Management Options and Value
Firms use options to reward managers as
well as other employees. There are two effects that these options have on value
per share. One is created by options that have already been granted. These
options, most of which have exercise prices well below the stock price, reduce
the value of equity per share, since a portion of the existing equity in the firm
has to be set aside to meet these eventual option exercises. The other is the
likelihood that these firms will use options on a continuing basis to reward
employees or to compensate them. These expected option grants reduce the
portion of the expected future cash flows that accrue to existing stockholders.
The
Magnitude of the Option Overhang
The
use of options in management compensation packages is not new to firms. Many
firms in the 1970s and 1980s initiated option-based compensation packages to
induce top managers to think like stockholders in their decision making. In
most cases, though, the drain on value created by these options was small
enough that you could ignore it and not affect the value per share
substantially. In the last decade, however, the surge in both the number and
the value of technology firms has highlighted the importance of dealing with
these options in valuation.
What is different about technology firms?
One is that management contracts at these firms are much more heavily weighted
towards options than are those at other firms. The second is that the paucity
of cash at these firms has meant that options are granted not just to top
managers but to employees all through the organization, making the total option
grants much larger. The third is that some of the smaller firms have used
options to meet operating expenses and pay for supplies.
Figure
16.2 summarizes the number of options outstanding as a percent of outstanding
stock at technology firms and compares them to options outstanding at
non-technology firms.
As
Figure 16.2 makes clear, the overhang is larger for younger new technology
firms.
Characteristics
of Option Grants
Firms
that use employee options usually restrict when and whether these options can
be exercised. It is standard, for instance, that the options granted to an
employee cannot be exercised until they are vested. For this to occur,
the employee usually has to remain for a period that is specified with the
contract. While firms do this to keep employee turnover low, it also has
implications for option valuation that are examined later. Firms that issue
options do not face any tax consequences in the year in which they make the
issue. When the options are exercised, however, they are allowed to treat the
difference between the stock price and the exercise price as an employee
expense. This tax deductibility also has implications for option value.
Options
in Existence
Given
the large number of options outstanding at many technology firms, your first
task is to consider ways in which you can incorporate their effect into value
per share. The section begins by presenting the argument for why these
outstanding options matter when computing value per share and then considering
four ways in which you can incorporate their effect on value.
Why
they affect value per share?
Why
do existing options affect value per share? Note that not all options do. In
fact, options issued and listed by the options exchanges have no effect on the
value per share of the firms on which they are issued. The options issued by
firms do have an effect on value per share, since there is a chance that they
will be exercised in the near or far future. Given that these options offer the
right to individuals to buy stock at a fixed price, they will be exercised only
if the stock price rises above that exercise price. When they are exercised,
the firm has two choices, both of which have negative consequences for existing
stockholders. It can issue additional shares to cover the option exercise. But this increases the number of shares
outstanding and reduces the value per share to existing stockholders.[1] Alternatively, it can use cashflows from
operations to buy back shares in the open market and use these shares to meet
the option exercise. This reduces the cash flows available to current equity
investors in future periods and makes their equity less valuable today.
Ways
of Incorporating existing options into value
There
are four approaches that are used to incorporate the effect of options that are
already outstanding into the value per share. However, the first three
approaches can lead to misleading estimates of value.
I. Use
fully diluted number of shares to estimate per-share value
The simplest way to incorporate the
effect of outstanding options on value per share is to divide the value of
equity by the number of shares that will be outstanding if all options are
exercised today Ð the fully diluted number of shares. While this approach has
the virtue of simplicity, it will lead to too low of an estimate of value per
share for two reasons.
á
It
considers all options outstanding, not just the ones that are in the money and
vested. To be fair, there are variants of this approach where the shares
outstanding are adjusted to reflect only in-the-money and vested options.
á
It does not
incorporate the expected proceeds from exercise, which will comprise a cash
inflow to the firm.
Finally,
this approach does not take into consideration the time premium of the options
into the valuation.
Illustration
16.7: Fully Diluted Approach to estimating Value per Share: Commerce One
Commerce
One, as a young and fast-growting B2B business, used options liberally in the
period 1996 to 2000 to compensate employees. Table 16.3 summarizes the options
granted, exercised and canceled each year and also provides information on the
total number of options outstanding at the firm at the end of each of these
years.
Table
16.3: Options Granted, Exercised and Canceled: Commerce One (in Ô000s)
|
|
Granted |
Exercised |
Canceled |
Outstanding |
|
1998 |
7336 |
462 |
1338 |
11334 |
|
1999 |
26288 |
7431 |
2995 |
17195 |
|
2000 |
29023 |
8033 |
2275 |
45911 |
At
the end of 2000, Commerce One had options on 45.911 million shares outstanding,
with a wide range of exercise prices and expiration dates. Table 16.4
summarizes the details of these options.
Table
16.4; Details of Options outstanding: Commerce One
|
Exercise Price Range |
Number of options |
Remaining life |
Average exercise price |
Exercisable & Vested |
Average Exercise price |
|
$ 0.00 - $ 0.40 |
4,771,451 |
7.26 |
$0.19 |
1,889,590 |
$0.13 |
|
$ 0.67 - $ 3.50 |
7,414,524 |
8.38 |
$2.33 |
1,672,662 |
$2.32 |
|
$ 4.71 - $ 24.61 |
5,498,253 |
8.75 |
$15.42 |
1,036,632 |
$14.07 |
|
$25.31 - $ 28.81 |
2,746,602 |
9.73 |
$27.88 |
274,724 |
$27.56 |
|
$30.00 - $ 33.00 |
4,851,300 |
9.29 |
$32.70 |
1,053,513 |
$32.80 |
|
$34.17 - $ 54.69 |
5,032,969 |
9.38 |
$42.75 |
631,181 |
$42.48 |
|
$54.88 - $ 62.81 |
7,926,752 |
9.39 |
$59.75 |
919,951 |
$56.86 |
|
$64.19 - $ 75.07 |
5,000,268 |
9.36 |
$72.12 |
837,853 |
$73.15 |
|
$78.50 - $101.81 |
2,103,829 |
9.2 |
$86.94 |
387,099 |
$89.94 |
|
$104.44 |
565,275 |
9.16 |
$104.44 |
117,755 |
$104.44 |
|
Total |
45,911,223 |
8.92 |
$35.49 |
8,820,960 |
$28.16 |
For
the number of options, the total for remaining life and average exercise price
is the weighted average. For the exercisable and vested options, the total for
average exercise price is the weighted average.
To apply the fully diluted approach to
estimate the per share value, we first estimated the total value of equity for
Commerce One using a discounted cash flow model. The value we obtained was
$4,941 million[2]. At the end of 2000, Commerce One had
228.32 million shares outstanding. To estimate the value of equity per share,
we use the total number of shares that would be outstanding if all options were
exercised.
Value
of Equity per share 
Note,
though, that some of these options are not vested or exercisable. If we
considered only exercisable options, we would estimate a value of equity per
share that is higher.
Value
of Equity per share 
II.
Estimate expected option exercises in the future and build in expected dilution
In this approach, you forecast when in
the future options will be exercised and build in the expected cash outflows
associated with the exercise by assuming that the firm will go out and buy back
stock to cover the exercise. The biggest limitation of this approach is that it
requires estimates of what the stock price will be in the future and when
options will be exercised on the stock. Given that your objective is to examine
whether the price today is correct, forecasting future prices to estimate the
current value per share seems circular. In general, this approach is neither
practical nor is it particularly useful in coming up with reasonable estimates
of value.
III.
Treasury Stock Approach
This approach is a variant of the fully diluted approach.
Here, the number of shares is adjusted to reflect options that are outstanding,
but the expected proceeds from the exercise (exercise price * number of
options) are added to the value of equity. Similar to the fully diluted
approach, this approach does not consider the time premium on the options and
there is no effective way of dealing with vesting. Generally, this approach, by
under estimating the value of options granted, will over estimate the value of
equity per share.
The biggest advantage of this approach is
that it does not require a value per share (or stock price) to incorporate the
option value into per-share value. As you will see with the last (and
recommended) approach, there is a circularity that is created when the stock
price is used in estimating value
per share.
Illustration
16.8: Treasury Stock Approach: Commerce One
To estimate the value per share with the
treasury stock approach for Commerce One, we consider the expected proceeds for
the exercise of the options today. To simplify calculations, we use the total
number of options outstanding and the weighted average exercise price from
Table 16.4.
Expected proceeds from option exercise 
We add the expected proceeds from option
exercise to the value of equity that we estimated for Commerce One and then
divide by the total number of shares outstanding to estimate the value of
equity per share:
Value per share 
Here
again, we could have used the modified approach of looking only at in-the-money
options.
Expected
proceeds from option exercise 
Value per share 
Note
that the value per share using this approach is higher than the value per share
using the fully diluted approach. The difference is greatest when options have a
higher exercise price relative to the current stock price. The estimated value
per share still ignores the time premium of the options.
IV.
Value Options using option pricing model
The
correct approach to dealing with options is to estimate the value of the
options today, given todayÕs value per share and the time premium on the
option. Once this value has been estimated, it is subtracted from the equity
value and divided by the number of shares outstanding to arrive at value per
share.
Value
of Equity per share = 
In valuing these options, however, there
are four measurement issues that you have to confront. One relates to the fact
that not all of the options outstanding are vested, and that some of the
non-vested options might never be vested. The second relates to the stock price
to use in valuing these options. As the description in the last paragraph , the
value per share is an input to the process as well as the output. The third
issue is taxation. Since firms are allowed to deduct a portion of the expense
associated with option exercises, there may be a potential tax saving when the
options are exercised. The final issue relates to private firms or firms on the
verge of a public offering, like Rediff.com. Key inputs to the option pricing
model, including the stock price and the variance, cannot be obtained for these
firms, but the options have to be valued nevertheless.
Dealing
with Vesting
As
noted earlier in the chapter, firms granting employee options usually require
that the employee receiving the options stay with the firm for a specified
period for the option to be vested. Consequently, when you examine the options
outstanding at a firm, you are looking at a mix of vested and non-vested
options. The non-vested options should be worth less than the vested options,
but the probability of vesting will depend upon how in-the-money the options
are and the period left for an employee to vest. While there have been attempts[3] to develop option pricing models that
allow for the possibility that employees may leave a firm before vesting and
forfeit the value of their options, the likelihood of such an occurrence when a
managerÕs holdings are substantial should be small. Carpenter (1998) developed a simple extension of the
standard option pricing model to allow for early exercise and forfeiture and
used it to value executive options.
Which
stock price?
The
answer to this question may seem obvious. Since the stock is traded and you can
obtain a stock price, it would seem that you should be using the current stock
price to value options. However, you are valuing these options to arrive at a
value per share that you will then compare to the market price to decide
whether a stock is under or over valued. Thus, using the current market price
to arrive at the value of the options and then using this option value to
estimate an entirely different value per share seems inconsistent.
There
is a solution. You can value the options using the estimated value per share.
This creates circular reasoning in your valuation. In other words, you need the
option value to estimate value per share and value per share to estimate the
option value. We would recommend that the value per share be initially
estimated using the treasury stock approach and that you then converge on the
proper value per share by iteration.[4]
There
is another related issue. When options are exercised, they increase the number
of shares outstanding and, by doing so, there can have an effect on the stock
price. In conventional option pricing models, the exercise of the option does
not affect the stock price. These models have to be adapted to allow for the
dilutive effect of option exercise.
This can be done fairly simply by adjusting the current stock price for
the expected effects of dilution.
Taxation
When
options are exercised, the firm can deduct the difference between the stock
price at the time and the exercise price as an employee expense for tax
purposes. This potential tax benefit reduces the drain on value created by
having options outstanding. One way in which you could estimate the tax benefit
is to multiply the difference between the stock price today and the exercise
price by the tax rate; clearly, this would make sense only if the options are
in-the-money. While this does not allow for the expected price appreciation
over time, it has the benefit of simplicity. An alternative way of estimating
the tax benefit is to compute the after-tax value of the options.
After-tax
Value of Options = Value from option pricing model (1- tax rate)
This
approach is also straightforward and allows you to consider the tax benefits
from option exercise in valuation. One of the advantages of this approach is
that it can be used to consider the potential tax benefit even when options are
out of the money.
Non-traded
Firms
A
couple of key inputs to the option pricing model Ð the current price per share
and the variance in stock prices Ð cannot be obtained if a firm is not publicly
traded. There are two choices in this scenario for the current share price. One
is to revert to the treasury stock approach to estimate the value of the
options outstanding and abandon the option pricing models. The other is to stay
with the option pricing models and to estimate the value per share, from the
discounted cash flow model. The variance of similar firms that are publicly
traded can be used to estimate the value of the options.