Employee Stock Option Analysis Champaign group #1 Dan BeckerBrian MacDonald Cristina BeldicaJamey Maxwell Jawahar KalianiMike Perry

What Are Employee Stock Options?  Stock options permit employees to purchase shares of common stock at a price usually set equal to the market price of the stock at the time the firm grants the stock option. Per Stickney and Weil textbook

How Significant Are Employee Stock Options?

Yes, That Is in Billions of Dollars!

Exercise Price Vs. Market Price

Why Do Firms Issue Stock Options?  To motivate employees to take actions that will increase the market value of a firm’s common shares (agency problem).  To conserve cash.  To attract and retain top talent. National center for employee ownership estimates that employees control. 8.3% of total U.S. Corporate equity, or $663 billion, up from less than 2%. Just a decade ago. Employee stock option plans account for at least $200. Billion of that total.

Stock Option Terminology  Grant date - the date a firm gives a stock option to an employee.  Exercise price – the price specified in the stock option contract for purchasing the common stock. Also called strike price.  Vesting Period – Period of time over which employee gains ownership of options.  Exercise date – the date employees exchange the option and cash for shares of common stock.

Types of Stock Options  Incentive (qualified) vs. Non-qualified. Distinction is made based on the IRS code and relates to the tax treatment of each plan. Incentive options more favorable to employees. Employer receives no tax deduction for compensation expense. No tax paid by employee until stock is sold (long term captial gain or loss). Non-qualified options more favorable to employer. Employer receives tax deduction equal to difference between the market and option price at exercise date.

Incentive Stock Options (ISO’s)  Called “qualified” because they qualify for special tax treatment.  Employee pays no tax on the difference between the market price of the stock and the exercise price of the option until the shares acquired with the options are sold. At that point, the entire option gain (the initial spread at exercise plus any subsequent appreciation) is taxed at long-term capital gains rates.  Employer receives no tax deduction and recognizes no compensation expense.

ISO Conditions  Incentive stock options must be: Granted within ten years of the plan date. Given an option price equal to or greater than the stock’s fair market value on the grant date. Exercised within ten years of the grant date. Exercised only by the employee, who cannot own more than 10% of the voting power before the grant date. Once exercised, the stock must not be disposed of within two years of the option’s grant, or within one year after the exercise date.

Effect of Incentive Stock Options on Employees  Generally reserved for top employees. Employees in higher tax brackets benefit more from capital gains tax treatment than employees in lower tax brackets. Higher-paid workers generally have a better cash position to exercise the options and wait out the one-year minimum period between the exercise date and sale date. If fail to meet the holding period requirement, the stock sale is a "disqualifying disposition.” Employee is taxed as if he had held nonqualified options. The spread between the exercise price and market price at the exercise date is taxed as ordinary income, and only the subsequent appreciation is taxed as capital gain.

ISO’s Final Considerations  The total fair market value of exercisable incentive stock options in a year may not exceed $100,000.  Exercisable only by the employee and are non- transferable, except through a will.  The spread at exercise is considered a preference item for purposes of calculating the alternative minimum tax (AMT), increasing taxable income for AMT purposes. A disqualifying disposition can help you avoid this tax.

Non-qualified Stock Options  Exercise price is typically equal to the market price of the stock.  Employee recognizes ordinary income and pays taxes for the difference between the market price and option price on the exercise date.  Employer recognizes no compensation expense on the books but receives a tax deduction for the difference between the market price and option price on the exercise date.

Non-qualified Continued  If exercise price is less than market price of the stock at grant date then: Employee recognizes ordinary income equal to the spread between the FMV of the stock and the option price on the grant date. Employer receives a corresponding compensation deduction for tax purposes.

Tax Treatment Comparison

Tax Benefit Example

Accounting for Stock Options  FASB accounting for stock based compensation.  Firms not required to include the cost of stock options in their income statements.  Firms must disclose the cost of the options in a footnote, and a table comparing the reported net income vs. The net income reduced by the cost of options.

Pro Forma Disclosure for Amazon

Pro Forma Disclosure for E-bay

Terminology  In the money – stock options with exercise prices less than the current market price of the stock.  Out of the money – stock options with exercise prices greater than the market price of the stock.

Amazon’s Disclosure Market Price at $37.50 Out of the Money In the Money Out of the Money

E-bay’s Disclosure Market Price at $54.75 Out of the MoneyIn the Money Out of the Money

V ALUATION Stock Option

Valuation Two Parties  Employer Opportunity to issue shares for a greater price in future Option value < cash compensation + long term resource  Employer/Employee  Employee Opportunity to work at higher cash compensation & commit Option value > cash compensation + long-term commitment

Valuation Two Elements  Valuation of dream paper called the Option Value consists of two elements Intrinsic value Benefit realized from difference in current market price and exercise price Time value Benefit from any increase in stock price in the exercise period

Valuation Pricing Models  Pricing models Binomial model Black-Scholes model

Valuation Pricing Models- Binomial  Binomial Model Just two outcomes per period price up or down C Cu Cd Cu 2 Cd 2 Cud C Current call price First period Cu Call price when stock price goes up Cu = C (1 + u) Cd Call price when stock price goes down Cd = C (1 + d) Second period Cu 2 = C(1+u)(1+u) Cd 2 = C(1+d)(1+d) Cud = C(1+u)(1+d)

Valuation Pricing Models- Black-Scholes

Valuation Pricing factors  Option value is dependent upon following factors Current stock price Strike price Time to expiration Stock volatility Risk-free interest rate  Analyze major factors

Valuation Analyze factor-Strike Price  In the money: current stock price > strike price  Out of the money: current stock price < strike price  Intrinsic value = current stock price – strike price  Time value = option price – intrinsic value

Valuation Analyze factor-Time to expiration  Time to expiration determines the time value of the option  Time value or speculative value reflects what traders are willing to pay for the uncertainty of the underlying stock  Time value increases with the time to expiration.

Valuation Analyze factor-Stock Volatility  Volatility is the measure of historical variation in the price of the stock  Greater volatility means larger gain in the value of option  FASB allows options to be valued at zero volatility pre-IPO

Valuation Analyze factor-Risk free interest rate  Risk free interest rate is the rate earned on risk less investment (T-bill)  Call option varies directly with the interest rates  Put option prices vary inversely

Valuation Pro-forma Disclosures

Valuation Amazon and E-bay

Valuation Outstanding option pre-IPO & IPO comparison Amazon E-bay

Summary  Incentive vs. Non Qualified.  No Book Entries Made / Footnote Disclosure.  Valuation requires estimates and assumptions.