Biotech Values

[biomaven0]

MacDonald (2003) analytically demonstrates that, under positive private information and current tax policies, it is only optimal to exercise the options and hold the shares if the firm also pays large amount of dividends

Here's that paper:

http://www.kellogg.northwestern.edu/faculty/mcdonald/htm/opexer.pdf

The paper has a subtle flaw. He assumes that because people are holding the exercised shares there is no diversification effect of an exercise and hold. To illustrate how that is incorrect, consider the case of an option for 100 shares with a strike price of $10 and a stock price of $20. That would produce about 35 shares after paying the exercise price and taxes. Let's assume the stock now crashes to $10. The executive who exercised and held still has shares worth $350, while his options would have zero immediate value. (And after such a crash, employees often get dismissed, so some chance he walks away with nothing at all without exercising, because there will only be 30 days to exercise post dismissal). Further, there would be a useful potential tax loss as well in the exercise and hold case.

(And his section on Section 83(b) elections just illustrates that he is an ivory tower academic rather than someone who understands how the real world works. Virtually all 83(b) elections in practice involve private companies where the spread between the FMV and payment for the shares is zero or trivial. So in those cases it is a no-brainer to make the election).

Ignoring diversification and cash needs though, it is never optimal to exercise early.