ELF
Capital Management, LLC
(Endowment
Like Fund Management)
January
15, 2010
This is the ELF Capital Management,
LLC Market Letter for the month ended December 2009. If you do not wish to be included in our
circulation, please reply indicating your desire to be removed and we will be
happy to oblige. Alternatively, any of
your friends or colleagues may receive this on a regular basis by entering
their email address on our list-server via this link.
Feel free to forward this to any of your friends! Thanks for your interest and we hope you enjoy
the letter.
Will ESO’s Gain Popularity?
Since the
New Year began, this is the first time I’ve had the ability to ring in 2010 with
many clients and friends who read my monthly letters – So, Happy New Year to
you all. Please accept my best wishes
for a happy and prosperous 2010!
For many
business owners and employees, January is time when bonuses are awarded to
those who’ve helped their company achieve profits. It is a time when a firm’s human capital
(AKA, its people) is rewarded for helping the firm increase its financial
capital. And, after a frightening year,
these bonus payments may be more meaningful than any year prior!
If you’ve
been following the financial news media, you’ve heard that the banking sector
has been posting a strong profit recovery since last year.
Larry
Kudlow, I greatly admire your work – which I’ve followed since you were chief
economist at former Bear Stearns in the 1980’s.
Yet, the dialogue since your January 11th show confuses me as
to whether you are seeking to manage populist sentiment or are becoming more
liberal in your beliefs.
Before
Larry’s evening tirades, however, several major banks were already planning to
pay bonuses this year in a more creative way – part cash; and part equity that
vests over a period of time. And, these
payments have the potential of being taken back (clawed back) under certain
circumstances. With this type of pay
plan, the equity portion is supposed to reward employees for past performance in
a way that incentivizes/motivates them to create sound profit performance over
the longer term.
This sounds
a lot like the ESO programs that are fairly common to employees in the
technology sector. So, are ESO’s soon to
be popular again?
What Are ESO’s and Why Might They
Gain Popularity?
Before I
continue, it probably helps to explain that ESO is an acronym (abbreviation)
for Employee Stock Option. Unlike the tradable
option contracts that are created by financial institutions and traded in the
open markets, these are stock options issued by a company granting an employee
the right to buy its shares at a stated price (the exercise price) on or before
a certain period of time (the exercise period).
ESO’s
can be an excellent tool for providing a number of financial advantages to a
company. And two prominent uses, as this
economy recovers from a harsh downturn, seem to be the ability to: (a) tie
employee compensation to company performance and (b) provide a cost efficient
capital raising mechanism for the employer to finance growth.
The popular
thinking today is that cash bonuses only serve to reward employees for taking
undue risks in their efforts to generate profits. Management consultants commonly refer to this
as an “agency problem”. This conflict,
or agency problem, arises when people (the company’s employees) entrusted to
look after the interests of others (the company’s shareholders) use their power
and authority for their own benefit instead.
However, this is not only a problem that pervades corporations, such can
be found in clubs, churches and in Government as well.
As we look at
what contributed to the worst economic downturn in most of our lifetimes, I
think we all might agree that it came about as a result of a “bursting” of a
credit lending “bubble”. It’s been
explained that “greedy” people facilitated lending other people’s money without
regard to whether or not the borrowers could repay. This problem fell apart when investors began
to realize that no one was looking out for their interests and, as a result,
headed for the exits. What ensued was a
loss of confidence in our financial system which brought us to where we are
today. This is an over-simplification of
the cause and blame should be spread quite broadly amongst individuals,
business and Government.
Despite
this, if employees are awarded equity, or options on equity, their interests
become aligned with the interests of the shareholders. So, using ESO’s might offer a great
“free-market” way of ensuring against the kind of short-term thinking that
contributed to the busted credit lending bubble we are experiencing.
Another
result of the current economic downturn is the lack of available credit for new
and recovering small to medium sized businesses. Yes, we are hearing that demand for credit is
at an all time low. However, those
statistics include all borrowers – both businesses and individuals. While the personal savings rate is on the
rise, overly strict lending standards are challenging small and medium sized
businesses ability to access capital.
And, in each economic recovery over the past century, it is small
business that led us out of recession and created the jobs needed to sustain
economic recovery and growth.
For a
growing company, ESO’s can align employees with shareholder interests and offer
a viable source of cost efficient capital to finance that growth. How so?
An ESO Example
Let’s take
a look, through a simplified illustration, at how an ESO creates alignment with
employees and shareholders as well as providing the company a source of
capital.
In this
example, let’s say that XYZ Company awards stock option contracts to one or
more of its employees. XYZ’s stock is
currently worth $10 per share and the Company’s Board and shareholders have
adopted a plan that allows it to issue stock options. XYZ’s stock is publicly traded. Each currently issued stock option gives the
holder the right to purchase 1 share of XYZ Company’s common stock for $10 (the
exercise price) within the next ten years (the exercise period), subject to a
vesting schedule requirement. XYZ awards
1,000 stock options to Employee A in reward for his/her positive efforts over
the past year and as an incentive to continue such successful performance in
the future.
By the way,
vesting is contractual term that limits the number of options available to be
exercised until some period of time passes.
In this example, let’s assume that 10% of the stock options are
immediately vested and the remaining amount vests 30% annually over each of the
next three years. Hence, 100% of the
stock options currently awarded are available for conversion into common stock
after three years.
So after
the stock options are awarded to Employee A, assuming XYZ’s stock price is
still at $10 per share, the 1,000 options awarded have zero intrinsic
value. For this scenario, intrinsic
value is the difference between XYZ’s Stock price ($10) and the options
exercise price ($10) – because $10 minus $10 equals zero. However, the option does have value to
Employee A because of the 10 year right to purchase XYZ stock at $10 per share.
Now, let’s
fast forward three years and assume that XYZ’s stock is trading at $25 per share. Employee A’s fully vested stock options now
have an intrinsic value of $15,000 ([$25 - $10] times 1,000 share options).
At this
point, I hope it is easier to see how Employee A’s financial interests are
aligned with those of the shareholders.
As the Company’s share price increases in value, so does the value of
Employee A’s stock options.
But, how
does this help XYZ Company raise capital?
Let’s say that Employee A wants to convert the stock options into cash;
or, he/she wants to manage his/her future income tax burden. In order for Employee A to pursue either of
these avenues, the options need to be converted into stock. When the option is exercised, Employee A will
pay $10 per share to XYZ. If all are
exercised, Employee A will pay $10,000 ($10 times 1,000 options) and XYZ will
issue Employee A 1,000 shares of its stock.
Then, Employee A can sell the shares in the open market or hold them longer
term to achieve potential income tax savings.
In short, the exercise price goes into XYZ’s coffers.
ESO’s and Income Taxes
Above, I
discussed how Employee A might want to manage the income tax effect. This supposes that Employee A is a
Under the
tax laws, when you receive an option to buy stock as payment for your services,
you may have income when you receive the option, when you exercise the option,
or when you sell or otherwise dispose of the option or stock (acquired through
the exercise of the option). Generally,
the timing, type, and amount of reportable income depend on whether you receive
a non-statutory stock option or a statutory stock option. Statutory stock options are also referred to
as Qualifying Stock Options (QSO’s) or Incentive Stock Options (ISO’s); while
non-statutory stock options are often referred to as Non-Qualifying Stock
Options (NQSO’s). So that you don’t fall
asleep on me, I won’t go too deeply into tax law.
However, before
going any further, it is important to impress upon you that the rules for characterizing
ESO’s on an income tax return are quite involved. Due to the complexity, it is important that
you speak with a tax professional soon after you receive them to determine what
your tax obligations are. With ESO’s, it
is always wise to plan in advance if you want to maximize the value.
To keep
this simple, let’s continue with the facts of the illustration above:
Example
A: the ESO’s are Non-Qualifying Stock
Options
We already
know that the ESO’s had no intrinsic value when granted and we’ll just assume
that the time value of the options was not determinable when issued. In this case, there is no reportable income
when the options were granteded. Instead,
Employee A will have reportable income when he/she converts (exercises) the
options for stock.
Let’s
suppose that Employee A converts all 1,000 options after 3 years – when XYZ’s
stock is trading at $25 per share. Upon
exercising the option, Employee A will have $15,000 of reportable income – this
income will be taxed as compensation that is subject to Social Security and
Medicare taxes (AKA employment taxes).
Also, at conversion, XYZ can expense $15,000 as compensation expense,
pays the employer share of payroll tax and receives $10,000 in cash (the
exercise price times the number of options exercised).
As a result,
Employee A owns 1,000 shares of XYZ stock with a cost basis of $25 per share
(the $10 paid plus the $15 included in income).
Employee A can either immediately sell the stock for cash or hold the
shares as an investment. In either
scenario, he/she would report the sale as a Capital Gain or Loss transaction on
Schedule D. And, the holding period
begins on the date Employee A exercised the option.
Example
B: the ESO’s are Qualifying Stock
Options
Now, let’s
suppose that XYZ crafted their stock option plan in accordance with US Code
section 422 (of Title 26) relating to Incentive Stock Options.
For
Qualifying Stock Options, no income tax or employment taxes are due when the
options are granted or when they are exercised.
Instead, the tax is deferred until Employee A sells the stock, at which
time he/she is taxed on the entire gain.
As long as the sale is at least two years after the options were granted
and at least one year after they were exercised, they’ll be taxed at the lower,
long-term capital gains rate. If these
rules are not followed, the sale is considered a “disqualifying disposition”
and the transaction is taxed as if they were Non-Qualifying Stock Options.
There is
one important caveat, however. While
there are no income or employment taxes due when QSO’s are exercised, any gain
would be recognized as a tax preference item for figuring the Alternative
Minimum Tax (AMT). This may trigger AMT
in the year that the option was exercised and any AMT tax paid, as a result,
would not be used to increase the taxable basis of the stock like in the NSQO
example above.
It is also
important to note that stock options are not only granted to employees. Some companies grant these options to
non-employee Board members and independent contractors for their services. In these cases, the options granted to these
parties are always treated for tax purposes as Non-Qualifying Stock Options.
So, while
the taxation of ESO’s are a little challenging to grasp, they can be an
excellent tool for their ability to: (a) tie employee compensation to company
performance and (b) provide a cost efficient capital raising mechanism for the
employer to finance growth.
Market Update
Despite the
continual warnings from media pundits that US stock markets were fairly valued since
the end of November, the markets rose higher in December and in the first week
of the New Year. These pundits had been
creating a “wall of worry” that Mr. Market just seemed to ignore. We ignored the worry as well.
To us, the optimistic
factors are those leading economic indicators that appear to be reflecting we
are in a recovery, coupled with the belief that corporations have cut expenses
so efficiently that even modest revenue increases will provide significant
profit growth over the next quarter or two.
As we are just beginning to receive corporate earnings reports for the
December quarter just ended, we remain optimistic that they will show signs of a
recovery gaining momentum.
At the end
of the first week of 2010, the Dow Jones Industrials and every other major
We’ll continue
to assess economic indicators as the data rolls in over this year’s first quarter
and reassess our optimism. The only events
that draw concern for us is – what will happen when and if
Our current
allocations, including our special situation stocks, gave us a nice boost in
December. As a result, we ended 2009
solidly besting each of the major market indices we compare ourselves to. We ended the month of December UP 5.83% and
finished 2009 UP 43.31% - turning in our strongest yearly performance yet. Here are some comparative numbers for you to
review:
For
disclosure purposes, past performance is not necessarily indicative of future
results and ELF Capital Management LLC (ELF), formerly Hoffman White &
Kaelber Financial Services LLC, cannot guarantee the success of its services. There is a chance that investments managed by
ELF may lose a substantial amount of their initial value.
ELF is an
independent discretionary investment management firm established in February
2003. ELF manages a strategic allocation
of primarily exchange-traded index funds (ETFs), and may invest in other
carefully selected securities. ELF may
also employ hedging techniques, through the use of short positions and
options. ELF manages individual portfolio
accounts for both individual and business clients.
The ELF ETF
Strategy returns presented herein represents a composite of actual results from
all client portfolios managed by ELF.
Currently, it is the only composite presented by ELF and separate client
account portfolio positions are substantially similar, except as may be
modified for retirement plan accounts and accounts with net equity of $60,000
or less. There is no minimum account
size for inclusion into ELF’s ETF Strategy composite and accounts with net
equity of $60,000 or less have a tendency to downwardly skew the combined
results.
ELF’s
performance data presented herein includes the reinvestment of dividends and
capital gains; as well, ELF’s ETF Strategy composite returns are presented
after deducting actual management fees, transaction costs or other expenses, if
any. ELF charges an annual investment
management fee as follows: 1.25% on the first $250,000; 1.00% on the next
$750,000; 0.95% on the next $4,000,000; and, 0.75% thereafter.
Broad market
index information provided is solely for the purpose of comparison. This index data was obtained from third party
sources believed reliable; however, ELF does not guaranty its accuracy. An investment account managed by ELF should
not be construed as an investment in an index or in a program that seeks to
replicate any index. In most cases,
investors choose a market “index” having comparable characteristics to their
portfolio as a benchmark. An ETF is a
security that tracks an index benchmark or components thereof. As ELF actively manages a strategic
allocation of primarily ETFs, selecting a comparable benchmark poses
significant challenges. Over time, the
broad market indices provided above may exhibit more, similar or less
variability of returns and risk than ELF’s strategic allocation. As well, the broad market index information
provided above reflects gross returns and have not been reduced by any
estimated fees or expenses that a person might incur in trying to replicate an
index.