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:http://www.equilar.com/newsletter/september_2006/ect_sept_2006_article2.html
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 (2005 - 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: http://en.wikipedia.org/wiki/Employee_stock_option
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(d1) – K℮-rt*N(d2)
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: http://www.equilar.com/newsletter/september_2006/ect_sept_2006_article2.html
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
1,300,000
0.6506
17.86
300,000
0.1501
350,000
Richard J. Justice
Name
Exercise
Price
($/Share)
Expiration
Date
5% ($)
10% ($)
9/29/2014
12,800,739
31,528,829
17.80
8/12/2014
2,944,093
7,251,441
0.1751
17.86
9/29/2014
3,446,353
8,488,531
525,000
0.2627
17.86
9/29/2014
5,169,529
12,732,797
Dennis D. Powell
400,000
0.2002
17.86
9/29/2014
3,938,689
9,701,178
Randy Pond
425,000
0.2127
17.86
9/29/2014
4,184,857
10,307,502
John T. Chambers
Charles H. Giancarlo
Option Exercises and Holdings
Number of Securities
Underlying Unexercised
Options at July 29, 2006
Name
John T. Chambers
Number of
Shares
Acquired on
Exercise
Value
Realized ($)
Exercisable
Unexercisable
Value of Unexercised In-theMoney Options at July 29,
2006 ($)
Exercisable
Unexercisable
5,850,000
69,674,752
25,316,667
4,533,333
34,149,856
3,882,999
Charles H. Giancarlo
900,000
12,569,877
5,129,999
1,545,001
9,282,901
1,088,048
Richard J. Justice
300,000
2,677,685
3,572,500
1,442,500
1,211,450
1,164,662
Dennis D. Powell
183,750
1,968,151
2,089,562
1,114,521
3,451,875
868,302
Randy Pond
150,000
1,181,314
3,279,416
1,249,584
3,604,181
1,167,200
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.
Black-Scholes model with the weightedaverage assumptions
The weighted-average estimated value of employee stock
options granted during fiscal 2005 and fiscal 2004 were
$6.19 and $8.77, respectively.
Pro forma Financial Statement
(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.