Employee stock option
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Employee stock options are call options on the company's own stock. There are restrictions that attempt to align the holder's interest with those of the business' shareholders. If the company's stock rises, holders of options experience a direct financial benefit. This gives employees incentives to behave in ways that will boost the company's stock.
They are mostly offered to management as part of the executive compensation package. They are also offered to lower staff, especially by businesses not yet profitable. They can also be offered to suppliers and lawyers and promoters for services rendered.
[edit] Mechanics
These options are similar to other options with some differences.
1.) The exercise price is typically set at the company's stock price on the day of the option grant. Regulators in 2006 found that many companies back dated options to a previous market low, so that holders received an instant gain. They also found that options are frequently issued just before the public announcement of good news, that was expected to cause a stock price increase. Some companies set the exercise price to be slightly higher than the current stock price, partially to deter criticism that option grants are too expensive a price for the stockholders to pay.
2.) The vesting schedule specifying when these options may first be exercised. They typically specify a holding period of three to ten years, or a schedule of progressively more becoming vested. This is longer than the typical 2 years of exchange-traded options. Thus employee stock options are similar to warrants.
Options only continue to vest so long as the employee is an employee. Stock options are sometimes jokingly referred to as "golden handcuffs" (in the same vein as golden handshakes or golden hellos). The employees may feel compelled to work out the time until they are able to liquidate the stock even if they might otherwise prefer to leave the company. This is especially the case in a strongly rising market. During the dot-com boom, many employees' compensation consisted largely of stock options; there are cases in which secretaries and janitors became multi-millionaires after their companies went public.
For companies that are not publicly traded, the options are typically not exercisable (and therefore worth nothing) until the company is either acquired or goes public with an IPO.
3.) Employee stock options are not transferable. They cannot be sold to any other party. The one typical exception is that in the event of the death of the employee, the spouse inherits all the vested options. Theoretically, to realize their value, they must be exercised and sold. Because the exercise will trigger a taxable event, holders with access to high level financial products can freeze the options' value with derivative products. In practice top mangement who want to leave their job for a better offer can negotiate compensation from the new business for the options they leave behind.
4.) The options expire at a pre-determined date. This is to force their eventual exercise.
[edit] Arguments Pro and Con employee options
1. )Pro: They require no cash. For businesses not yet profitable who are 'burning' cash, this is unquestionably good. More shares will dilute the losses per share.
2.) Pro: The holder has no taxable income until the option is exercised. The tax due then is calculated at the lower capital gains rate. Con: This benefits the holders at the expense of the taxpayer.
3.) Pro: Giving actual shares instead would result in immediate dilution of earnings and voting control. Con: The cost of the shares would then be known and recorded as an expense. Since the market value of the shares will inevitably be greater than the book value there will be a gain to the pre-existing shareholders (see book value). A falling stock price will be felt more by the holder of shares because the money to buy them has been earned and taxed. It is 'real' not just an 'opportunity' cost.
4.) Pro: A rising share price gives employees incentive to work harder and longer. Con: The reverse effect can cause employees to quit.
5.) Pro: Stock options align the holder's interest with the shareholders'. Con: Management will be motivated to repurchase shares in the market (increasing EPS and probably share value), instead of paying dividends (because no dividends accrue to the options). Offering options to promoters gives them incentives to misrepresent the company to investors. Management can finesse the contraints of the options with derivatives. They can recover any lost value on quitting from the next business.
6.) Pro: Martin J. Whitman argues[1] that while stock options may dilute the value held by each of a company's existing shareholders, they are of little concern to creditors, and that "GAAP (generally accepted accounting principles) ought to be geared toward meeting the needs and desires of creditors rather than the needs and desires of short-term stock market speculators." Con: Currently GAAP financial statements are for the point of view of the shareholder. Creditors most frequently have their own reporting requirements written into their contracts.
[edit] Valuation
The value of the the option is only known with certainty at its exercise. Then its value is the difference between the market value of the stock and the exercise price of the option.
It was argued for many years that options had no cost because there was no cash flow, and because the value of the company did not decrease. But, barter transactions that involve no cash (employment for shares) still have an implicit value. The opportunity cost of foregoing receipt of full market value for the issue of new shares is a 'true' cost. Yes, the equity of the business does go up (when management compensation is not measured) because 'some' money was received - but not the full market value.
The issue still in dispute is the timing of recognition of the cost of options.
- Do you wait for them to be exercised to recognize the 'true' value?
- Do you recognize them when awarded or when vested, and make a stab at the value?
- Do you subsequently adjust that value as the stock prices change?
- Do you record their cost in the Income Statement, or bypass it directly to Equity?
As of 2006, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) agree that the fair value at the grant date should be estimated at the grant date using an option pricing model. The majority of public and private companies apply the Black-Scholes model, however, through September 2006, over 350 companies have publicly disclosed the use of a lattice model in SEC filings. xcx
[edit] 'Diluted EPS' does not measure the potential cost of options.
[2]Shareholders are drained by the cost of options exercised, not the options outstanding. A company with an 'acceptable' 5% dilution from options outstanding, may in fact be exercising those 5% each and ever year, and reissuing new ones. In five years management would own a controlling 25% of the company. This reality is recognized by the media when they report how much CEOs earn each year. It is the value of options exercised that is included with salary and bonus.
"Diluted EPS" measures the dilution at a point in time at the stock price at that time. To measure the impact of options the question is "What % share of future earnings increases goes to the holders of options? And what % comes to me?" The liability to pay options compensation can grow exponentially and overwhelm all other growth of the company. The formula for this is
(in-the-money options outstanding as % total) * (P/E ratio) = % future earnings accrue to option holders
E.g. if the options outstanding equals 5% of the issued shares and the P/E=20, then (5/105*20=)95% of any increase in earnings goes, not to the shareholders, but to the options holders. (See proof at reference).
5% is the measure of current dilution. 95% is a measure of the earnings growth forfeit to options holders.
[edit] Share buybacks do not offset the cost of options
[3]This is the most common way that the cost of stock options is dismissed. When the company buys them back as fast as they are issued, the number of shares outstanding does not change, and the excess cost to buy back shares is offset by the gain from selling your proportionate interest in the company. But ....
The following diagram [[1]] shows a typical price structure. Shares are trading at three times book value, and management's options are well In-The-Money. The middle two columns reflect the two parts of a stock option exercise. The first reflects the gain to existing shareholders when they sell a part of their ownership in the company to new owners. The second reflects the cost of management compensation equal to the discount to market value. The last column reflects a share buy-back. The cost of the shares in the market exceeds what the company originally sold them for, so there is a loss. This loss offsets the first column's gain.
The middle column for Compensation cannot be ignored. The company does not receive full market value for the options exercised. The opportunity cost lost is management's gain. This is not a 'victimless crime'. Selling shares of a company is no different from selling assets of the company. The shares represent a proportionate ownership interest in all the assets. Assets given away to employees are an expense to the company.
Buying back shares will never offset the cost of stock options. There will always be the discount to market value that is management's compensation.
[edit] U.S. GAAP
FAS 123 Revised, does not state a preference in valuation model. However, it does state that "a lattice model can be designed to accommodate dynamic assumptions of expected volatility and dividends over the option’s contractual term, and estimates of expected option exercise patterns during the option’s contractual term, including the effect of blackout periods. Therefore, the design of a lattice model more fully reflects the substantive characteristics of a particular employee share option or similar instrument. Nevertheless, both a lattice model and the Black-Scholes-Merton formula, as well as other valuation techniques that meet the requirements in paragraph A8, can provide a fair value estimate that is consistent with the measurement objective and fair-value-based method of this Statement." The simplest and most common form of a lattice model is a binomial model.
According to US generally accepted accounting principles in effect before June 2005, stock options granted to employees did not need to be recognized as an expense on the income statement when granted, although the cost was disclosed in the notes to the financial statements. This allows a potentially large form of employee compensation to not show up as an expense in the current year, and therefore, currently overstate income. Many assert that over-reporting of income by methods such as this by American corporations was one contributing factor in the Stock Market Downturn of 2002.
Employee stock options have to be expensed under US GAAP (generally accepted accounting principles) in the US. Each company must begin expensing stock options no later than the first reporting period of a fiscal year beginning after June 15th, 2005. As most companies have fiscal years that are calendars, for most companies this means beginning with the first quarter of 2006. As a result, companies that have not voluntarily started expensing options will only see an income statement effect in fiscal year 2006. Companies will be allowed, but not required, to restate prior-period results after the effective date. This will be quite a change versus before, since options did not have to be expensed in case the exercise price was at or above the stock price (intrinsic value based method APB 25). Only a disclosure in the footnotes was required. Intentions from the international accounting body IASB indicate that similar treatment will follow internationally.
Method of option expensing: SAB 107, issued by the SEC, does not specify a preferred valuation model, but 3 criteria must be met when selecting a valuation model: The model 1) is applied in a manner consistent with the fair value measurement objective and other requirements of FAS123R; 2) is based on established financial economic theory and generally applied in the field; and 3) reflects all substantive characteristics of the instrument (i.e. assumptions on volatility, interest rate, dividend yield, etc. need to be specified).
[edit] Types of Employee Stock Options in the United States
In the U.S., stock options granted to employees are of two forms, that differ primarily in their tax treatment. They may be either:
- Incentive stock options (ISOs)
- Non-qualified stock options (NQSOs)
[edit] Taxation of employee stock options in the USA
Because most employee stock options are nontransferrable, are not immediately exercisable, and have other restrictions, the IRS considers that their "fair market value" cannot be "readily determined", and therefore "no taxable event" occurs when an employee receives an option grant. Depending on the type of option granted, the employee may or may not be taxed upon exercise. Non-qualified stock options (those most often granted to employees) are taxed upon exercise. Incentive stock options are not, assuming that the employee complies with certain additional requirements. Most importantly, shares acquired upon exercise must be held for at least one year after the date of exercise. If any of the additional requirements are not fulfilled, there is a "disqualifying dispositon" and the gain realized upon exercise is taxed as ordinary income.
[edit] Notes
- ^ Third Avenue Value Fund Letters to our Shareholders July 31, 2004 (PDF), page 2.
- ^ http://members.shaw.ca/RetailInvestor/truths.html#dilutedEPS
- ^ http://members.shaw.ca/RetailInvestor/truths.html#netback
![[1]](http://members.shaw.ca/RetailInvestor/netback.jpeg){kind=link}