Employee Stock Options Presented By: Justin Hovis Wilson Kwong Jessica vandenAkker

Outline Overview of Stock Options and Stock- Based 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 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 ( 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 Joseph Rue, Ara Volkan, Ron Best and Gerald Lobo

Modified Example of Methods Accounting Under the Intrinsic Method: 12/31/03Dr. Cash$100 Cr. Common Stock$100 Accounting Under FAS 123: 12/31/01Dr. Option Expense$16 Cr. Paid-in Capital: Options $16 12/31/03Dr. Cash$100 Dr. Paid-in Capital: Options$16 Cr. Common Stock $100 Cr. Paid-in Capital $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 2)Server and Tools 3)Information Worker 4)Business Solutions 5)MSN 6)Mobile and Embedded Services 7)Home and Entertainment

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 : 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 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 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!