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  • the_nervous_resistor the_nervous_resistor Jul 17, 2002 4:05 PM Flag

    Expensing Options.

    Help me. It seems to me that the company and the shareholders get a cash inflow when employee stock options are exercised.

    How about a simple example.

    Walter, a hypothetical employee, is granted a stock option contract for say 1000 shares on January 1, 2002. The board determines that the recent fairmarket price that is $50, so the exercise price will be $50, like all the other contracts written for that period. The contract is valid for five years.

    The options vest at 82.5 share per month, so in one year on January 1, 2003, Walter is fully vested.

    So, suppose January 1, 2003 rolls around, and Walter has 1000 shares vested. He decides to exercise the shares, and the market price for the stock is $70. (lucky Walter).

    Walter writes a check for $50,000 to the company for the exercise. This money goes into the company's kitty. The shareholders should suffer no dilution on the asset side, e.g., cash per share.

    Walter has one of two tax problems: AMT or shorterm gain. His next 1040 will have both activated. Walter has a taxable, unrealized gain of $20,000 (=1000x($70-50)), that must be reported for alternative minimum tax (AMT).

    However, it is likely that Walter needs the money to pay the tax and maybe to repay a loan that he took out to come up with the $50,000 for the exercise. So, he sells the stock, and receives $70,000. His short-term taxable gain on $20,000 is likely 40-50% of this, so Walter has about $11,000 to $12,000 left in the end. Let's say $12,000.

    The company expenses the spread of $20,000 on their tax return, lowering earnings by $20,000. On a cash basis, they realize a $8,800 tax reduction, assuming a corporate tax rate of 44%. So, for cash flow purposes, the company and shareholders received $58,800 in positive cashflow for the exercise of the 1000 share option.

    The governments (state and fed) get the $8,000 in taxes from Walter, but they lose $8,800 in corporate taxes. So, they essentially net out zero.

    Walter gets $12,000.
    Comany gets $58,800.
    Govts. gets about zero.

    The real winner in this example is the company and the shareholders. Yes, there is incremental dilution, but that dilution came with cash in the bank.

    I am not thinking here of a CEO who cooks the books to spike the stock price and exercise options. But even in that case, the company receives an inflow of cash and reduced taxes paid.

    The company and the shareholders still get a significant cashflow upon stock option exercise.

    If I have this picture wrong, please tell me.

    Thank you.



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