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an analysis of

Employee Stock Options not for dummies Author John Olagues

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Table of Contents 1) What are Employee Stock Options... Contract terms and restrictions 2) Purposes of the Employee Stock Options grants 3) Values of the Employee Stock Options grants 4) Risks of losing the Employee Stock Options value 5) Fiduciary Duties of advisers to reduce risks 6) Premature Exercises, Selling and Diversifying of ESOs and the consequences 7) Insider Trading Policies used to force early exercises 8) Probabilities of increased values 9) Early Exercises and consequences to the employee and the company10) Taxes to the employee and the company11) Dynamic Employee Stock Options..a new superior options design that works 1

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What are Employee Stock Options?Employee Stock Options are contracts between an employee or executive and the company which grants the options. Most often these grants are substitutes for part of the grantees compensation. These contracts give the employee/grantee rights to buy a certain number of shares of company stock from the company. The company assumes certain liabilities to issue and deliver the shares to the grantee if and when the employee stock options are exercised. These employee stock options contracts usually have the grant day market price as the exercise price, have maximum time to expiration of 10 years and can not be exercised until the options vest (perhaps 1 to 4 years after the grant). The term of these contracts are outlined in the Employee Stock Plan and the Grant Agreements. The options are generally not transferable and not pledgeable.Generally, there are no prohibitions in those contract documents against selling exchange traded calls or buying puts to manage the employee stock options efficiently. The contract terms cannot be changed if the change is detrimental to the employee, unless the employee agrees to the change. 2

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Google, Cisco and Apple Plan Documents Below are links to the Google Stock Plan Document, the Cisco Incentive Stock Plan document and to Apple's Stock Plan Document. Google http://www.secinfo.com/d14D5a.r3mD3.d.htm#1stPage Cisco http://www.secinfo.com/d14D5a.v5RKa.d.htm Applehttps://mail-attachment.googleusercontent.com/attachment/?ui=2&ik=53fbb1432b&view=att&th=13737f47396603d2&attid=0.1&disp=inline&safe=1&zw&saduie=AG9B_P-A3YBdVyb5dP27bKQ7mICC&sadet=1336839257456&sads=YngX7kheBqgErOKAMKEUXwfA0BQ

None have prohibitions against selling calls and buying puts. 3

Although all of the Stock Plan documents prohibit transferring or pledging the employee stock options (Google allows a limited form of selling to selected banks and under some circumstances the Cisco Employee Stock Options can be transferred to family members). Nor is there any prohibition against hedging in the Options Award Agreements.Options Award Agreements generally outline the specific terms of a particular award. For example: the Award Agreement states the number of shares that can be bought, the exercise price, the vesting period(s), and the expiration date. The Stock Plan and Award Agreements are the documents that constitute the full contract between the company and the grantee regarding the granted equity compensation. Since there is no prohibition against hedging in the contract documents, why do many companies discourage the strategy? Some even tell their employees that hedging is prohibited by the plan. If holders of employee stock options are prohibited from hedging ESOs, then why is it not clearly written in those contract documents? 4

The answer is that the company officials know that there is generally no prohibition in the company documents but they know that premature exercises benefits the company in three ways as explained below. Therefore the company encourages premature exercises. 1. On premature exercise, the employee forfeits the remaining "time premium", which the company recaptures. In effect the company's remaining liability to the employee is eliminated. 2. The employee pays an early tax, and the company gets an early deduction from income tax, equal to the difference between what the exercise price is and what the stock could be sold for in the market. 3.The employee pays the exercise price early and that adds to the cash flow to the company also. See the following slide for a better understanding of the consequences of early exercises to the employee. 5

When most of the plans were established, there was no prohibition against hedging. And the plans require that if there is a change to the plan which may be adverse to the grantee, the company needs the approval of the grantee. So the companies can not just insert a prohibition against hedging into their present plans, because that diminishes the value of the ESOs to the existing grantees and those who relied on there being no prohibition. 7

So the companies try to make employees think that there is a prohibition when there is none. But there is a drawback to that strategy and that is if the company adviser tells the employee he cannot hedge and the stock goes down after he is told that he cannot hedge, the company would be liable for damages. Also, in my opinion, the advisers who tell their clients that they cannot hedge when the documents clearly allow hedging, open themselves up to a liability similar to the company's liability. The difference in value that the grantee will receive is on average about 40% more from selling calls and buying puts compared with a premature exercise strategy with the stock 90% above the exercise price after vesting. So the liability is not incidental. 8

In summary, Google, Cisco and Apple have no prohibitions against selling calls or buying puts in the plan documents. Holders of ESOs are free to manage their equity compensation as they see fit as long as it is consistent with the Plan Documents and Options Agreements, without further approval from anyone. However, it does appear that Apple has in January 2012 modified its Insider Trading Policy to try to prohibit all trading in puts and calls even when selling the stock is allowed under 10 b-5 and their Insider Trading Policy. Similarly Google apparently changed its Insider Trading Policy to prohibit "hedging" There has never been and will never be a prosecution of a civil complaint or criminal complaint under 10 b-5 for selling calls or buying puts when the sale of stock is permitted by 10 b-5 at the same time in the same account. So why does Apple and perhaps Google prohibit trading in calls and puts when trading the stock is permitted under 10 b-5? The answer is that they want to use the Insider Trading Policy to try to stop the most efficient way of managing the grants by the owners of employee stock options. They do this because efficient management by the employee raises the cost to the company and delays the cash flows to the company. Selling calls versus ESOs actually extends the alignment of employee /shareholders whereas all alignment is lost upon early exercise and sale. 9

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Purposes of the Employee Stock Options GrantsThese options are granted to align the interests of the grantee with the shareholders. They are granted as cashless compensation for past and future performances with the company and to attract and retain long term high quality employees. But it is undecided as to how effective they are in that objective. In addition, the companies use the grants of employee stock options to preserve present cash. Options grants are also made to generate future cash flows when the company issues and sells new shares pursuant to the exercise of the employee stock options. New cash is also generated when the companies deduct from taxable income the "intrinsic value" of the employee stock options when exercised. A major portion of the entire cash flows for some companies come as a result of exercises of employee stock options. 10

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See the links below for how valuable those cash flows are to the companies. http://www.slideshare.net/OLAslideshare/employee-stock-options-and-investments http://www.slideshare.net/OLAslideshare/ssrn-id1101271 Effectively, the grant and exercise of the employee stock options become a form of "money creation" for companies which have liquid markets for their stock. However, this "money creation" that comes as a result of the issuance of and exercise of the employee stock options, will come faster if premature exercises of the options are made. Therein lies the reason behind the promotion of the early exercise, sell and diversify strategy to the great mass of grantees other than some top executives who understand the true "nature of the game" and hold their ESOs to near expiration. 11

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Value of Employee Stock Options Values of Employee Stock Options can be calculated using standard theoretical models. The assumptions of "expected time" to expiration can be input into the calculation instead of the maximum time to expiration in consideration of the probability that the grantee will terminate employment early or prematurely exercise the employee stock options. The matrix on the following page illustrates the values of the employee stock options on the grant day to buy 1000 shares when the stock is trading at $40. 12

Illustration of the values of the employee stock options on grant day using different volatilities with the stock trading at $40, with an expected time to expiration of 6.5 years. # of ESOs.........Assumed.........Assumed........Expected time........Theoretical Value ofGranted..........Interest rate........Volatility........to Expiration..........1000 ESOs at grant

..1000.....................3%..................25..................6.5 yrs....................$12,600

..1000.....................3%..................40..................6.5 yrs....................$17,400

..1000.....................3%..................50..................6.5 yrs....................$20,470

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SSo the "fair value" of 1000 ESOs or SARs granted with an exercise price of $40, and with 10 years of maximum contractual life with a .50 volatility is $20,470on the day granted. The perceived values of the options by the employee may be more or less that the amounts stated depending on his expectations of longevity with the company and the quality of advice received to managesuch grants. The values in the right hand column are the values at risk on the day of grant.These values erode everyday unless the stock increases in market value. 13

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Risks of Losing those ESO values What are the risks of losing the value of those employee stock options and what are the fiduciary's duties to understand and advise reduction of that risk efficiently. See the next two slides for an illustration of where the risk is the highest when holding employee stock options. The illustrations show that the best time to reduce risk is when the ESOs are moderately in-the-money. That can be done efficiently only by selling calls and buying puts. The following slides illustrate the risk of loss of the value granted and why holding vested moderately in-the-money employee stock options unhedged is more risky than holding deep in-the-money employee stock options. The fourth slide addresses how to reduce that risk. 14

Illustration of the risks of losing the granted values with different expected times to expiration and different volatilities. Expected time........Expected Volatilities.......Probabilities of ESOsto Expiration...........of the Underlying.............being Worthless.......................................Stock.........................at Expiration 5 yrs..................................30..................................40 3 yrs..................................30..................................44 1 yr....................................30..................................47------------------------------------------------------------------------ 5 yrs..................................50..................................603 yrs..................................50..................................571 yr....................................50..................................54------------------------------------------------------------------------ So with 5 expected years to expiration with a .30 volatility, the chance is 40% that you will receive nothing for your ESOs. With higher volatilities, the chances are higher that you will receive nothing. 15

.Where is the Highest Risk when holding Employee Stock Options?The Matrix below shows the “fair value” of employee stock options at various stock prices at different times to expiration. This allows an examination of the changes in the ESOs value over times and the risks of holding the ESOs under different conditions. Exer.......Stock.......Volatility......Days to..........Fair.......…......Time.Price......Price..........................Expiration......Value...............Value50………50.00.............35.............1400............14.01...............14.01 …......The color equations below show the % drops in the50………56.25.............35.............1400............18.38...............12.13…........ESOs "fair value" with 25% drops in the stock. 50………75.00.............35.............1400............33.07 ………....8.07…........The largest % drops in the ESOs are with the options 50………93.75 ............35..............1400............49.48................5.75…........that are moderately in-the-money compared to the 50…..…100.00.............35..............1400........... 55.21...............5.21 ...........% drops in the deep in-the-money ESOs. 50….…. 125.00............35..............1400............78.73............... 3.73 50……..50.00..............35..............1000..............11.76...............11.76……......This is proof that when the stock is trading50……..56.25..............35..............1000..............15.92................9.67……...... at $100 with an exercise price of $50, the risk 50……..75.00..............35..............1000..............30.58................5.58 ……..... is less than when the stock was trading at $75. 50……..93.75..............35..............1000..............47.22................3.47….....….The higher risk is from the higher volatility of the 50……100.00..............35..............1000............. 53.03................3.03….......…options values and the much larger erosion of50……125.00..............35..............1000..............76.93................1.93…....…. higher “time values” when the stock is moderately above the exercise price50……..50.00..............35...............500................8.31................8.31 50……..56.25..............35...............500...............12.35................6.13............33.07 to 12.35 = 20.72 = 63% drop 50……..75.00..............35...............500...............27.42............... 2.47 …..…..55.21 to 27.42 = 27.79 = 50% drop50……..93.75..............35...............500...............44.83................1.18….....…78.73 to 44.83 = 33.90 = 43% drop50…….100.00.............35...............500...............50.97................0.9750…….125.00.............35...............500...............75.61................0.61 16 .

.Exercise...Stock.....Volatility.....Days to..........Fair…............Time.Price.........Price.......................Expiration......Value..............Value50……......50.00.............35............500..............8.31................8.31……… 50……......56.25.............35............500............ 12.35...............6.11……… 50…..…....75.00.............35............500.............27.42............... 2.47 ……… 50…..…....93.75.............35............500.............44.83................1.18………. 50…….....100.00............35............500.............50.97................0.97……… 50…....….125.00............35............500.............75.61................0.61...........25 % stock drops over 400 days show greater percentage losses for the ESOs with lower "intrinsic values" as shown in the color graphs shown below 50.............50.00..............35...........100..............3.68...................3.6850……... ..56.25.............35............100..............7.82.................. 1.57............ 27.42 to 7.82 = 71.5% drop 50……... ..75.00.............35............100............25.12........... .......0.12 .............50.97 to 25.12 = 50.7% drop50……... ..93.75.............35............100............43.83.......... ........0.07..............75.61 to 43.83 = 43.0% drop50……....125.00.............35......... ..100............75.05........ ..... ....0.05

If different percentage drops of the stock were examined, (for example 30 35, or 40% drops), the results of the percentage drops of the options would show greater percentage drops. If the stock drops occurred over longer periods, the percentage drops in the options would be even greater because of the greater erosion of the "time value" over longer periods.This means that if fiduciaries are concerned with risk reduction, they are required to advise reducing risk when the ESOs are most risky. And that occurs when the ESOs are moderately in-the-money. The strategy of early exercise, sell and diversify is highly inappropriate when the ESOs are moderately in-the- money and that strategy is inappropriate except in rare situations. The inappropriateness results from the required forfeiture of "time value" and the payment of an early tax and the questionable benefits and costs of "diversifying". That leaves only one choice to efficiently manage ESOs that are significant parts of the employees assets. That is to sell calls or do other efficient risk reduction trades in the exchange traded options markets.When the stock is trading at 50% above the exercise price shortly after vesting, the only efficient way to reduce the risk is to sell exchange traded calls. This means that promoting the strategy of early exercises, selling and diversifying under these circumstances makes the advisers liable for violation of their fiduciary duties and in violation of SEC Rule 10 b-5. The following slides will explain how to generally handle your options grants. 17

. So, in view of the information in the slides above, how does a holder of moderately in-the-money ESOs, (i.e. the stock is trading at $75 with a $50 exercise price) efficiently reduce the risk?The employee simply opens a brokerage account and sells some calls (perhaps 5 or 6 calls for every 1000 ESOs that he has that are vested). Perhaps the ones with the exercise price of $80 or $85 with 9 months to 2 years time remaining are the most appropriate. That would reduce his risk by about 35 % and he still has a substantial alignment with the shareholders. If the employee sold more calls, the risks and alignment would both be reduced further.If he wanted protection against extreme downward moves, he could purchase a small number of puts, perhaps in his IRA, and sell less calls.This strategy assumes that there is no prohibition by the company and that the ESO holder has sufficient collateral to finance the call sales or the put purchases and that there is a reasonably liquid market to make the options trades.On the other hand if the company wanted to facilitate the reduction of risk to holders of moderately in-the-money ESOs without hedging, they could design the options to better achieve all the objectives of the ESO grants. Check out the link below for a much improved type of employee stock option which is illustrated at the end of this book.http://www.slideshare.net/OLAslideshare/new-dynamicemployeestockoptionspresentati-4-12038997 18

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Fiduciary Duties Fiduciaries Relationships“Fiduciary” relationships are those relationships existing between parties to a transaction wherein one party is duty bound to act with the utmost good faith for the benefit of the other; such a relationship ordinarily arises when one party reposes a confidence in the integrity of the other, and the other voluntarily accepts that confidence Broker's General Fiduciary duties to client. A broker's fiduciary duties to a principal may include an obligation not to advance the broker's own interests or make a secret profit, a duty to account for all funds or property rightfully belonging to the principal,and a duty of disclosure. A broker also owes a principal a of duty of good faith. 19

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Fiduciary’s duty to advise risk reduction. A broker, as an agent, has a duty to use reasonable efforts to give his or her principal information relevant to the affairs that have been entrusted to the broker.The rule requiring a broker to act with the utmost good faith towards his or her principal places the broker under a legal obligation to make a full, fair, and prompt disclosure to the principal of all facts within the broker's knowledge which are or may be material to the matter in connection with which the broker is employed, which might affect the principal's rights and interests or the principal's action in relation to the subject matter of the employment, or which in any way pertain to the discharge of the agency which the broker has undertaken. New England Retail Properties, Inc. v. Maturo, 102 Conn. App. 476, 925 A.2d 1151 (2007), certification denied, 284 Conn. 912, 931 A.2d 932 (2007). The duty to disclose could also include informing the the principle of varying risks involved in a particular transaction, strategy or course of action. 20

Is a stock broker, wealth manager or broker-dealer a fiduciary to a customer?The ordinary relationship of a stockbroker to the customer is that of principal and agent. In some respects a stockbroker is a trustee. A stockbroker, like any other broker, is under a duty to act in good faith toward his or her customer,and, generally, the relationship between a stockbroker and a customer is a fiduciary one.First Union Discount Brokerage Services, Inc. v. Milos, 744 F. Supp. 1145 (S.D. Fla. 1990), aff'd, 997 F.2d 835 (11th Cir. 1993);Saboundjian v. Bank Audi (USA), 157 A.D.2d 278, 556 N.Y.S.2d 258, 11 U.C.C. Rep. Serv. 2d 1165 (1st Dep't 1990); Byrley v. Nationwide Life Ins. Co., 94 Ohio App. 3d 1, 640 N.E.2d 187 (6th Dist. Erie County 1994).- State common-law action for breach of fiduciary duty against a stockbroker based on the handling of a stock brokerage account on behalf of a profit-sharing plan was not preempted by ERISA; the state law involved was one of general application, which imposed duty on all stockbrokers regardless of the identity of their customers, and ran in favor of all customers, including employee benefit plans. Duffy v. Cavalier, 215 Cal. App. 3d 1517, 264 Cal. Rptr. 740 (1st Dist. 1989). 21

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So fiduciaries are obligated to identify and advise efficiently risk reductions to their client. However, if the fiduciary does so and the employee/client efficiently reduces risk, it raises the costs to the company and delays cash flows to the company. Indeed, it also delays the fiduciaries from getting "Assets Under Management". So Craig McCann and Kaye Thomas in 2005, created a paper called "Optimal Exercise of Employee Stock Options and Securities Arbitrations" for the purpose of giving some alleged authority for the early exercise, sell and diversify strategy. The paper overstates the merits of diversifying and understates the penalties of premature exercises. It also avoids addressing situations where the risks are greatest. A further analysis of the paper is on the following two slides or can be found athttp://www.slideshare.net/OLAslideshare/debunking-of-mccann-thomas-paper 22

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Summary of Craig McCann, Kaye Thomas paper promoting Early Exercise, Sell and Diversify. The strategy of early exercise, sell stock, and diversify rarely has any merit even in the circumstance that McCann and Thomas artificially chose in their paper "Optimal Exercise of Employee Stock Options and Securities Arbitrations", because the early exercise penalties of forfeiture of the remaining “time value” and the payment of an early tax, outweigh any advantage “diversification” may have.So the promoters of that strategy minimize the penalties of early exercise and exaggerate the merits of “diversifying” in order to help the companies, themselves and the wealth managers at the expense of their clients/grantees.They do not mention that the stock trading at their "Optimal Exercise Price" or higher after three years of vesting has a 1 chance in 11 nor do they mention that highest and most probable risks occur when the stock is trading substantially lower than their optimal exercise price. Effectively, the alleged authoritative paper says to ignore the highest risks, and wait for the risks to drop and then make early exercises, sell and diversify. That strategy has been proven to be worthless. 23

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However, if selling calls and/or buying puts, to reduce the risk of holding in-the-money calls is prohibited by the company, which is rare, or if the employee has no collateral to support the sales of calls or the buying of puts, then this efficient strategy of selling calls is not available.The best strategy then is probably to assume the risk and do as Steve Jobs, Ron Johnson, Paul Otellini, Larry Ellison, John Chambers, James Dimon, and 135 Goldman Sachs executives and others did. See below. None believed that early exercise, sell and diversify, as promoted by McCann and Thomas, has any merit and held their employee stock options practically to expiration before exercising and immediately selling the stock. Steve Jobs exercised 120,000 on 8/12/07, ESOs expiring 8/13/07Apple's R. Johnson exercised 200,000 on 12/1/ 09 ESOs expiring 12/14/09Paul Otellini of Intel exercised 800,000 11/9/07, ESOs expiring 11/12/07Larry Ellison of Oracle exercised 10,000,000 on 4/3/09, ESOs expiring 6/4/09John Chambers of Cisco exercised 2,000,000 on 2/8/10, ESOs expiring 5/14/10John Chambers of Cisco exercised 1,350,000 on 2/13/07, ESOs expiring 5/1/07James Dimon of J.P. M. exercised 1,261,000 on 7/17/09, ESOs expiring 8/15/09 24

. Insider Trading Policies and Equity Compensation: Some Insider Trading Policies prohibit (or claim to prohibit) selling calls and buying puts at all times, whether the covered person possesses non-public material information or not. Those Insider Trading Policies even disallow selling "qualified covered calls" in blind trusts and pursuant to 10 b-5-1 plans. Some of those Insider Trading Policies prohibit trading calls and puts when selling long stock is 100% consistent with 10 b-5. Under these conditions the possibility of a civil or criminal proceeding being brought against the "qualified covered call seller" or covered put buyer or his employer for a Rule 10 b -5 violation is zero. There never has been a Rule 10 b-5 proceeding under such or similar conditions. So why do they make such prohibitions in the Insider Trading Policy if the probability of a 10 b-5 violation is zero? 25

. The answer is that most Stock Plan Documents and Grant Agreements do not prohibit selling calls or buying puts and the plans cannot be changed by the whim of the companies to diminish the values of the equity compensation to the grantee. If company changes the plan documents directly and the changes are harmful to the grantee/employee, the company has breached its contract with the employee/ grantees. If they use the Insider Trading Policies to indirectly change the plans, when the change is completely un-necessary to comply with Rule 10 b-5, the contracts that the employee has with the company are similarly breached by the companies. So why do the companies risk litigation for breach of contract by diminishing the value of employee stock options through prohibitions inserted in Insider Trading Policies that have no value as far as protection against possible violations of 10 b-5? 26

. "Qui Bene" Cicero asked? The Company and the Wealth Managers benefit but the employee/grantee loses, because the most efficient strategy to manage the grants of employee stock options is to sell calls and to a lesser degree to buy puts versus substantially in-the-money vested employee stock options. And that strategy becomes unavailable if a prohibition is legally inserted in the Insider Trading Policy. The employee is required to assume very big risks of loss because of a violation of his/her contract with the company. Perhaps the designers have no idea of what the consequences of these Insider Trading Policies are. Or perhaps they do fully understand the consequences of their policies. 27

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Just recently Apple Computer inserted a provision into its Insider Trading Policy that appears to prohibit selling exchange traded calls or buying puts versus long un-restricted stock or at any other time, even when there is zero chance of a violation of 10 b-5. This prohibition eliminates the only efficient way to manage an employee's Apple equity holdings and as a result will transfer billions to the company from the employees, while also benefitting the wealth managers as they now have an excuse for not using an efficient management method.

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But the Apple Employee Stock Plan and the grant agreements allow for selling calls and buying puts to efficiently manage their equity compensation grants. So this insertion into the Insider Trading Policy of a prohibition of selling calls and buying puts constitutes a breach of the Employee Stock Options contract. If you are an employee of Apple holding shares, or equity compensation grants, you are affected by this breach, which interferes with your ability to manage those assets efficiently. You should bring this matter to the attention of Apple and consider a suit if you are damaged as a result of the breach 29..

Probabilities of Stock being HigherIt is estimated that 90% of the time, the stock which was at $20 on the grant day, will be below $40 after 3 years from the day of grant for stocks with .30 volatility. And for the stock which is presently $20, the probability is 70% that it will be less than $30 after 3 years after the grant day. Wealth managers have a fiduciary duty to advise risk reduction in concentrated positions. And, most of the time, their advice should come when the stock is less than 100% above the exercise price. So how is it possible for wealth managers to advise efficient risk reduction most of the time (i.e. 90% of the time) when their only tool is to make premature exercises, sell stock and diversify? Even if the "time value" is near zero, the early tax payment penalty makes it inefficient. But they advise premature exercises anyway because of the benefits to the company and themselves. 30

Early Exercises and the Consequences to the Employee and the Company. Slides 33 and 34 show the results of early exercises.The penalties to the employee for early exercises of traditional ESOs are illustrated in red in slide 35 below. The benefits to the employer are also illustrated in red in slide 36 below. 31

This slide shows the total penalties (red) for early exercises. Exer... Market....Vol...Expected..TimeVal..Ear.Tax...Total....Net After TaxPrice.....Price............Time.Ex.. .Forfited...Penalty. Penalty...Proceeds

20...........30........30.... 5.5 yrs....$6114....$1200.....$7314......$600020...........40........30.....4.5 yrs....$4528....$1918.....$6418.....$12,00020...........50........30 ....3.5 yrs....$3368.. .$2100.....$5578.....$18,00020...........60........30.....2.5 yrs....$2372....$2000.....$4372.....$24,000 1000 ESOs exercised .30 Vol, 5% risk free Interest rate, "0" dividend--------------------------------------------------------------------------------------

20..........30.........60.....5.3 yrs....$9300....$1200....$10,500.....$600020..........40.........60.....4.3 yrs....$6460....$1918.....$8378.....$12,00020..........50.........60.....3.3 yrs....$4740....$2100.....$6840.....$18,00020..........60.........60.....2.3 yrs....$2870....$2000.....$4870.....$24,000 1000 ESOs exercised .60 vol, 3% risk free interest rate, "0" dividend 34

This slide shows the benefits to the company of early exercises. Exer....Market..Vol...Expected.Time.Val.....Cash Flows.........Early TaxPrice....Price............Time.Ex.. Received..Ex.pr. tax cred...Credit Benefit

20.........30.......30.... 5.5 yrs......$6114.... ..$20K......$4K ...........$120020.........40.......30.....4.5 yrs......$4528.... . $20K......$8K........... $1918 20.........50.......30 ....3.5 yrs......$3368.... . $20K....$12K............$210020.........60.......30.....2.5 yrs......$2372.... ..$20K....$16K............$2000 1000 ESOs exercised. 30 Vol, 5% risk free Interest rate, "0" dividend--------------------------------------------------------------------------------------20.........30......60......5.3yrs......$9300.......$20K......$4K...........$1200 20.........40......60......4.3 yrs......$6460... ..$20K......$8K...........$191820.........50......60......3.3 yrs......$4740......$20K....$12K...........$210020.........60......60......2.3 yrs......$2870......$20K....$16K...........$2000 1000 ESOs exercised .60 vol, 3% risk free interest rate, "0" dividend 35

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Taxes Taxes upon Grant. There is no tax liability to the grantee upon the grant of employee stock options and no tax deduction to the company. Taxes upon Vesting. There is no tax liability to the grantee upon the vesting of employee stock options and no tax deduction to the company. Taxes upon Exercise. There is a tax liability to the grantee and a tax deduction available to the company upon the exercise of employee stock options. That tax liability and tax deduction equals a percentage of the "intrinsic value" of the options. Taxes upon Sales after exercising. Any gains or losses that are achieved subsequent to the exercise of employee stock options are capital gains or losses.

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Taxes upon exercise of employee stock options by certain officers and directors may be delayed until the stock received is sold. This possibility is pursuant to IRC Section 83(c)(3) and is very interesting. It says (3) Sales which may give rise to suit under section 16(b) of the Securities Exchange Act of 1934

So long as the sale of property at a profit could subject a person to suit under section 16(b) of the Securities Exchange Act of 1934, such person’s rights in such property are—(A) subject to a substantial risk of forfeiture, and(B) not transferable.

(4) For purposes of determining an individual’s basis in property transferred in connection with the performance of services, rules similar to the rules of section 72 (w)shall apply. This means that for officers and directors, tax liability on stock received from the exercise of employee stock options occurs when the stock is sold. 37

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How are the gains and losses treated for tax purpose if a person sells calls or buys puts while holding recently vested ESOs with an exercise price of $50 while the stock is trading at $75? We give the answer by using an example: Assume that on April 18, 2012, you are not an officer or director and hold 10,000 vested ESOs to buy your company stock at $50 per share which is now trading at $75. The value of the ESOs would be equal to about $350,000 (i.e. $250,000 in "intrinsic value" and $100,000 in "time value"). Assume you then sell 60 calls with an exercise price of $80 that expire Jan 2014 or 21 months from the day of sale. Assume that the value is about $1350 per call making the 60 calls sell for $81,000. You have reduced the delta risk by about 35% and reduced the daily erosion risk about 100%. The calls will trade for higher prices than the "fair value" of the Employee Stock Options with the same exercise price and expected time to expiration including the "time value" and the "intrinsic value". 38

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There is no tax on the opening position. My view is that the two positions, (i.e. the sale of the 60 calls and the 10,000 Employee Stock Options) are not offsetting as defined in Section 1092. Even if the positions were offsetting as defined in Section 1092, any losses liquidated from buy back of calls, or expiration and assignment of calls are deductible currently as short term capital losses since ESOs never have a "fair market value" and never have an "unrecognized gain" which otherwise might be used to delay the liquidated losses on the call selling transactions. My view is that any liquidated gains on the sale of the calls are short term capital gains when closed and reportable currently. This treatment provides a manner in which the income taxes from the ESOs can be delayed to near expiration day, and any gains on the calls can be delayed to expiration day of the calls. But liquidated losses from the call sales (if there are losses) can be deducted currently as short term capital losses. If the employee wanted protection from extreme moves of the stock, he/she could buy puts in an IRA and reduce the number of calls sold and achieve additional tax advantages. 39

Dynamic Employee Stock Options

A New Design for Employee Stock Options 40

"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 41

The topic of this presentation is most relevant today as there are structural problems with the traditional employee stock options. Traditional options by their nature prevent effective long term alliances between employees and shareholders largely because of the risk-averse attitudes of the employees and their interest in reducing that risk. Unless the employees, managers or executives are willing to use hedging strategies involving selling exchange traded calls or buying exchange traded puts on company stock, their only choice to reduce risk is by early exercises and sell stock, and perhaps diversify the net after tax proceeds.

This strategy of making early exercises is so highly penalized in most cases of traditional ESOs that it is unwise in all but rare cases to use the strategy. 42

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. The goals are to: A. Align the interests of the managers, officers and directors with the interests of the shareholders by making the value of their equity compensation dependent on an increase in value of the company shares. B. Attract and Influence high quality employees to be loyal long term employees. C. Preserve and increase the cash position of the company. D. Encourage early cash flows to the company from the early payment of the exercise price and the tax credits upon exercises. E. Allow for the efficient management of the granted options by the grantees. F. Maintain the theoretical costs of the plans to a modest level. 43

How well do Traditional ESOs accomplish those goals ?A. The traditional ESOs do align the employee/executive with shareholders during the vesting periods and after vesting as long as the employee/executive holds the ESOs and they understand the values and risks of the ESOs. B. Company cash is preserved and indeed additional cash flows are generated by any early exercises (which are encouraged by the company and the options holders' advisers through their promotion of the premature exercise, sell stock and diversify strategy). C. The traditional ESOs because of vesting requirements, non-transferrability and non-pledgeability make it difficult for risk-averse grantees to efficiently manage traditional ESO positions. Premature exercises after vesting require penalties to the grantees in the form ofa) a forfeiture of the remaining "time value" which is quite high when volatility is reasonably high and b) an early payment of taxes. D. Early exercises, usually followed by sales of stock cause an early termination of 100% of the grantee/company alignment and long term incentives from those ESOs. E. Theoretical expenses against earnings are moderate, given the restrictions, although "fair values" on the grant day are often understated by the company. 44

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 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 percentage (perhaps 25%) of the full intrinsic value of the options upon exercise plus the recovery of the otherwise forfeited remaining "time value" in 100% of the options. 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. However, the exercise will cause a tax liability on 75% the intrinsic value of the options. No "time value" is forfeited although a partial penalty for an early tax payment is incurred.

The following ESO plan goals are enhanced(see next slide) 45.

A. A substantial alignment of interests is extended past the exercise and sale of stock as the grantee still will hold substantial new ESOs.

B. Company cash is preserved and earlier cash flows will come to the company since the employee will likely exercise earlier. The two penalties of early exercises (i.e. forfeiture of "time value" and an early tax payment) by the grantee are substantially eliminated. The grantee, therefore will likely exercise much earlier causing more and earlier cash flows to the company. 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. The stock can be sold and hedging will not be necessary. D. The theoretical costs to the company of the Dynamic ESOs are about 3.5% greater than traditional ESOs.

E. Even the job of the wealth manager becomes much easier as he can not be accused of mismanaging the ESOs. 46

The terms of the settlement of the exercise could be the following. For example: Upon exercise, grantee receives 75% (rather than 100%) of the stock at the exercise price plus new ESOs with new 10 year expiration dates and market value exercise prices. The "fair value" of the new ESOs would equal the sum of a) + b): a) 25% of the "intrinsic value" of the exercised ESOs that would have been gained on a traditional ESO exercise, plus b) the amount of the remaining "time value" otherwise forfeited to the company upon early exercise of 100% of the employee stock options. The receipt of 75% of the stock could be changed by the company to receipt of 60% or 80% of the stock at the exercise price, which will change the 25% of new options to 40% or 20%. The grantee would receive new options equal to 40%, 25%, or 20% of the full "intrinsic value" plus the return of the otherwise forfeited "time value" in new options.The plan could give the choices of the percentages of stock received to the grantee or pre-determined by the company. 47

The following two slides are familiar graphs. They illustrate among other things, the value of the "time premiums" (i.e. time value) and "intrinsic values" and how they change with different volatilities and different prices of the stock at different times.The slides also show the net take home amounts after tax for traditional ESOs exercised, assuming a total tax of 40%.

The companies will take the "intrinsic value" as a tax deduction upon the exercise. Dynamic ESOs will have different results. The grantee gets less stock upon exercise than with the TESOs but the grantee gets a new load of new DESOs. The tax deduction to the company will be reduced. 48

Let us 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. First we use the .30 volatility graphs A. Employee exercises when the stock is trading at $30 with 5.5 years expected time to expiration. The results are: the employee receives 750 shares for a purchase price of $20 and receives new ESOs with an exercise price of $30 with 10 years to expiration. The new ESOs have a value of $2500 from 25% of the "intrinsic value" plus $6114 of "time value" = $8614.He would receive 720 new ESOs, which are valued at $8614. The "fair value" of the package upon exercise, that the employee receives is $7500 in intrinsic value + $8614 in new options value. Which equals the exact value the employee had prior to exercise. B. If the employee waited until the stock increased to $50 to exercise and there were 3.5 expected years to expiration, he would again receive 750 shares at $20 and new DESOs as follows. The new options value is $7500 (i.e. $30 x 2500) plus $3368 of "time value" = $10,868, giving 530 new ESOs with an exercise price of $50 with 10 years maximum life. 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). 51

If the assumptions in the block of the second graph (slide 11) where a .60 volatility was used, 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 $26,464 in value. The $11,460 would equal 521 new options.

The only penalty for early exercise is that there is an early tax required on the "intrinsic value" (i.e. $15,000) received in stock. 52

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…Colum….Total New...Tot. Intri. Val. Price….Price…….......Time to exp...Remain...Intrin.Val… 5+6.....Options. Rec...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 amount before tax 53

To further reduce the gaming of the timing of the sales of the stock received from the exercise of the DESOs, the company would compare the sales price with the average closing prices of the stock for the 30 business days following the sales. If the sales price is greater than the average, then the difference is returned to the company. The difference can never be greater than the intrinsic value received from the exercised options

To reduce the gaming of the grant day exercise prices, the company would take the average closing prices of the 21 business days following the grant day and make the exercise price equal to the higher of the two. 54

Conclusion It has been estimated that there are 10 million employees in the U.S who receive employee stock options yearly and millions more worldwide. Very few of those employees, executives or their advisers understand the nature of, the value of, the risk of losing that value or the proper ways to maximize that value, reduce risk and delay taxes It is hoped that this short book will increase those numbers. 55