Employee Stock Options Presented by: Gary Liang Daniel Lee Joyce Yuen

Agenda Employee Stock Option  Definition  Trend  Pros and Cons  Accounting  Manipulation  Outlook Adobe System Cisco System

What is ESO? An employee stock option is a Warrant on a company's own stock issued as a form of non-cash compensation.

Characteristics of Warrant Warrant is an option issued by a corporation Granting the purchaser the right to acquire shares The transaction results in a cash inflow to the corporation in exchange for a NEW issue of common shares.

The Era of ESO Poitras (2004) –Executive Stock Option Disclosure: Is FAS 123 Adequate?

Recent Trend of ESO - S&P 500 Companies Figure source:

Why ESO? 1.Agency Problem  Moral Hazard Occur from separation of ownership and control Effort is unobservable, managers may shirk on effort  ESO aims at aligning executives’ and employees’ interests with shareholders  Long term incentive for execs and employees

Why ESO? (cont.) 2.No Cash Requirement  especially good for growing companies or companies with high intellectual capital 3.Accounting incentive (before 2004)

Why ESO? (cont.) 3.Personal tax incentive  No income taxed until exercised  When taxed, categorized as capital gain (only 50% taxable) 4.Deferred dilutions of earnings and voting controls 5.Rising share price motivates employees to work harder and longer

Critiques of ESOs The main criticisms against executive stock options: (i) The difficulty of accounting, expensing options in particular; (ii) The opportunity cost of options for the granting firm higher than the value of options to undiversified executives; (iii) Giving executives extra incentives to manipulate accounting information; (iv) Rewarding executives excessively in the boom market; (v) Failure to penalize bad performance by resetting option price in the down market (vi) Encouraging executives to take excessive risks at the cost of the shareholders. Reference: Chongwoo Choe, Xiangkang Yin (2006). Should Executive Stock Options Be Abandoned? Australian Journal of Management, 31(2), 163

Accounting of ESO (1972) Accounting Principle Board 25 (1972)  Expense will be the fair value amount or the intrinsic amount  Loophole: if a firm sets the exercise price of the option equal to the Market price at grant date, then $0 expense is recognized

Accounting of ESO (1995) Financial Accounting Standard Board 123 (1995)  Financial Accounting Standards Board (FASB) encouraged the use of fair value methods & mandated disclosure in the notes, but firms could still use the intrinsic method

Accounting of ESO (2005) FASB 123 ( revised)  FASB made fair value method of expensing stock options mandatory for all annual and interim reports after June 15, 2005 Effects:  Sliced 20% of reported income (Business week, 2003)

Valuations of ESO Intrinsic Value = Market Price at grant day – exercise price Fair value of stock options = “intrinsic value + time value”:  The Lattice Model (e.g. Binominal Model)  Black-Scholes Model  Other valuations

Choice of Valuation Model The majority of public and private companies apply the Black-Scholes model, however, through September 2006, over 350 companies have publicly disclosed the use of a lattice model in SEC filings. Source:

Black-Scholes and Lattice-Binominal Not Accurate! Black-Scholes  Assume free transferability, but not for ESO  Assume non-contingent exercisable option, but ESO void as soon as holders leave the company  Contain lots of estimations Lattice-Binominal  Can be applied to more different kinds of options  Still contain estimations

Black-Scholes Model C(S,T) = S*N(d 1 ) – K℮ -rt *N(d 2 ) Lots of estimations in the valuation, another loophole for manipulation?

The “Power” of Estimations Capital One Financial, 2002  Reduce option life from 8.5 to 5 years  Cut option cost $29.3 million Broadcom Corp., 2002  Reduce volatility from 90% to 70%  Save $79 million

Evidences from Academic Studies One out of five companies in the Standard & Poor's 500-stock index reduced option life, stock volatility, or both, in 2002, increasing actual or pro forma earnings in the process. -Jack T. Ciesielski, The Analyst's Accounting Observer Compared accounting assumptions used to value options in 2002 with actual historical trends and found that many companies underestimated both volatility and the risk-free interest rate. -Derek Johnston-Wilson, Colorado State University

Other Management Manipulations Other Management manipulation  Management controls over stock option grants  Stock repurchase instead of dividends  Misrepresentation of company performance  Executives influence the restrictions of the stock options in their own favour  Forfeiting profitable but risky businesses

Back-Dating Proposed by Erik Lie (2005) in his study  dates on which options are granted to executives are chosen with the benefit of hindsight to be past dates when the stock price was particularly low SEC investigated the issue, big time  Included Jack Welch, GE and Donald Tyson, Tyson Food  Silicon Valley firms (30-40)

Back-Dating Lynn Turner, a former SEC chief accountant, suspects it's a fairly common practice and ‘bigger than most people realize.’ Adds a Silicon Valley lawyer who asked not to be named: ‘I’d be surprised if there was even one public tech company that did not employ this practice in those [bubble] years.”  Randall and Erik Lie, 2005

Outlook for ESO Loopholes still exist Decreasing trend due to changing accounting requirements  Among the S&P 500 companies, stock option grants dropped 26% in 2005 Substitutes: Restricted Stocks  In 2005 the S&P 500 companies increased such awards by 44%

Recent Trend of ESO – S&P 500 Companies Figure source:

Company Overview Adobe Systems Incorporated offers business and mobile software and services worldwide It operates in five business segments: Creative Solutions, Knowledge Worker Solutions (KWS), Mobile and Device Solutions (MDS), Enterprise and Developer Solutions (EDS), and Other Stock Symbol: NASDAQ NM: ADBE Doesn’t have any debt Doesn’t pay a dividend

How Adobe Grants Stock Options Based on relative position Based on responsibilities Based on performance Based on anticipated future performance Grants options at a exercise price equal to that day’s closing price

Executive Compensation Summary

Past Financial Statements

2006 Financial Statements

Stock Options Outstanding

Assumptions to Value Options and Employee Stock

Company Overview Worldwide leader in networking for the Internet Founded in 1984 by a group of computer scientists from Stanford University. Stock Symbol: NASDAQ NM: CSCO (Common Stock) IPO: Cisco went public on February 16, 1990 at a split-adjusted price of about 6 cents. Employees: As of the end of Q2 FY 2007 (January 27, 2007) Cisco has 54,563 employees worldwide.

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN AMONG CISCO SYSTEMS, INC., THE S & P INFORMATION TECHNOLOGY INDEX AND THE S & P 500 INDEX

Compensation Components The three material elements of Cisco’s executive officer compensation are: (i) base salary, (ii) variable cash incentive awards and (iii) long-term, equity-based incentive awards.

Option Grants in 2006 Individual Grants Potential Realizable Value at Assumed Annual Rates of Stock Price Appreciation for Option Term Number of Securities Underlying Options Granted % of Total Options Granted to Employees in Fiscal Year Exercise Price ($/Share) Expiration Date Name5% ($)10% ($) John T. Chambers1,300, /29/201412,800,73931,528,829 Charles H. Giancarlo 300, /12/20142,944,0937,251, , /29/20143,446,3538,488,531 Richard J. Justice525, /29/20145,169,52912,732,797 Dennis D. Powell400, /29/20143,938,6899,701,178 Randy Pond425, /29/20144,184,85710,307,502

Option Exercises and Holdings Number of Shares Acquired on Exercise Value Realized ($) Number of Securities Underlying Unexercised Options at July 29, 2006 Value of Unexercised In-the- Money Options at July 29, 2006 ($) NameExercisableUnexercisableExercisableUnexercisable John T. Chambers5,850,00069,674,75225,316,6674,533,33334,149,8563,882,999 Charles H. Giancarlo900,00012,569,8775,129,9991,545,0019,282,9011,088,048 Richard J. Justice300,0002,677,6853,572,5001,442,5001,211,4501,164,662 Dennis D. Powell183,7501,968,1512,089,5621,114,5213,451,875868,302 Randy Pond150,0001,181,3143,279,4161,249,5843,604,1811,167,200

Consolidated Balance Sheets (in millions, except par value)

Consolidated Statements of Operations (in millions, except per-share amounts)

Consolidated Statements of Cash Flows (in millions)

Consolidated Statements of Shareholders' Equity (in millions)

Ranges of outstanding and exercise options as of July 29, 2006 (in millions)

Intrinsic value of stock options The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value based on stock options with an exercise price less than the Company’s closing stock price of $18.08 as of July 29, 2006, which would have been received by the option holders had those option holders exercised their options as of that date. The total number of in-the-money stock options exercisable as of July 29, 2006 was 303 million. As of July 30, 2005, 906 million outstanding stock options were exercisable and the weighted-average exercise price was $28.80.

The weighted-average estimated value of employee stock options granted during fiscal 2005 and fiscal 2004 were $6.19 and $8.77, respectively. Black-Scholes model with the weighted- average assumptions

(1) Net income and net income per share prior to fiscal 2006 did not include stock-based compensation expense related to employee stock options and employee stock purchases under SFAS 123 because the Company did not adopt the recognition provisions of SFAS 123. (2) Stock-based compensation expense prior to fiscal 2006 is calculated based on the pro forma application of SFAS 123. (3) Net income and net income per share prior to fiscal 2006 represents pro forma information based on SFAS 123. Pro forma Financial Statement