Employee Stock Options
Presented By:
Justin Hovis
Wilson Kwong
Jessica vandenAkker
Outline

Overview of Stock Options and StockBased Compensation

Stock Based Compensation & Microsoft

Stock Options at Cisco
What Are Stock
Options?
Stock Options
Form of Employee compensation
 Option

 Grants
holder right to buy a specific number
of shares at a specific price (exercise price)
on or after a specific date (exercise date)
 Grant date is the date the option is given to
the employee
Features of Stock Options
Tend to vest at certain rate over time, say
25% become exercisable each year
 Non-transferable & generally forfeitable if
employee leaves firm
 When exercised, firm will generally issue
new stock or may repurchase stock in the
market

Features of Stock Options

Executive Stock Options (ExSO)
 Stock
option plans given to the top 5
executives

Employee Stock Options (ESO)
 Broad-based
stock option plans available to at
least 50% of full-time workforce
ExSOs & ESOs

ESOs make up over 90% of value of stock
options given
 Main

issue is the value of compensation
ExSO much higher individual values
 Main
concern is corporate governance & level
of compensation given to top executives
Why Stock Options?

Agency Theory
 Stock
options are intended to minimize the
problem of the separation of management
and ownership
 Stock options would help management think
and act like owners

New Economy Firms
 High
in Intellectual Capital
Intrinsic Value of Stock Options

The Intrinsic Value of a stock option is its
market price at grant date less the
exercise price
Intrinsic
Value
Market Price
@ Grant Date
Exercise
Price
Fair Value of Stock Options
The Fair Value of stock options is the
intrinsic value as well as the time value,
which incorporates the volatility of the
stock over its vesting period
 2 Valuation Methods:

 Binomial
(Lattice) Model
 BlackScholes Model
Fair Value of Stock Options

The BlackScholes Method
 Assumes
options are freely transferable and
investor is fully hedged
 Less accurate for longer-period options
 Possibility for management manipulation in
estimates
History of Accounting for
Employee Stock Options

APB 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
History of Accounting for
Employee Stock Options

FAS 123 (1993)
 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
History of Accounting for
Employee Stock Options

FAS 123 (2004 - revised)
 FASB
made fair value method of expensing
stock options mandatory for all annual and
interim reports after June 15, 2005
Comparison of Valuation

Modified Example*:
 Grant

Date: (Jan 1, Year 1)
Stock option granted with a strike price of $100
and BlackScholes value of $16
 Exercise
Date: Jan 1, Year 2
 Exercised: Jan 1, Year 3, market price = $121
* Example taken from: “Stock Options Revisited” (2003, p.37) by
Gerald Lobo
Joseph Rue, Ara Volkan, Ron Best and
Modified Example of Methods
Accounting Under the Intrinsic Method:
12/31/03
Dr. Cash
$100
Cr. Common Stock
$100
Accounting Under FAS 123:
12/31/01
Dr. Option Expense
$16
Cr. Paid-in Capital: Options
12/31/03
Dr. Cash
Dr. Paid-in Capital: Options
Cr. Common Stock
Cr. Paid-in Capital
$16
$100
$16
$100
$16
FAS 123 (2004 – Revised)

Allows for compensation expense to be
revalued each period to include current
price movements and for forfeitures

Applies to all stock-based compensation
including: stock options, restricted stock,
and restricted stock units
Alternatives to Stock Options

Restricted Stock & Restricted Stock Units

Employee Share Purchase Plans (EMPPs)

Stock Appreciation Rights (SARs)
Future of Stock Based
Compensation

Many firms anticipated the change in
accounting policy and have changed their
method of compensation:
 Coca-Cola
 Amazon.com
 IBM
 Microsoft
Why Restricted Stock?
 Less
risk
 Better motivation for managers to act as
owners
 Holder has additional rights of receiving
dividends and voting rights
 Tax advantages when performance based
Conclusion
Accounting standards heavily influenced
form of compensation
 Recent changes have motivated firms to
find more efficient methods of
compensation
 Likely that future loopholes will be found
(ie tax benefit of restricted stock)

MICROSOFT
Microsoft’s Lines of Business

1)Client

5)MSN

2)Server and Tools


3)Information Worker

6)Mobile and
Embedded Services
7)Home and
Entertainment

4)Business Solutions
Stock Based Compensation
2004: 5.73 billion dollars
 2003: 3.75 billion dollars
 2002: 3.78 billion dollars
 2001: Net Income would’ve been 2.7
billion less if it was re-stated
 Adopted SFAS123 in Fiscal 2003

Executive Compensation

Bill Gates and Steve Ballmer: salary of
$591,000

No stock options received

No stock options outstanding
Other Execs.
J. Allchin: exercised $5.9 million of shares
and holds $7.2 million of unexercised
options
 J. Raikes: exercised $37 million of shares
and holds $7.2 million of unexercised
options
 Executives officers, and directors hold
30%+ of common shares

Diluted EPS
2004: EPS of 0.75
 2003: EPS of 0.69


After-tax, after stock based compensation,
EPS were 0.35 and 0.23 respectively

Decrease of 53% and 67%
Employee Options Transfer

In 2004 completed an options transfer program
with JP Morgan

344.6 million eligible options (55% of total) were
sold off

$2.21 billion of unrecognized compensation
costs
Employee Options Transfer

JP Morgan paid $382 million

Approximate average of $1.10 per option

Price relative to 3 week avg. of Microsoft’s
closing stock price
Employee Options Transfer

Options eligible for transfer had a strike price
$33 or higher

The options deep out-of-the-money

Possible reason for low transfer price

All unvested options became vested after
transfer
Stock Awards (Restricted Stock)

Shift from stock options to stock awards

“Provides more predictable long-term
rewards than options…”

Based on specified performance variables
Stock Awards cont…

Generally a 3 year vesting period

5 year amortization period

Stock Awards not very clear in financial
statements

Stock options had a break down of number
outstanding and strike prices
Special Dividend

$3.00 dividend paid in Dec. 2004

Over $30 billion paid out

Approval of dividend allowed for changes
to past stock plan
Special Dividend cont…

In theory, the stock price drops by the
dividend payout at post-dividend

Options are generally not protected from
dividends
Exercise Price Change

New strike price = (Closing Price$3)/Closing Price x Pre-dividend strike Price

Strike price will be dropped by less than $3
Shares Covered per Option
Number of Shares Post-Div
= Closing Price / (Closing Price - $3) x
Number of Shares Pre-Div

Overall Summary

Microsoft was quick to adopt accounting for
stock compensation (2003)

Decided to phase out stock options

Paid out a large special dividend

Adjusted the terms of their options
Company Overview
Worldwide leader in networking for the
Internet
 Founded in 1984
 Exchange – NASDAQ
 Ticker – CSCO
 Share Price – $18
 Briefly the world’s most valuable company

Fiscal 2004 Performance
Revenue: $22B
 Net Income (As Reported): $4.4B
 EPS (Diluted): $0.62
 Cash From Operations: $7.1B
 Figures subject to pro forma adjustment

 Options
valued at Intrinsic Value in
accordance with APB 25
Pro Forma Adjustment
“The Black-Scholes option pricing model was developed for use in estimating the value of
traded options that have no vesting restrictions and are fully transferable. In addition,
option pricing models require the input of highly subjective assumptions, including the
expected stock price volatility and expected life. Because the company’s employee stock
options have characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the estimate,
in management’s opinion, the existing valuation models do not provide a reliable measure
of the fair value of the company’s employee stock options.”
Executive Compensation
Options Exercised – Fiscal 2004
Option Grants – Fiscal 2004
Executive Share Ownership
(4) Includes options to purchase 30,866,667 shares
(11) Includes options to purchase 100,000 shares
Conclusions

One of the worst offenders in use of
excessive ESOs and ExSOs

Impact on share valuation?

Future compensation strategies?
The End
Thank You!