compensation lecture 19 stock options and other equity based compensation
TRANSCRIPT
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
$8
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
Med
ian
CE
O P
ay
($ m
illio
ns
)
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
8
10
12
80 82 84 86 88 90 92 94 96 98Year
Ho
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EO
We
alt
h c
han
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s p
er
$10
00
ch
an
ge
in
sh
are
ho
lde
r w
ea
lth
$0
$200,000
$400,000
$600,000
$800,000
$1,000,000
$1,200,000
Ho
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EO
We
alt
h c
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er
10 p
erc
en
t c
ha
ng
e i
n c
om
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ma
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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