A "value flow" diagram for the option exercise.
Huey, I recently sketched the following diagram, and have kept it posted near my computer ever since. For lack of a better term, I call it a "value flow" diagram.
Dang! The SI graphics still isn't working. You'll have to help me out by sketching it for me.
Using a full 8" x 11" sheet of paper:
write "company" at top center,
write "employee" about 2 inches below company,
write "mr market" to the extreme left of employee, and
write "uncle sam" to the extreme right of employee.
Assume employee has a non-qualified stock option for 1 share granted by company many years earlier, exercise price of $10, mr market has priced company stock at 70 on the exercise date, employee marginal tax rate of 33 1/3%, and company effective tax rate of 33 1/3%.
The employee decides to exercise and cash in on that $60 intrinsic value of his option .. so let's draw some value flows on the diagram. For each one of the following, draw an arrow from the "from" to the "to" and writing the "value" next to the arrow:
"value" from "from" to "to", a generic example;
$10 from employee to company;
"1 share" from company to employee;
"1 share" from employee to mr market;
"$70" from mr market to employee; and
"$20" from employee to uncle sam.
Let's pause and examine what we've drawn. Other than the tax benefit, IMHO we've drawn EVERY value flow for these entities attributable to the option exercise. Examining the net for each entitiy:
(1) the net of value flows to/from the employee reveals that the employee had a $60 gain (which IRS calls ordinary income) on which the employee pays $20 tax to net $40 after-tax income;
(2) the net for uncle sam is the $20 tax from the employee;
(3) the combined value flows for the company, a capitalization transaction, increase shareholder equity $10 and increase shares outstanding by 1.
(4) the net for mr market is what it is.
IMO, not only is the diagram accurate, it is "fair". The employee has paid a "fair share" of taxes and uncle sam ended up with the tax in his pocket.
Now using a dashed arrow on the diagram, show a value flow of $20 from uncle sam to the company. This represents the tax credit (an actual cash flow) permitted by the IRS for "employee compensation expense".
The tax credit value flow is real because it is permitted. But does it make sense? Where is the $60 compensation expense flow from the company to the employee? If we showed that on the diagram, would THAT make sense?
And is it fair? Why should the IRS net be $0? (This is exactly the case only when employee and company tax rates are equal. In general, the IRS net may be positive or negative.)
Ron |
