 192–193 Separate accounts, 124 Sexton, Jennifer, 126 Shadow option plans, 195

Shareholder return, 13 Shareholders: risk of loss, 178 shadow option plans and, 195 Shares, 199 versus stock options, 185–186 transferring, 194 Shopnow.com, 136 Signing bonuses, 172 Silicon Valley start-up firms. See also Neweconomy companies; Start-up companies use of stock options, 5 Smith, Orrin, 16 Spain, treatment of stock options, 145–146 Standard of living analysis, 80 Stanley Works, 123 Starbucks Coffee Company, 14–16 bean stocks program, 179–181 Start-up companies: grant price of, 176 joining as new hire, 172, 176 options use, 29 Statements: of exercise period, 52–53 of restrictions on exercising, 53 Steinberg, Jonathan, 135 Steinmetz, Barbara, 77–82, 123–124 Steinmetz Financial Planning, 77 Step vesting, 51, 190 Stock: common versus preferred, 202–203 explanation of, 25–26, 199 interest rates and, 119 market timing and, 112 portfolio allocation to, 197–198 price determination, 199–200 price volatility, 134–135 private, 26 public, 26 restricted, 153 types of, 27–28 valuation of, 26–27 Stock appreciation rights (SARs), 69, 149–150 Stock exchanges, 200 listing with, 200–201 Stock markets, volatility of, 203

index

Stock option plans: decision making for, 187 determination of, 25 reasons for, 186–187 Stock options: accounting benefits, 5 in asset allocation plan, 119–124 defined, 21–22, 185 effect of public offering on, 201 for employees, 3–4 exchange for restricted stock, 138 first use of, 4 forfeiture of, 131, 163 indexed, 36 in the money, 33 nonqualified, 5 as pay, 133, 162, 178–179 performance-accelerated, 7 selling or transferring, 194 versus shares of stock, 185–186 tax benefits, 5 (see also Tax treatment) types of, 23, 188 underwater, 135, 194 valuing, 55–58 vesting, 5 Stock power form, 75 Stock splits, effect on options, 195, 203 Stock swaps, 66, 68–69, 193 Straight vesting, 49–50, 190 Strike price, 21 Super stock options, 39–40 Switzerland, tax treatment of stock options, 44–45 Talent, war over, 6 Tax deductions, 5, 11 for exercise of NSOs, 29 option-related, for companies, 142 Tax-deferred yield, 93 Tax obligations, 23 accounting for, in valuation, 160–161 upon exercise, 190–191 of overseas workers, 44–45 upon sale of shares, 39–40, 141 Tax strategies, 40–45 avoiding annual taxation, 100 charitable lead trusts, 41–42 early exercise, 40–41 income deferral, 100

255

for ISOs, 43–44 Section 83(b) elections, 53–55 for short-term cash investments, 101 tax-deferred accounts, 100 Tax treatment: in Europe, 146–148 of 401(k) plans, 154 of ISOs, 23, 35 in Japan, 148–149 of NSOs, 33–35, 191 of restricted stocks, 153 of Section 423 plans, 153 of super stock options, 39 of wrap accounts, 125–127 Technology companies. See also Dot-coms; New-economy companies burn rate of, 168 CEO compensation packages, 16–18 reaction to Nasdaq’s decline, 134 stock price volatility of, 134 vesting rates, 49–50 Telefónica, 145 Termination of employment, 129–131 effect on options, 163 exercise period and, 52–53 3Com, 137 TotalFina, 146 Toyota, 149 Trading price, 24 Trading restrictions. See Blackout periods; Lockup agreements TriNet VCO, 173 Trusts, 79 Turnover rate, stock options and, 181 Underwater options, 135, 194 Unvested options: divorce and, 141 exercising, 53–55 VA Linux, 132, 159–160 Valuation: of stock, 26–27 of stock options, 55–58, 171, 173–175, 189 tax burden and, 160–161 Value: building, 12–14 erosion of, 134–137

256

index

Vanguard Emerging Markets Fund, 104 Vanguard S&P 500 Fund, 103 Vanguard Short-Term Tax-Exempt Fund, 101 Vanguard Small-Cap Stock Index Fund, 104 VarsityBooks.com, 18 Venture capital–backed companies, 173–175 VentureOne, 162 Verio, 136 Versata Inc., 137 Vesting: cliff, 50–51, 190 explanation of, 47, 190 median rate of, 49–50 performance, 51, 190 restrictions on, 22 shortening period of, 7 step, 51, 190 straight, 49–50, 190 at technology companies, 49–50 types of, 50–51 Vesting schedule, 47, 50, 175 accelerating, 172 for ESOPs, 152 Via Net.Works, 136 Villalonga, Juan, 145 Vitria Technology, 137

Volatility, 134–135, 203 advantages of, 139 effect on portfolio, 204–205 effect on stock options, 205 risks of, 96–97 Votava, G. Joseph, Jr., 111 Wage inflation, 6 Walker, Dwayne M., 136 Wal-Mart, 140 Waste Industries, 10–12 Watson Wyatt Worldwide, 142, 169 Wealth through the Workplace Act of 1999, 39 Wessel, David, 44 Westward Pay Strategies, 49–50 Whitman, Margaret, 40–41 Wills, 79 Withholding taxes, on NSOs, 33–34 Wolff, Stuart H., 136 Work force, motivating, 48. See also Performance incentives Wrap accounts, 124–125 tax treatment of, 125–127 Wray, David, 6 Wrubel, Robert W., 136 Zero-basis stock, 43–44 Zollars, Robert, 169