On December 12, 2006, Google announced a plan to

create transferable stock options for employees other

than for officers and directors.

Their new non-qualified ESOs and some existing non-qualified

ESOs will become transferable. The expressed idea is to give

holders of Google ESOs some added liquidity and value.

In a detailed news release (attached) Google was asked:

"Why did Google create this program?"

Google replied:

"We want to permit Google employees to capture the "time premium" of their options. Because the current option program does not allow the sale of employee stock options, employees are able to realize value from the options only by exercising and then selling the stock at a price higher than the exercise price. With this program, employees will be able to realize not only the intrinsic value (the difference between grant price and market price for Google stock), but also the time value of their options. Financial institutions such as banks may be willing to pay a premium above the intrinsic value for many options because of the time value"

Although many details of the plan have not been announced,

one important point has.

When the ESOs with more than 2 years to expiration are

sold, the expiration date for the new options owner will

change to 2 years from the purchase date. This has important

implications. In other words, if the employee owns stock

options which are vested and have 5 expected yrs. remaining

to expiration, he can sell the options to the Morgan allied

bidders and receive only 2 years "time premium" minus

the bidders' costs and profit, whatever that may be.

For example:

Assume the employee owns vested ESOs to buy 1000 Google

at 300 with the stock trading at 460. The expected volatility

is .29 with expected expiration 5 years from today.

The "Theoretical Value" of the options is $240,000 (i.e. $160,000

of intrinsic value plus $80,000 of time premium). If the owner

exercises and sells the received stock, he will make the intrinsic

value minus tax or about $100,000 net.

If he sells the options to the Morgan Bidders, he will

receive the "Fair Value" on 2 year options minus Morgan's

bidders costs and profits (i.e. $195,000 - the bidders' costs

and profits).

The employee's net would be about $116,000 after tax.

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My analysis.

Since the Google ESOs could not be transferred prior

to the new transferable plan, many employees would

have ended up by making premature exercises to

obtain some cash from their in-the-money options.

This results in forfeiture of the remaining "time premium"

back to the company. Very few exercise their options

at the end of the expiration period.

The transferable options, we are told, allows the employee

to cash in by selling the ESOs thereby capturing the intrinsic

value plus some of the the remaining "time premium".

Sounds like it could be a good idea to me. Is it really?

Here are some of the criticisms:

A) The prices that are to be bid by the Morgan allied bidders

will be below "Fair Value" value unless a large group of

traders is allowed to participate as buyers. Google indicated

that the Morgan bidders expect to buy the ESOs at the bid

price and to then hedge by shorting the stock (or perhaps by

writing other calls as most expert traders would do).

This writer and his associates personally did just that as 

members of the CBOE and the PSE for ten years using

strategies that he created in the late 1970's and early eighties.

The Morgan allied buyers will want a discount to

"Theoretical Vallue" because of three factors: 

1) They must hold the options till expiration, making the

options illiquid. However, if the bidders are allowed to hedge

by selling listed LEAPs, the capital tied up by having to

hold the stock options to expiration would be minimal.

2) There are many risks associated with buying long term

calls and shorting stock to hedge. For example there is the

erosion risk and changing volatility and interest rates risks.

Hedging by writing listed long term calls, if allowed by Google,

may not be that easy as the markets in long calls are

sometimes quite wide, although lately the markets seems to

be tighter.

3) The buyers will be buying options that will have

unique exercise prices and unique times to expiration.

Unless the bidders are highly competent, that may

cause a mess of calculation issues.

These three factors will require buyers to look

for a bit more profit per trade which means lower bids to

the employees.

Grantees

The grantees, rather than selling their ESOs to the Morgan

allied bidders, could themselves hedge with the same

options that the Morgan bidders will use to hedge. If they

owned Google stock, the grantees could easily hedge with no

margin and receive all of the proceeds of the sale.

If the grantee had no stock he would have to advance

margin in the form of cash or securities.

If the employee hedges, rather than sells to the Morgan

bidders, the employee will get 100% of the time premium

and delay his taxes. Contrary to what many pundits claim,

there are no prohibitions on hedging by the grantees other

than during Lock-Out periods where grantees are required to

refrain from buying or selling company securities. I

have attached the Google Options Plan and a typical

Options agreement which "constitute the entire agreement

of the parties".

The employee/owner of vested ESOs with 5 expected yrs.

to expiration could capture the "time premium" from the 2

year options two and one half times by writing the calls.

Margin requirements and the like are not prohibitory.

Any Google employee should have enough

assets to carry some margin positions. If the Google

employee holds stock, there may be no margin requirement.

B) The transferable plan will encourage the ESO holders to sell

their equity positions a bit earlier than otherwise, thereby

reducing the mutual alignment of interests.

However, sales of ESOs with more than two years remaining

will still forfeit some "time premium", depending on the time

remaining greater than two years.

C) The plan will result in lower volatility of the stock,

thereby diminishing the value of all outstanding

Google ESOs and listed options. The reason why this will

happen is beyond the scope of this article. On the day

after the announcement, we saw drops in the market

prices of all long term out-of-the-money and at-the-money

listed options in Google. This "Theoretical Value" decrease

may dissipate over time. But as traders know, the constant

stream of options sale orders lowers implied volatility

which may last for long periods. The general implied

volatility in Google has decreased from 30 to 27 since

Google's announcement in December.

D) The "time premium" that was forfeited all to Google in the

past by early exercises will now be divided up between Google,

the Morgan bidders and the employee, rather than

100% previously going to Google.

E) This plan will raise the costs to Google because of 2 factors:

a) The "Fair Value" of the options at grant will be increased

slightly (5-10%), thereby causing higher accounting expenses.

Google says that the increased "Fair Value" will cause a

$260,000,000 write-off on the existing 6.6 million ESOs that will

become transferable. The idea that the transferable feature

will add $39.39 of "Fair Value" to the average option is

incorrect. This means that Google will write off an expense

of $39.39 dollars on 6.6 million outstanding options each.

This in my view is far out of line, unless Google was far

overstating the lack of transferability in its earlier calculations

of "Fair Value".

b) The forfeited "time premiums" although less than in the

past will no longer all go to Google, thereby increasing real

expenses. Google has indicated that they may reduce the

number of options granted to offset the added costs.

F) Over time, Google will find their employees with fewer

holdings of ESOs thereby requiring a "re-load" of options

to maintain the same alignment of mutual interests.

Summary

Unless, I am missing something, its a big loser for Google

if they indeed have to write off $260,000,000 to add

the feature. Its a big winner for Morgan and its bidders.

Its positive for the employees who need to cash in

early. To the average sophisticated grantees/traders,

the transferable feature has little value.

If Google cuts back on the number of ESOs granted to

employees to offset the transferability factor and costs, the

employees will have a net loss.

Of course the plan does represent an improvement

for the employee over the strategy of premature

exercise, sell stock and diversify. It also allows the

sale of out of the money ESOs after vesting thereby

receiving something for the out of the money options.

...........................................................................

On the other hand, there is a much easier way to

design a plan to accomplish Google's objectives with very

little costs to Google and substantial benefits to

Google's employees. If Google wants the employees to

"capture time premium", all they have to do is reload the

grantee with new 10 year options whose fair value equals

the " time premium" forfeited upon exercise.

But this cuts out the Four Bidders.

John Olagues

The author, JOHN OLAGUES, is a former member of the Chicago Board Options Exchange and the Pacific Stock Exchange for over ten years. He offers a unique view of employee stock options from a trader’s standpoint rather than from the standpoint of an accountant, compensation planner or academic. To contact JOHN OLAGUES email olagues@hotmail.com and  see www.optionsforemployees.com.