In many of my articles I advise employees to avoid

premature exercises of their employee stock options

because it forfeits the remaining "time premium" to the

company and incurs an early tax liability for the employee

which also goes to decrease the tax liability of the company.

But how much is actually lost by the employee by early

exercises, considering everything?

The purpose of this article is to answer that question.

The general answer is that it depends on how long prior to

the expiration date are the early exercises made. It also

depends on the expected volatility and the interest rate

and the relationship of the stock price to the exercise

price.

To sum up the above paragraph, it depends on the value

of the remaining theoretical "time premium".

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It also very much depends on the tax consequences

of premature exercises, and the tax consequences of hedging.

If as some pundits claim, there is a possibility of the Straddle

Rule or the Constructive Sale Rule or the mismatching of tax

treatments coming into play from hedging, this may be costly

to the hedger and reduce the advantage that he will get from

hedging.

On the other hand, in my view, those critics of hedging are

merely promoting the interests of the companies by

discouraging hedging and encouraging premature exercises.

No highly competent advisor would encourage substantially

premature exercises, unless the optionee is desperate for

the money and has no other alternatives.

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Let's take as an example: Amazon .

Today August 14, 2007. AMZN traded at $73.45 at the close.

Assume three years ago, an optionee was granted 1000 options

to purchase AMZN at 45. The options expire in 7 years (5 years

expected expiration) from today.

If he were to exercise his options and sell the stock, he would

receive $28,450 and pay perhaps 40% tax, retaining 60% of

the $28,450 or $17,070.

However, the value of those options are equal to $43,700 prior

to exercise.That $43,700 can be captured and the tax

payable can be minimized and delayed. Isn't $43,700

better than $17,070.

Let's assume that the exercise price was 30 under the same

assumptions of volatility, time remaining and interest rates.

The net proceeds upon sale would be $43.45 x .60 = $26,070.

The theoretical value of the options prior to exercise

is $52,000 which I believe can be captured with

minimized taxes.

So if the AMZN ESOs were 145% in the money, you could

net 100% more by hedging than by premature exercising and

selling.

This is a simple answer that illustrates dramatically how

much an optionee throws away by premature exercises.

Its hard to believe that there are advisors who actually

advise optionees to make substantial premature exercises.

John Olagues