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Financial Planning for Scientists, Part 14: Stock Options

Over the last year, I've discussed many different aspects of designing a financial plan, focusing my attention on the financial planning options available to postdocs and faculty. I've looked at self-designed investments such as stock portfolios, professionally designed investments such as mutual funds, and employer-designed pension plans.

But the fact is many of us aren't going to be in academia forever. There aren't enough jobs there, and in any case, many of us hunker after that mythical "industry job." You know--the one wherein the research budget is unlimited, the "journal clubs" are on the ski slopes, and everyone gets this thing called equity that allows them to drive Porsches in the summer and fancy SUVs in the winter.

And although an increasing number of us are actually getting those industry jobs, we're also finding that when we get them, they're not quite all they were cut out to be. It often turns out the ski slope journal club had to be canned, the research budget was slashed last year, and the president is the only one with a fancy car.

One thing that hasn't changed, though, is that in most industry positions you will probably be offered some form of equity in the company. Usually, this equity comes in the form of stock options. So this month, we'll look at what, exactly, stock options are, how much they're worth, and how they should figure into your financial planning.

A stock option is exactly what it sounds like. It gives the holder the option to buy a stock. Usually, it's offered to an employee by the company that person works for, and it's an option to buy the stock of that company.

So what's so special about that? If you think about it, if the company is a public company, you, I, or just about anyone else can go out and buy that company's stock. In a way, we've all got "an option" to purchase that stock. The difference is that a stock option plan gives the employee the option to buy the stock at a particular price--a price that may be lower than the current price of that stock in the open market.

Let's use an example. Jane works at BioPharmGene, a small biotech company. The company's stock is currently trading at $2.00 a share. Jane's stock option plan allows her to purchase up to 1000 shares of BioPharmGene over the next 5 years--directly from the company--at a "strike price" of $2.00 a share (today's market price).

In Jane's first 2 years at BioPharmGene, the stock price sinks to about $1.50, because of a general slump in the stock market. During that time, Jane would be crazy to buy stock from the company for $2.00 a share, because she could buy the exact same stock on the open market for $1.50. Because her options are "out of the money" (the term used when the exercise price is lower than the market price) she would never choose to exercise them.

For the next 2 years (years 3 and 4 of her 5-year options) the stock price of BioPharmGene goes up to $5.00 a share, based on some good news about the company's lead product. During this time, Jane might want to exercise her options, or she might want to see what happens to the company's stock in year 5. If she exercises her options, she would buy 1000 shares from the company for $2.00 each (for a total of $2000). She could then immediately sell her shares on the open market for $5.00 a share, making an instant and just about risk-free $3000 profit (less applicable taxes, of course).

But let's say that instead, Jane decides to wait, and not exercise her options until year 5. If the stock price goes up again in year 5, she would make even more money. But if the stock price went back down to $1.50 and stayed there until the end of year 5, she would have lost her opportunity to make money off the stock options forever. The stock options would expire "out of the money" and yield no investment value whatsoever to Jane.

As a result of this uncertainty in stock price over time, stock options are extremely hard to put a value on. We can see from our simple example above that there was a window of time during which Jane's options were "in the money"; where they could have been exercised for a net gain of $3000. But throughout the entire 5 years, regardless of the current price of the stock, the options had some inherent value because of their potential--at any point during those 5 years, the stock price of the company could go up, making the options exercisable. Stock options are valued on that potential, rather than on their actual exercise value at any point in time. Although coming up with an option value is complicated, typical valuation equations will take into account the volatility of the particular stock (its propensity to go up and down in market price wildly), and the amount of time left in the options. In our example, the options would have a greater value in year 1 than in year 5, simply because Jane would have 4 more years to wait and see if the stock price went up.

Another stock option concept that is becoming increasingly popular in industry (and which adds an extra layer of complexity to stock option valuation) is the idea of a "vesting date." In an attempt to keep employees working at their company just a little bit longer, many companies have put a vesting date condition on their options. In Jane's example above, BioPharmGene might have stipulated that her options would vest in 3 years. This means that Jane could not use them for the first 3 years she held them--she could only exercise her options in years 4 or 5. The company would also stipulate that Jane would lose the options if she left. This creates an incentive for Jane to stay at BioPharmGene, at least until she can cash in her options in year 4.

Unfortunately, this concept has backfired on many companies--and their employees--since the "dot-bomb" tech stock crash earlier this year. People were joining companies for their options and, as stock prices in those companies rose dramatically, many were becoming "paper millionaires," with stock options that, if exercisable, would be worth millions. Because these employees thought they would be able to cash these options in when they vested, they spent all of their savings, and even got loans based on the value of their options. When the stock prices dropped dramatically before the options could be vested, many employees found themselves with worthless options, no savings, and a huge amount of debt. One of the reasons for this unfortunate situation is that technology employees were relying too heavily on their stock options in their financial planning strategies.

So, although stock options may have significant inherent value, I think that they are best thought of as a "discretionary bonus" rather than a significant part of a financial plan. That is, until the cash is in your hand, don't count on it, don't spend it, and don't make changes to your financial planning. It's a tough thing to do: At the end of 1999, Synsorb Biotech (for example) had over 1,000,000 outstanding stock options, at exercise prices ranging from $1 to over $10. Many of these options were good all the way out to 2008. In 2000, that company's stock price went to about $14. Even a relatively junior employee, holding 2500 options at $2 a share, would walk away with $30,000 in their pocket! But if that employee decided to hold out for more, for example, deciding to wait until the stock was worth $20 before exercising, they'd be out of luck: Today, the company's stock is trading at about $1 a share, meaning that those 2500 options, once worth the price of a new car, probably couldn't be traded in for a skateboard.

Next month, I'll be closing out this series. I'll take all of the information that's been presented during its course series and discuss how it all fits together. In short, I'll try to show you how to build a balanced portfolio.