December 13, 2006

Google Transferable Stock Options (TSO's)

Google Transferable Stock Options (TSOs) are, in my cynical view, Google's way of solving the problem of having someone else take the fall for what happens to its employee's stock options when the Google stock price eventually takes a dive.

Disclaimer: I thought Google stock was a sucker bet all the way up, which may bear on how seriously to take this post. I have never owned it, and have no transaction involving it (i.e. am not "short").

Briefly: Google has a stock problem. A stock's price, even in a bubble, can't rise forever. Google gives employees "options", a right to buy the stock at a specific price. These take time to become active ("vest"). A look at the calendar shows there must be a lot coming due. And I suspect many employees thinking they should get out while the getting is good.

Employee options, to turn into money, normally first have to turn into stock. This dumps stock on the market. Which can drive down the stock price. Which will cause more employees to think they have to get out while the getting is good. Which will further drive down the stock price ...

See the problem?

Moreover, there's a complicated tax law "gotcha" which can hurt employees enormously with bubble-stock options. I won't explain it all, but if you wait to sell the stock, and the stock craters, you can basically end up owing huge taxes on profits which no longer exist. Which is another incentive to sell the stock as fast as possible.

Google employees who get caught in that trap would likely be very unhappy.

So, what to do? Google came up with a great solution: Pass the hot potato to the outsiders, the folks who are hearing the tale of the endless fountain of money. Let employees *sell* the options to outsiders.

At first glance, this sounds like a great idea. After all, options are bought and sold every day. Why should employees not be able to sell theirs? Well, in ordinary circumstances, it wouldn't be a problem. But in a situation like Google, it's a set-up to rip-off the ultimate buyers for the benefit of Google and its employees.

First, someone better versed in the technicalities of options mathematics should check me on this, but I believe many simple option valuation models will give a "wrong" answer for the value of an option in a situation like Google's stock, which is relatively new and has gone almost straight-up. That is, intuitively, the stock price behavior is going to change dramatically at some point, to leveling-off or dropping, and that's not accounted-for in any theory where the calculation has internally modelled an infinite time series dramatically different from the existing series (technically: "misestimation of implied volatility"?).

If everyone is using the same "wrong" rule for their cost, then it's all just a standard market game of Greater Fool. But if some sellers have a *zero* cost, to buyers at an "inflated" cost, that's taking the game to another level.

And more deeply, normally, a market in options is limited in the ability to cause a stability problem, because kind of like matter/anti-matter pairs, a normal option transaction has two people on opposite sides of that transaction, so "financial energy" is obviously conserved. An *exception* to this situation is company-granted options, like Google is doing now. Which is roughly comparable to energy creation (money) while shunting the corresponding equivalent anti-matter (stock) to a time-displaced future date. There's still conservation in an overall sense (Google is not God, so can't get around that constraint), but it can be very imbalancing to put off the day of reckoning. And more importantly, the people who get wrecked at that future date tend to be different from the people who make out like bandits at the time of creation.

Note - this is a complicated topic. I know, "stock options accounting" are fighting words to many. This is a blog post, not a financial treatise.

But here's the "beauty" of what Google is doing - by selling the employee options, the employees can take profits without the options turning into stock! Which keeps the stock price up. Which encourages the buyer to hold onto the options. Which further puts off the day they turn into stock ... Brilliant!

That is, it keeps the party going on by putting off one pressure to sell stock. And who pays the ultimate bill? The buyer of the employee option, who at some point eventually gets stuck paying a high price for something which (oversimplified) becomes worthless when the stock starts leveling-off / going-down.

Doing Evil? Well, depends on whether you're the seller (who's at Google) or the buyer (aka citizen-lunchmeat)...

By Seth Finkelstein | posted in google | on December 13, 2006 02:28 AM (Infothought permalink)
Seth Finkelstein's Infothought blog (Wikipedia, Google, censorware, and an inside view of net-politics) - Syndicate site (subscribe, RSS)

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I don't work for Google, nor do I own any Google stock, but I have been getting quite an education in stock options trading of late.

In short, if you have options valued at $36, that's really the "zero" point. [The brokerage] won't let me exercise my options until they're about 50 cents over the "zero" line, and even then that would bag me a whole $40. Not worth it. To get into "real money", our stock would need to hit $100/share. I don't expect that anytime soon. This leaves me with picking a good "strike price" to get a reasonable amount of dough as opposed to letting my options plain go to waste.

I don't know this for a fact, but I suspect that executive/officer options are valued much lower than mine, and thus are able to exercise them for a pretty penny whenever they choose, usually when resigning or retiring. Citizen Lunchmeat, indeed.

Posted by: Ethan at December 13, 2006 09:58 AM

There are faster ways to lose money than work the options market - commodity futures. But not many.

Commodity options is about as ludricous as you can get. The problem is that the markets aren't necessarily liquid when you need them to be.

Stock option pricing is all about volatility. I am not a or your financial planner but if someone try's to sell you an option based on a Black-Scholes price - ask them if the volatilty of the underlying insturment is gaussian.

I have no sympathy for anyone losing money in any options market.

I have no trouble with Google people selling options, just don't expect me to buy them at any price.

From the NYTimes article:
"“If they can see what others would pay for them, then option valuation would become simple for employees.”"
A market price is a good price. But like I said above and Seth reffered to - what happens if the price of GOOG starts to change in a way outside the bounds of the implied volatility?

The answer is easy - somebody gets burnt.

Posted by: tqft at December 13, 2006 07:06 PM