Receiving stock option grants as part of an employment compensation package is an important rite of passage in any career. These grants not only indicate that you now have a certain level of professional value, they also provide an opportunity to benefit directly and significantly from the growth and good fortune of the company you work for.
But equity compensation has another benefit. When considering a new job opportunity, the value of any equity you would have to surrender to accept a role with a new company should factor heavily in any compensation negotiations. Going into negotiations armed with clear valuations of surrendered equity can increase the chances of walking away with a more lucrative compensation package.
The goal when exercising stock options is to capture a spread value as the market price ascends above the strike price. This spread, referred to as intrinsic value, is the first component needed when calculating the value of stock options. However, if the market price is below the strike price at any point during the lifespan of the option, it is considered “underwater” and holds zero intrinsic value.
No executive worth their salt would ever give away an underwater option during its ten-year lifespan. Why? Because they know that this option still carries a second but much less transparent component of option valuation: time value.
Time value represents the future opportunity for stock price appreciation during the life of the option. At grant, an option primarily consists of time value and possibly a small amount of intrinsic value. This balance generally flips over time as stocks appreciate in price, and time value continues to decay. At the end of ten years, the time value eventually drops to zero.
Consider the impact of time value on a real-world executive compensation package. Sonoco Products (ticker: SON) was trading at around $56 per share in May 2022. The company awarded stock options to its executive team in February 2019 with a strike price of $60.77. Since the market price of SON was below the strike price in May 2022, these stock options were underwater and the grants were deemed worthless on paper.
However, because these stock option grants will not expire until February 2029, they still have meaningful time value. For example, the CEO’s 30,121 options that were granted in 2019 had zero intrinsic value in May 2022, but they had roughly $13.67 per share in time value.1 That’s more than $411,000 of equity replacement value that should be considered if he was negotiating a compensation package for a role with a new company.
This example illustrates the importance of understanding both the time value and intrinsic value in option valuation in order to unlock the full replacement value of your stock options. If you are able to negotiate a replacement for the surrendered time value of underwater options with a prospective employer, you stand a much better chance of maximizing the value of any resulting employment offer.
1Using the Black-Sholes options pricing model
If you are considering a new job opportunity and would like some advice, reach out to your Blue Chip Partners advisor. We are here to help you get the most life out of your wealth.
Expressions of opinion are as of this date and are subject to change without notice. The information provided does not constitute tax, legal, accounting, or other professional advice and is without warranty as to the accuracy or completeness of the information. Any information provided is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation to buy, hold or sell any security. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There are limitations associated with the use of any method of securities analysis. Indices are included for informational purposes only; investors cannot invest directly in any index. Every investor's situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Past performance does not guarantee future results. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that any statements, opinions or forecasts provided herein will prove to be correct.