Employee Stock Options
Employee stock options are usually granted to management personnel to attract talent and to motivate them to increase the value of the company, and, therefore, its stock price. Employee stock options give the employee the right to buy company stock after a stipulated period of employment for a stipulated price that is usually equal to the price of the company's stock when the stock option was granted. The recent news about back-dated options involves specifying a date previous to the actual granting of the option to when the stock price was at its lowest, thereby making the stock option grant more valuable, but not accounting for the added expense in financial statements.
Employee stock options differ from exchange-traded call options because
- there is a vesting requirement that requires the employee to work a minimum number of years for the company;
- the term of the options can last 10 years, but usually not longer, because, then, the options would be treated as nonstatutory stock options, which would receive less unfavorable tax treatment;
- and if an employee leaves the company, he must either exercise his vested options or forfeit them.
Evaluating employee stock options
Stock options have value, so if a company grants employees stock options, then the company is giving something that has value. If the company sold the options to the public, it would have more cash. Indeed, when the employee exercises the option, the company can deduct the market value of the stock in its taxes. By giving it to employees, it is giving an equivalent of cash, and, therefore, it should be expensed on the company's income statement. However, many companies have resisted this, because it will result in lower reported earnings.
The purpose of evaluating employee stock options is to determine the impact on company earnings such grants have. Previously, many companies, particularly high-tech companies that used them extensively to attract top talent, reported the option grants in footnotes rather than as a compensation expense, which would lower reported earnings. On the other hand, it is more difficult to evaluate footnotes than to compare numbers among different companies. Now that companies are required to expense option grants, they are looking at various ways to determine a value for the granted options.
Various pricing models are used, especially the Black-Scholes formula, which is commonly used to valuate exchange-traded options. The problem with using pricing models is that different companies can use different models, and, thus, it may be misleading for investors to compare the financial numbers of one company with another. A further complication is that a major component of all pricing models is the volatility of the stock, which must be estimated.
One company, Zions, tried a marketing approach by creating options with similar terms to employee stock options, then sold them to sophisticated investors at an auction. The options sold for half of what pricing models would have predicted. However, this market-based approach may be flawed, due to the number and sophistication of the bidders, and various other factors.
Is the Market Value of an Employee Stock Option Really a Better Indicator of the Actual Expense to the Company?
It seems unlikely that the market value of an employee stock option will be equal to its actual expense to the company, for they are not really connected. Companies, of course, prefer the market value if it lowers the compensation expense, and Zion's experiment would seem to indicate that. Of course, if pricing models yielded a lower figure, then companies wouldn't even be talking about using the market model, which has its own problems, such as actually issuing the securities and selling them in a bidding auction. The companies just want a lower expense number, which will result in higher reported earnings. It may be better to require companies to use a single pricing model so that investors can compare apples to apples.
- The Zuckerberg Tax - NYTimes.com - Although employee stock options are taxed like any other employee compensation when they are exercised and the stock is sold, significant tax savings can be realized by borrowing against the stock instead of selling it. The interest paid on the loan will be significantly less than 30%+ tax assessed on the proceeds of a stock sale. Reportedly, Lawrence J. Ellison, the CEO of Oracle, borrowed more than $1 billion against his shares in Oracle to buy one of the world's most expensive yachts. When Steve Jobs became CEO of Apple in 1997, he received stock, which at the time of his death, was worth over $2 billion. He never sold any of it and so he never had to pay any tax on it. Though the estate will have to pay tax on the fair market value of the stock when Jobs died, the beneficiaries of the shares can sell the stock and pay tax only on the price difference between the sale price and that fair market value.
- USATODAY.com - Stock options to ripple through earnings - Most companies have to deduct the cost of stock options in their reports this year, and this article discusses how this will lower the expected earnings of some companies, especially since many analysts haven't included options costs in their estimates.