Getting the most from your share options

How do you get out optimally?

When you first receive share options, one can feel like the dog that caught the proverbial bus (oh yay, I got it! But what do I do with it?). The HR department tells you that there is a certain price at which the shares must be exercised and a certain date by which that must happen, then good luck to you. And by the way, if the share price is below the exercise price on expiry date, then toughies, but they’re worthless.

The first instinct is to try and figure what they are worth. There are fancy models out there (such as the Black-Scholes or Binomial models) which can be rather intimidating and largely unhelpful. Most share option schemes issued to senior staff, tend to have expiries well in the future – anything between five and ten years. This means that, provided management don’t spectacularly foul up, and allowing for the vagaries of markets, they tend to get into a well-in-the-money situation well before expiry time. (‘Well-in-the-money’ means the share price is much higher than the exercise price.)

That’s when an important dilemma springs up – how do I get out optimally? When a share price is double the exercise price but with four years to go, what do you do? How do we resolve the trade-off between the bird in the hand and the two in the bush?

You need to modify how you think about these options that you own. In layman’s terms, the value in a company share option lies in the fact that you have a free loan to own shares for a while. The growth on that free loan is a superb perk. When a share is well-in-the-money, the extra value of having an option as opposed to simply owning the shares tends to diminish. The other factor is (unsurprisingly) tax. If you believe the share price is going to rise, then you might be better off keeping the options because you will have a larger number of shares increasing in value. If you believe that the share price will not rise too much, you might be better off exercising the shares so that you can use the capital more effectively elsewhere.

How to get the most out of your share options lies in four key factors:

  1. The realistic performance prospects for the share as against the market
  2. Return prospects on the equity market
  3. Dividend rate on the share. In SA options typically don’t accommodate for dividends
  4. The implications of income tax in the options vs. capital gains tax on the physical shares. (This will always require a calculation)

If the share price is significantly higher than the exercise price, it becomes a more attractive option to exercise the share options because you have less relative benefit in the free loan. The other factor is that as a share price goes up, the more your wealth becomes concentrated in a single investment. At a certain point in time you need to choose to forgo some of the benefits of the options in favour of risk diversification. Here’s a process we hope you’ll find helpful:

  1. Have an option exercise phase-out plan. You would be very lucky (or perhaps an ‘insider’) to have a spot-on exercise all in one go.
  2. Exercise your options in three tranches (as an example) based on pre-determined share prices. If the share is currently trading at R100 per share, you might decide to exercise 33% of your options at R120, another 33% at R160 and the last batch at R200.
  3. You will never time the top exactly; don’t kid yourself that you can. The exit process is trawling, not spearfishing.
  4. Write the plan out!
  5. If your share option scheme has more than a year to go, then as a rule of thumb, the share price should be at least three times the exercise price.
  6. If your option scheme has not significantly exceeded the exercise price and is less than a year to expiry, you need to get specialised advice.
  7. If you are likely to resign, retire or change scheme then revisit your option phase-out plan.
  8. If you are worried about being the only one who doesn’t seem to understand their options, take it from us – 98% of option-holders are pretty clueless too. So don’t be shy to ask, this is a complicated aspect of investments for anybody to understand.

There are some highly-rated shares in the industrial sector that are very expensive and begging for some profit-taking, whereas value cyclical industrials (e.g. Imperial), financials and resources are more rationally priced.

A good share option scheme can make the difference between a good retirement and a fantastic one. You don’t have to know or understand all the fancy maths that surrounds them to make the most of this fantastic corporate perk. Time and again, we see people snatch the money way too early. Don’t do it. If in doubt – ask.

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