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Employee Stock Options Presented By: Justin Hovis Wilson Kwong Jessica vandenAkker.
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Transcript of Employee Stock Options Presented By: Justin Hovis Wilson Kwong Jessica vandenAkker.
Employee Stock Options
Presented By:Justin HovisWilson KwongJessica vandenAkker
Outline
Overview of Stock Options and Stock-Based Compensation
Stock Based Compensation & Microsoft
Stock Options at Cisco
What Are Stock Options?
Stock Options
Form of Employee compensation Option
Grants holder right to buy a specific number of shares at a specific price (exercise price) on or after a specific date (exercise date)
Grant date is the date the option is given to the employee
Features of Stock Options
Tend to vest at certain rate over time, say 25% become exercisable each year
Non-transferable & generally forfeitable if employee leaves firm
When exercised, firm will generally issue new stock or may repurchase stock in the market
Features of Stock Options
Executive Stock Options (ExSO)Stock option plans given to the top 5
executives Employee Stock Options (ESO)
Broad-based stock option plans available to at least 50% of full-time workforce
ExSOs & ESOs
ESOs make up over 90% of value of stock options givenMain issue is the value of compensation
ExSO much higher individual valuesMain concern is corporate governance & level
of compensation given to top executives
Why Stock Options?
Agency TheoryStock options are intended to minimize the
problem of the separation of management and ownership
Stock options would help management think and act like owners
New Economy FirmsHigh in Intellectual Capital
Intrinsic Value of Stock Options
The Intrinsic Value of a stock option is its market price at grant date less the exercise price
Intrinsic Value
Market Price @ Grant Date
Exercise Price
Fair Value of Stock Options
The Fair Value of stock options is the intrinsic value as well as the time value, which incorporates the volatility of the stock over its vesting period
2 Valuation Methods:Binomial (Lattice) ModelBlackScholes Model
Fair Value of Stock Options
The BlackScholes Method
Assumes options are freely transferable and investor is fully hedged
Less accurate for longer-period optionsPossibility for management manipulation in
estimates
History of Accounting for Employee Stock Options APB 25 (1972)
Expense will be the fair value amount or the intrinsic amount
Loophole: if a firm sets the exercise price of the option equal to the Market price at grant date, then $0 expense is recognized
History of Accounting for Employee Stock Options
FAS 123 (1993)Financial Accounting Standards Board
(FASB) encouraged the use of fair value methods & mandated disclosure in the notes, but firms could still use the intrinsic method
History of Accounting for Employee Stock Options
FAS 123 (2004 - revised)FASB made fair value method of expensing
stock options mandatory for all annual and interim reports after June 15, 2005
Comparison of Valuation
Modified Example*:Grant Date: (Jan 1, Year 1)
Stock option granted with a strike price of $100 and BlackScholes value of $16
Exercise Date: Jan 1, Year 2Exercised: Jan 1, Year 3, market price = $121
* Example taken from: “Stock Options Revisited” (2003, p.37) by Joseph Rue, Ara Volkan, Ron Best and
Gerald Lobo
Modified Example of Methods
Accounting Under the Intrinsic Method:12/31/03 Dr. Cash $100
Cr. Common Stock $100
Accounting Under FAS 123:12/31/01 Dr. Option Expense $16
Cr. Paid-in Capital: Options $16 12/31/03 Dr. Cash $100
Dr. Paid-in Capital: Options $16 Cr. Common Stock $100 Cr. Paid-in Capital $16
FAS 123 (2004 – Revised)
Allows for compensation expense to be revalued each period to include current price movements and for forfeitures
Applies to all stock-based compensation including: stock options, restricted stock, and restricted stock units
Alternatives to Stock Options
Restricted Stock & Restricted Stock Units
Employee Share Purchase Plans (EMPPs)
Stock Appreciation Rights (SARs)
Future of Stock Based Compensation Many firms anticipated the change in
accounting policy and have changed their method of compensation:Coca-ColaAmazon.com IBMMicrosoft
Why Restricted Stock?
Less risk Better motivation for managers to act as
ownersHolder has additional rights of receiving
dividends and voting rightsTax advantages when performance based
Conclusion
Accounting standards heavily influenced form of compensation
Recent changes have motivated firms to find more efficient methods of compensation
Likely that future loopholes will be found (ie tax benefit of restricted stock)
MICROSOFT
Microsoft’s Lines of Business
1)Client
2)Server and Tools
3)Information Worker
4)Business Solutions
5)MSN
6)Mobile and Embedded Services
7)Home and Entertainment
Stock Based Compensation
2004: 5.73 billion dollars 2003: 3.75 billion dollars 2002: 3.78 billion dollars 2001: Net Income would’ve been 2.7
billion less if it was re-stated Adopted SFAS123 in Fiscal 2003
Executive Compensation
Bill Gates and Steve Ballmer: salary of $591,000
No stock options received
No stock options outstanding
Other Execs.
J. Allchin: exercised $5.9 million of shares and holds $7.2 million of unexercised options
J. Raikes: exercised $37 million of shares and holds $7.2 million of unexercised options
Executives officers, and directors hold 30%+ of common shares
Diluted EPS
2004: EPS of 0.75 2003: EPS of 0.69
After-tax, after stock based compensation, EPS were 0.35 and 0.23 respectively
Decrease of 53% and 67%
Employee Options Transfer
In 2004 completed an options transfer program with JP Morgan
344.6 million eligible options (55% of total) were sold off
$2.21 billion of unrecognized compensation costs
Employee Options Transfer
JP Morgan paid $382 million
Approximate average of $1.10 per option
Price relative to 3 week avg. of Microsoft’s closing stock price
Employee Options Transfer
Options eligible for transfer had a strike price $33 or higher
The options deep out-of-the-money
Possible reason for low transfer price
All unvested options became vested after transfer
Stock Awards (Restricted Stock)
Shift from stock options to stock awards
“Provides more predictable long-term rewards than options…”
Based on specified performance variables
Stock Awards cont…
Generally a 3 year vesting period
5 year amortization period
Stock Awards not very clear in financial statements
Stock options had a break down of number outstanding and strike prices
Special Dividend
$3.00 dividend paid in Dec. 2004
Over $30 billion paid out
Approval of dividend allowed for changes to past stock plan
Special Dividend cont…
In theory, the stock price drops by the dividend payout at post-dividend
Options are generally not protected from dividends
Exercise Price Change
New strike price = (Closing Price-$3)/Closing Price x Pre-dividend strike Price
Strike price will be dropped by less than $3
Shares Covered per Option
Number of Shares Post-Div
= Closing Price / (Closing Price - $3) x Number of Shares Pre-Div
Overall Summary
Microsoft was quick to adopt accounting for stock compensation (2003)
Decided to phase out stock options
Paid out a large special dividend
Adjusted the terms of their options
Company Overview
Worldwide leader in networking for the Internet
Founded in 1984 Exchange – NASDAQ Ticker – CSCO Share Price – $18 Briefly the world’s most valuable company
Fiscal 2004 Performance
Revenue: $22B Net Income (As Reported): $4.4B EPS (Diluted): $0.62 Cash From Operations: $7.1B Figures subject to pro forma adjustment
Options valued at Intrinsic Value in accordance with APB 25
Pro Forma Adjustment
“The Black-Scholes option pricing model was developed for use in estimating the value of traded options that have no vesting restrictions and are fully transferable. In addition, option pricing models require the input of highly subjective assumptions, including the
expected stock price volatility and expected life. Because the company’s employee stock options have characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the estimate, in management’s opinion, the existing valuation models do not provide a reliable
measure of the fair value of the company’s employee stock options.”
Executive Compensation
Options Exercised – Fiscal 2004
Option Grants – Fiscal 2004
Executive Share Ownership
(4) Includes options to purchase 30,866,667 shares
(11) Includes options to purchase 100,000 shares
Conclusions
One of the worst offenders in use of excessive ESOs and ExSOs
Impact on share valuation?
Future compensation strategies?
The End
Thank You!