Employee Stock Options: Protect Your Paper Profits

If you're a five-year veteran employee of Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks), you're probably feeling pretty wealthy right now.

Microsoft grants stock options to all employees upon employment and annually in the first quarter. Options granted in the first quarter of 1994 have appreciated 1,340%. Average gain in your options over the past five years is 624%.

Do the next five years look so rosy? That depends. Microsoft has a market capitalization of $360 billion. For the stock price to double, Microsoft has to create an additional $360 billion in enterprise value -- that's a lot of copies of MS Office 2000.

But what's the worst case? Suppose Microsoft is broken up, a la AT&T (T Quote - Cramer on T - Stock Picks), in a settlement with the Justice Department. Does the stock price plunge to 50? In that case, the value of your options would decline by 67%.

This is the dilemma facing many employees with stock option plans. After four years of extraordinary stock market gains, many participants in these programs are standing on substantial paper profits. Imagine how many Dell (DELL Quote - Cramer on DELL - Stock Picks) millionaires are in Austin, Texas.

There is the risk, however, as employees of Electronics for Imaging (EFII Quote - Cramer on EFII - Stock Picks), Healthsouth (HRC Quote - Cramer on HRC - Stock Picks), PeopleSoft (PSFT Quote - Cramer on PSFT - Stock Picks) and Parametric Technology (PMTC Quote - Cramer on PMTC - Stock Picks) have found in the last year, that these gains can be wiped out in a matter of days. How?

Putting aside fancy Black-Scholes calculations, the value of the stock options is simply:

(current stock price - strike price of option) x number of options

if current price is greater than strike price

The strike price is set when the options are issued. It's usually the same as the stock price on the issue date. If the current stock price is less than the strike price, however, then the value of the option is zero.

Healthsouth shares were at 30 1/8 on July 20. By Oct. 8, the stock was at 7 11/16, the lowest level since August 1994. All employee stock options issued since that date were at that point worthless. (Shares have since recovered somewhat to around 15.)

People have many excuses for not proactively managing their options:

• "My boss would think I was disloyal if I exercised these options and sold the stock." While it's probably not a good idea to brag to your boss or your co-workers about taking profits, a quick review of insider trading records for your company will show you that senior managers and directors are continuously exercising their options and selling their positions. They are well aware of the risks. You can find this information at Yahoo! Finance. See, for example, insider sales at Compaq.
• "I don't want to pay the taxes." That's the ongoing tradeoff: the certainty of paying taxes now vs. the uncertainty of substantial losses later.
• "My company's always done great!" Complacency is a dangerous thing.
• "This is found money." So is a winning lottery ticket -- but you wouldn't leave that ticket on the dashboard of your car.

At my financial management firm, we have developed strategies for helping clients manage and diversify out of these option positions. They can be boiled down to four rules of thumb:

• Keep careful track of your options, preferably with a spreadsheet or with a personal finance package such as Money 99, which will recalculate the value of the options as the underlying stock price changes. You need to keep track of date of issue, strike price, quantity, vesting date and type of option. (Incentive stock options, also known as qualified options, have different tax consequences on both issuance and exercise than nonqualified stock options.) Your spreadsheet should allow you to enter the current stock price, compute the current value of the options (zero for those positions whose strike is below the current price).
• Make sure your accountant knows what you're doing. The calculation of taxes owed is very complex. (Details are available at the National Center for Employee Ownership Web site as well as in the group's excellent The Stock Options Book.) Furthermore, any taxes resulting from these transactions are due Jan. 15 -- not April 15, as with ordinary income.
• If vested options are 100% in the money, you should consider exercising at least 20% of these options a year and sell as much stock as necessary to pay for the exercise and any resulting taxes. If practical, hold the remaining stock for at least 12 months -- preferably 18 months -- to take advantage of lower capital gains rates. Proceeds from these stock sales can be used to pay for the exercise of more options.
• Every situation is different, so consult with your financial adviser. For example, if you are a current employee of Amazon.com (AMZN Quote - Cramer on AMZN - Stock Picks) or Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks), we'd ask you to consider exercising 80% of your vested options and selling the stock immediately, given our opinion that a substantial wipeout of Internet-related stocks is in the near future.
• If you don't need the money immediately (for example, to buy a new house) consider reinvesting the proceeds either in a diversified portfolio of 20 to 30 stocks, preferably in different industries than your company, or in stock mutual funds. Your goal is to reduce the risk associated with a concentrated position in a single stock while continuing to receive the returns associated with the broader stock market.

These rules of thumb are not to maximize wealth but to preserve it. The appreciation of the options that you hold today are a gift. Make sure to implement a plan so that this gift doesn't slip away.