A New Design for

Employee Stock Options

John Olagues504-875-4825 olagues@gmail.comhttp://www.wiley.com/WileyCDA/WileyTitle/productCd-0470471921.html

"Options were poorly structured, and, consequently, they failed to properly align the long-term interests of shareholders and managers, the paradigm so essential for effective corporate governance. The incentives they created overcame the good judgment of too many corporate managers.”

Alan Greenspan

Is there a way to design employee stock options to make them more effective in accomplishing the goals for which they were created?

Before we can answer that question, we must state the goals of using traditional ESOs. The goals for the company are to:

A. Align the interests of the managers, officers and directors with the interests of the shareholders. B. Attract and influence high quality employees to be loyal long term employees.

C. Save cash and generate cash flow.

D. Have reasonable theoretical costs against earnings.

Problems with Traditional Employee Stock Options

A. Because of the nature of traditional ESOs, the only efficient risk management for the grantees holding traditional ESOs is to sell calls or buy puts.

B. Early exercising, selling stock and diversifying ends the alignment and has associated large penalties to the grantee.It is essentially a bet against the company and a bet on the whole market.

The 4 color graphs below illustrate the value of the components of the employee stock options and the approximate consequences of early exercises.

What are Dynamic Employee Stock Options?

Dynamic Employee Stock Options are Options whereby the settlement of the exercises consist of the purchase of less than 100% of stock (perhaps 75%) plus payments to the grantee in the form of new ESOs with new 10 year maximum expiration and current market prices as the exercise prices.

The exact value and number of new ESOs is determined by a formula which includes :

a) a percentage (perhaps 25%) of the full intrinsic value of the options upon exercise plus

b) the recovery of the otherwise forfeited remaining "time value" in 100% of the options exercised.

Exercising Dynamic ESOs results in the "fair value" of the resulting combination of stock and options being equal to the "fair value" prior to the exercise.

The following ESO plan goals are enhanced (see next slide).

A. A substantial alignment of interests is extended past the exercise and sale of stock.

B. Company cash is preserved and earlier cash flows will come to the company since the employee will likely exercise earlier.

C. Efficient risk management of the grants by the grantee is facilitated since most of the penalties of early exercises of traditional ESOs are eliminated. D. The theoretical costs to the company of the Dynamic ESOs are about 3.5% greater than traditional ESOs.

The receipt of 75% of the stock could be changed by the company to receipt of 60% or 80% or 90% of the stock upon exercise, which will change the 25% of new options to 40% or 20% or 10%.

The grantee would receive, in total, new options equal to 40%, 25% or 20% or 10% of the full "intrinsic value" plus the return of the otherwise forfeited "time value" in new options.

To illustrate the results of the exercise of DESOs we can refer to slide 16

First, we assume that the 1000 vested ESOs in the slides were Dynamic ESOs with a 75/25 split upon exercise with the stock at various prices and various times remaining.

Also assume that the .30 volatility graph was used with the stock trading at $30 and a $20 exercise price with 5.5 years expected time to expiration. Slide 16 shows that the grantee could purchase 750 shares at $20 and also receive 700 new ESOs.

If the employee waited until the stock increased to $50 to exercise and there were 3.5 years expected to expiration, he/she would again receive again receive 750 shares at $20 and new DESOs as follows. The new options value is $7500 (i.e. $30 x 250) plus $3368 of "time value" = $10,868, giving 530 new ESOs with an exercise price of $50 with 10 years maximum life and an expected volatility of .30. The full value that the employee receives is $22,500 in "intrinsic value" plus $10,868 in new ESOs, which equals exactly the value prior to exercise ($33,368).

If the assumptions in the graphs in Slides 6 and 8 were used, where the volatility is .60, then the "fair value" after exercise would be the same as the "fair value" prior to exercise, which are greater than the "fair values" when we assumed the .30 volatility.

For example. Assume that the stock was trading at $40 with a .60 volatility when the DESOs were exercised and the split was 75/25. The grantee would receive 750 shares purchased at $20, plus new options with an exercise price of $40 with 10 years maximum life and 6.3 years expected life. The grantees value is $15,000 in receiving 750 shares 20 points below market, plus $5000 in new options value, plus the "time value" of $6460 returned in the form of new options. The total is $26,460 in value. The $11,460 would equal 521 new options.

The only penalty for early exercise is that there is an early tax to the grantee required on the "intrinsic value" (i.e. $15,000) received in stock, which the company deducts.

Exercise of Vested 1,000 DESOs with 75/25 Split 1 2 3 4 5 6 7 8 9 Stock ….Ex ..…Vol.....Expected...Time value..25% of…Colu..Total New....Tot. Intr. Val. Price….Price…….....Time to exp...Remain...Intrin.Val…5+6...Option Rec..of Stock Rec.------------------------------------------------------------------------------------------------------ $30.….. $20…....30…....5.5 years….$6114..…$2500......$8614…...700...........$7500 $40…....$20…....30……4.5 years…..$4526…..$5000…..$9526…...580.........$15,000$50…….$20……30……3.5 years…..$3368…..$7500....$10,868 ….530.........$22,500$60…….$20……30……2.5 years… $2372…$10,000…$12,372.....503.........$30,000$30. …..$20…....60....…5.3 years….$9300…..$2500….$11,800….715...........$7500$40.…...$20…....60……4.3 years….$6460…..$5000….$11,464…..521.........$15,000$50...….$20…….60……3.3 years....$4740…..$7500….$12,240…..445.........$22,500$60...….$20…....60……2.3 years….$2670....$10,000…$12,670…..384.........$30,000

The options with a .30 volatility assume an interest rate of 5%The options with a .60 volatility assume an interest rate of 3%The amount of stock received upon exercise is 750 shares for a cost of $20 per share.All new ESOs have an exercise price equal to the market price and 10 years maximum life.Column 7 equals the total value of the new ESOs in each case. Column 9 shows the Intrinsic value amount before tax.

In the case of existing traditional ESOs, the plan can be changed to allow grantees to choose to have the ESOs to be treated as a Dynamic ESOs upon exercise, perhaps with a 75/25 split.

In view of the substantial benefits to all parties, the small additional theoretical costs would be well worth it.

Finally, because of the nature of Dynamic ESOs and the continued alignment after exercise and sale of stock, the incentive for the grantee to game the exercise and sales in possible violation of SEC Rule 10 b-5 would be substantially reduced.

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