Google to allow sale of options as well as exercise

Back in 2004, Google demonstrated a willingness to push the financial envelope with their cut-out-the-middleman dutch auction IPO, and now they're at it again:

Google Inc., in a move to attract and retain talent, will let employees sell their stock options through an online auction hosted by Morgan Stanley.

The program is available to all employees except for the top 13 executives, said Dave Rolefson, Google's equity and executive compensation manager. They will be able to sell options that are vested, or eligible for sale, through Morgan Stanley.

The exchange, which Google says is the first of its kind, will give employees a way to put a value on their options and a chance to sell them in a competitive market. Allowing options to trade may help Mountain View, California-based Google, owner of the most-used Internet search engine, attract and motivate employees at a time when the stock is trading at almost $500.

Since this program applies to current options, it looks to me like a big windfall to current employees. However, it seems like it would have a mixed effect on employee retention. Since options are worth more when held than exercised, the current system gives incentive for employees to stay at the company longer, since they have to exercise vested options when they leave. Under the new system, employees can sell the options and give up less value, thus giving them less reason to stay.

On the other hand, the new system should look better to prospective employees unhappy about getting options with a $500 strike price. A little downswing and those options will be way under water, and they are enormously risky. Yet by exercising modestly increased options (say at $550), the employee would be giving up an enormous amount of EV (10/11ths of the earn, to be precise). Hence the best strategy is to hold on to them despite the incredible risk, which sort of sucks. Now, whether the options are underwater or modestly increased, the employee can offload the huge risk to the professionals without losing much earn.

There will be some loss of earn, as I believe the sold options expire in 2 years, whereas the originals likely expired in closer to 10. Still, even if you maximize EV by selling the options 2 years before you plan to leave the company, you are still getting rid of 2 years of risk.

One thing I'm not sure of is who bears the cost for this. That is, in the case of risk-sharing, it's just a win-win. But what about employees who, instead of exercising, sell their options to people who hold them for 2 years until expiration and exercise them. The employee makes more money, the holder makes more money - who loses that money? It seems like the company probably does, but I'm unsure of the exact mechanics of stock options. When an employee exercises an option, where does the share come from? Was it set aside? Does the company issue it then, causing dilution? Does the company buy it on the open market?

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