In December, Google announced a groundbreaking plan to let non-executive employees sell vested stock options to the highest-bidding investment bank.

Often the options would be more valuable than if exercised for shares and the shares sold to realise a profit. This is because the investment banks would calculate the probability of an upside for the remaining term of the option they want to purchase, and develop appropriate and hedged derivatives to realise additional profit.

This method would not be caught up in the proposed ASX and Treasury initiatives for share option hedging disclosure, as the hedging will not be by employees, but by the investment banks they sell to.

In any case, while it sounds like a winner for employees it may not be so good for outside shareholders.

Google implies that the program will benefit outside shareholders because it “enhances our ability to compete effectively for the best talent in the marketplace and therefore sustain our competitive advantage,” according to a company blog.

Yet it does not intend to ask shareholders to approve the plan, despite a 2003 Securities and Exchange Commission rule that requires any company listed on the New York Stock Exchange or NASDAQ to obtain shareholder approval before adopting or materially revising a stock-based compensation plan.

If this does not represent a material revision, we don’t know what does.

Google will become the first company to let non-executive employees sell all vested stock options that were issued since the company went public or that will be issued in the future. Morgan Stanley will set up an auction process that will let financial institutions bid for the options.

An option gives the holder the right to buy one share of stock at a set price, called the strike price, during a certain period of time. Employee stock options typically expire after 10 years.

If the stock’s market price goes above the strike price, the option has intrinsic value and is said to be “in the money.” The employee could buy stock at the strike price, sell at the market price and pocket the difference. The bigger the difference, the higher the intrinsic value.

If the market price falls below the strike price, the option is said to be underwater and has no intrinsic value. But that doesn’t mean it has no value at all.

Stock options also trade on exchanges and investors will pay for underwater options because they know that at some point before they expire, the market price could go above the strike price. (Tradable options typically expire in a year or two.)

For options that are in the money, investors will typically pay more than their intrinsic value because they know that the stock price could go even higher, making them more valuable than they are today.

Companies like Google say employees tend to undervalue options because they can’t trade them and realise their value. When options go underwater, employees supposedly get morose and cannot do their jobs effectively.

In 2003, Microsoft gave workers a brief, one-time chance to sell their underwater options to JP Morgan. About half of them took advantage of the offer, which coincided with Microsoft’s decision to stop granting stock options to employees and start granting restricted stock.

The Microsoft program was not widely followed, despite predictions it might be. Various reasons have been provided as to why it has not taken off, from the administrative issues to companies being less interested in stock options, to the money JP Morgan is rumoured to have lost on the Microsoft arrangement.

Google’s program is unique because it applies to all options, regardless of their strike price, and will be ongoing. It applies only to options that are vested, or available to exercise.

Employees still have the choice of holding onto their options or cashing them in the old-fashioned way. But in many cases, they will find it more lucrative to sell to the highest bidder.

Suppose you have an option to buy Google shares at $400 per share.

You could exercise your option to buy stock at $400, then sell it at, say, $479 (the price at the time of the announcement) and make $79 per share.

Or you could sell it to the highest bidder. Nobody knows what that bid might be, but about the time of the announcement a tradable option to buy Google stock at $400 per share between then and January 2009 closed at about $150. That price is almost twice what you would get if you cashed in the option.

Now suppose you have an option with a strike price of $500, meaning it’s underwater by $21 per share.

Nevertheless, the last closing price for a two-year tradable Google option with a $500 strike price was $94.50.

We used a January 2009 expiration date because once a Google employee sells an option, it will expire either on the original expiration date or in two years, what ever is shorter.

Google’s new plan is a good deal for employees. If you look at exchange-traded options, investors are almost willing to pay more than intrinsic value. They will pay the intrinsic value plus a premium for the right to future appreciation. The only exceptions are when options are steeply in the money.

Likewise, investors might be willing to pay almost nothing for options that are deeply underwater.

Google warns its employees “not to place undue reliance on the value of publicly traded options when attempting to determine the value of their options under the (tradable stock option) program.” It says the program “will not be as efficient (as the public market) because there will be fewer market participants and slightly higher transaction costs.”

Google says it will have to “recognize more stock-based compensation per option than we would have otherwise for the foreseeable future after the program goes into effect.”

For complicated accounting reasons which would also apply under IFRS in Australia, the options available for trade will have a longer life expectancy, which will increase their value, which will result in higher compensation costs.

Google will reduce its past earnings to reflect options that have been issued to non-executive employees since its IPO.

Whether the plan will hurt future earnings depends on whether Google issues the same number of options it would have without the change or whether it issues fewer to reflect their enhanced value.

It will take fewer options to deliver the same value on the date of grant, but that does not necessarily mean Google will issue fewer options.

If Google issues the same number of options, that will be good for employees, but not necessarily for shareholders if it cuts earnings.

If the plan is popular with Google employees and acceptable to shareholders, other companies (particularly US high technology companies) are likely to follow suit.

This will likely cause other companies to take another look at transferable stock option programs, particularly when they have underwater stock options.

Could such a plan be put in place in Australia? At a first pass, we cannot see why not. However, a lot more work would need to be undertaken to investigate Australian compliance, accounting and tax implications before this can be said with any certainty.

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