The hidden value in Google's new stock option plan

Always the optimist, in my original post, I didn't think about the downside scenario for the new Google Transferable Stock Option (TSO) plan. That is where the real hidden value is in the whole plan.

It is the "out-of-the-money" options sometimes called "under water" options where this program really creates value for employees. Lets say you joined Google a year ago when the stock was at $475 a share. Your options were granted with an exercise price of $475, vesting 25% per year over 4 years. But here you are a year later and the stock is trading at $478. You have only made $3 per share? Wow! not what you expected right?

Options traders are willing to pay a lot more than $3 for your option because it doesn't expire for another 2 years. Today, a  January 2009 option to buy Google at $470 (option symbol -OUPAU) is trading at $110.  Wow! That option you thought was only worth $3 is really worth $110.

Employees who joined Google last month when the stock was $513 per share are now $35 per share under water and thinking maybe this wasn't such a smart move. Think again. Some of your options will vest in November 2007 and expire in November 2009. The value of that "under-water" option today is somewhat over $90. How could an option that is $35 under water be worth $90?

Future stock call options have both an "intrinsic value", the difference between the strike price and the current market price, and a "time premium" that erodes over time. There is a lot of time left in these options, and a lot of optimism about the direction of Google stock, so even though the intrinsic value is currently a negative $35, the time premium is $125, yielding a current option value of $90.

This is a very clever move by Google that opens up more value in employee stock options...even if they are under water. The way Google's stock price has been moving there are sure to be times in the coming year when it will swing below todays prices. Google employees have nothing to worry about...well, not much to worry about.

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Comments

[Dharmesh Shah]

Fascinating analysis.

One part that I'm curious about is how the time premium changes based on the actual structure of the option agreement. I'm guessing some options agreements force exercising when an employee leaves (at the then strike price). So, this would create an even further incentive for employees considering leaving not to do so (as the value of the vested options at the time of exit may be minimal or zero).

Have to give this all some thought. It's making my head hurt.

[Don Dodge]

Dharmesh, My guess is once the employee sells their options it doesn't matter if they continue to be an employee or not.

Most companies require employees to exercise their options or let them expire when they terminate employment. This is mostly for tax and accounting reasons. The fact that they have already "sold" their options before terminating, means that the tax and accounting issues have already been addressed. So, no problem.

[Roger]

Don, Nice post. I wrote a post on the topic over at Information Arbitrage that I thought you might find interesting http://www.informationarbitrage.com/2006/12/google_and_cita.html. Roger

[Chris D]

Don,

Interesting, indeed.

Do you know if there are the same restrictions on trading stock options as on options that have been exercised and converted into stock. I'm wondering how all of this is regulated by the SEC or over agencies. How does this play into Insider Trading regulations since the seller could have priviledged information (e.g. "I (as sales guy in Google) know that Google is having trouble making this yearly sales quota, so things don't look so good the next two years, say - I guess I should dump my options")

[Don Dodge]

Chris, Excellent questions. I don't know much about SEC rules, but they tend to only focus on the insiders with big positions. The small guys that make big bets on a stock or option are pretty easy to catch because it is such an unnatural act.

In one sense an employee exercising an option and selling the stock is no different than an employee selling a vested option to an investor. Either way they are selling.

All employees have some level of inside information, but usually not enough information or enough stock to make much difference. It is usually just the top executives that need to worry about trading on inside information,and these guys don't qualify for the Google program anyway.

This is all new territory so there is a lot to be learned. Time will tell.

[Dave]

Along the lines of "insider info," I was wondering how the relative price of what the option is going for may serve as an indicator of the future of the company...it seems like google has created a built in company index here. Any thoughts?

[Greg Simonds]

Don,
Interesting post. Employee Stock Options are a special breed of animal, that's for sure! BTW, do you have preferences as to a particular stock trading program?. I thought it might be helpful if people interested in Stock trading had a place to go to see a large selection of software products. Maybe this will offer users diversity in the choices available to them.