Compensation

Lecture 19Stock Options and Other Equity Based Compensation

Goals: You should be able to …

Describe employee stock optionsCharacteristicsGrowth over timeWhy firms grant them

Define ESPPs and ESOPs

Employee Stock Options

When employees are granted “employee stock options,” they are generally being granted call options on the company’s stock

Widely used 1990 forward – it was a major component of compensation in some industries (such as tech sector)

A Call Option

A call option gives its owner the right, but not the obligation, to buy a stock at a specified exercise or strike price on or before a specified exercise date.

European call options can be exercised only on a particular dayAmerican call options can be exercised on or before the date

Payoff to Owning Share of Stock(Payoffs from Buyer’s Perspective)(a)Stock Value

55 P Payoff diagrams show how the payoffs to owners of stock, call and put depend on the share price. (a) shows payoff to owning one share. (b) shows payoff to buying a call option exercisable at $55. {Note: To compute the profit of an option, you would need to subtract off price of the option!}

Every $1 increase in the value of the

stock increases payoff

by $1 (per share)

Buying a Call Option(Payoffs from Buyer’s Perspective)

(b) Call Option Value

55

55 P Payoff diagrams show how the payoffs to owners of stock, call and put depend on the share price. (a) shows payoff to owning one share. (b) shows payoff to buying a call option exercisable at $55. {Note: To compute the profit of an option, you would need to subtract off price of the option!}

Payoff increases dollar-for-dollar,

but only after price of stock exceeds

the exercise price

Call Option Terminology

If a call option is issued “at the money,” it means that the exercise price equals the current stock price“Under water” – exercise price exceeds current stock price (out of the money)“In the money” – exercise price is below current stock price

Some Properties of a Call Option

A call option is MORE valuable if:If stock prices rises

If exercise price falls

If volatility increases

If time to expiration increases

Why Grant Options?

Basic idea is to align employee and shareholder incentives

“Pay-to-performance” link

Particularly attractive form of compensation for cash-constrained firms

Young start-ups

Typical Features of Employee Stock Options

American call options (can exercise early)Typical life = 10 yearsGranted “at-the-money” (exercise price = share price at the time of the grant)Rarely dividend protectedCannot be sold (non-transferable)Have vesting restrictions, i.e., if you leave the firm before the option vests, it is worthless

The Rise of CEO Equity-based Pay

Source: Brian J. Hall 2002

Salary & Bonus

Equity-based Pay

$0

$1

$2

$3

$4

$5

$6

$7

$8

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

Med

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60%

58%

54%

49%

43%

40%

37%32%

86%92%96%95%90%

93%99%

63%

2001

66%

Link: CEO Wealth to Stock-Price-Performance

0

2

4

6

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80 82 84 86 88 90 92 94 96 98Year

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$1000 change 10 percent change

Source: Hall (2000), based on update of Hall and Liebman (1998).

It is not just CEO’s

Nov. 1999 survey by Institutional Investor: 15% of corporations grant options only to senior management. 77% grant to both senior and mid-level management. 8% grant to all full-time employees.Options grants to lower level employees has also grown. Cisco even gave options to interns!

Arguments for Expensing OptionsAlthough the ultimate value of the stock option will not be known until exercised, the option has value when granted. Just as cash wages are expensed from earnings, the value of options grants should be expensed because the firm is giving away something valuableWithout up front expensing, as long as the exercise price of the option is >= current stock price at grant, the company never recognizes this compensation as an expenses earnings for firms with options are overstated if they are not expensing them

Effect of Expensing OptionsFor the S&P 1500 firms, subtracting the value of option grants would have reduced reported earnings from 1998-2000 by roughly 10-15%.For tech firms, the reductions would be even more substantial.Even without expensing, firms are required to disclose information about options in a footnote to their financial statements.Must show “diluted” earnings per share.

Arguments Against ExpensingView options as a dilution of ownership rather than as a cash expense it is sufficient to fully disclose options so markets can determine implications of grants on future dilutionHow to value restricted options?

There are standard methods available for valuing traded options: Black-Scholes formula is most famousBut applying standard methods to employee stock options does not quite work (employee stock options cannot be traded)

How often would firms have to update the valuation?

Current StatusAfter a decade of debate, FAS 123(R) is now going into effect

Large public companies with fiscal years beginning after 6/15/05 must start expensing options grantsOthers must start by 12/15/05

Firms have fair amount of lattitudeValuation (e.g., P&G will use a binomial lattice model, Qualcomm will use Black Scholes)Prospective v. retrospective recognition

Will see some big earnings “hits”

Other Effects of Stock Options

It is extremely difficult to determine if options grants improve firm performance – they are correlated, but perhaps not causalEvidence suggests that firms with options programs tend to repurchase more stock and pay fewer dividends

Options are rarely dividend protected (if pay dividend, it reduces stock price and thus value of option)Firms often repurchase stock to undo the dilution from option grants

Employee Stock Purchase Plans

Employer –sponsored plan that allows employees to purchase company stock with after-tax incomeIn a typical plan, contributions are made by payroll deduction over a 6-month period

Then contributions are used to buy stock at 5% to 15% discount off the lower of the price at the beginning or the end of the periodLots of variation in the details!

Employee Stock Ownership Plan

A qualified plan that is invested entirely in company stockIf certain requirements are met, the plan can be used the employer as a means of raising funds on a tax-favored basis

Can borrow money indirectly from a bank and repay the loan with fully deductible repayment amounts – structured as contribution to ESOP