1. Compensation Stock Options and Other Equity Based Compensation

2. Goals: You should be able to … Describe employee stock options Characteristics Growth over time Why firms grant them Define ESPPs and ESOPs

3. Employee Stock Options When employees are granted “employee stock options,” they are generally being granted call options on the company’s stock Were used widely during the 1990s – it was a major component of compensation in some industries (such as tech sector)

4. A Call Option A call option gives its owner the right, but not the obligation, to buy a stock at a specified exercise or strike price on or before a specified exercise date. European call options can be exercised only on a particular day American call options can be exercised on or before the date

5. Payoff to Owning Share of Stock (Payoffs from Buyer’s Perspective) (a)Stock Value 55 P Payoff diagrams show how the payoffs to owners of stock, call and put depend on the share price. (a) shows payoff to owning one share. (b) shows payoff to buying a call option exercisable at $55. {Note: To compute the profit of an option, you would need to subtract off price of the option!} Every $1 increase in the value of the stock increases payoff by $1 (per share)

6. Buying a Call Option (Payoffs from Buyer’s Perspective) (b) Call Option Value 55 55 P Payoff diagrams show how the payoffs to owners of stock, call and put depend on the share price. (a) shows payoff to owning one share. (b) shows payoff to buying a call option exercisable at $55. {Note: To compute the profit of an option, you would need to subtract off price of the option!} Payoff increases dollar-for- dollar, but only after price of stock exceeds the exercise price

7. Call Option Terminology If a call option is issued “at the money,” it means that the exercise price equals the current stock price “Under water” – exercise price exceeds current stock price “In the money” – exercise price is below current stock price

8. Some Properties of a Call Option A call option is MORE valuable if: If stock prices rises If exercise price falls If volatility increases If time to expiration increases

9. Why Grant Options? Basic idea is to align employee and shareholder incentives “Pay-to-performance” link Particularly attractive form of compensation for cash-constrained firms Young start-ups

10. Typical Features of Employee Stock Options American call options (can exercise early) Typical life = 10 years Granted “at-the-money” (exercise price = share price at the time of the grant) Rarely dividend protected Cannot be sold (non-transferable) Have vesting restrictions, i.e., if you leave the firm before the option vests, it is worthless

11. The Rise of CEO Equity-based Pay Source: Brian J. Hall 2002 Salary & Bonus Equity-based Pay $0 $1 $2 $3 $4 $5 $6 $7 $8 19801982198419861988199019921994199619982000 Median CEO Pay ($ millions) 60% 58% 54% 49% 43% 40% 37% 32% 86% 92% 96% 95% 90% 93% 99% 63% 2001 66%

12. Link: CEO Wealth to Stock-Price-Performance 0 2 4 6 8 10 12 80828486889092949698 Year How CEO Wealth changes per $1000 change in shareholder wealth $0 $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 How CEO Wealth changes per 10 percent change in company market value $1000 change10 percent change Source: Hall (2000), based on update of Hall and Liebman (1998).

13. It is not just CEO’s Nov. 1999 survey by Institutional Investor: 15% of corporations grant options only to senior management. 77% grant to both senior and mid-level management. 8% grant to all full-time employees. Options grants to lower level employees has also grown. Cisco even gave options to interns!

14. Arguments for Expensing Options Although the ultimate value of the stock option will not be known until exercised, the option has value when granted. Just as cash wages are expensed from earnings, the value of options grants should be expensed because the firm is giving away something valuable Without up front expensing, as long as the exercise price of the option is >= current stock price at grant, the company never recognizes this compensation as an expenses  earnings for firms with options are overstated if they are not expensing them

15. Effect of Expensing Options For the S&P 1500 firms, subtracting the value of option grants would have reduced reported earnings from 1998-2000 by roughly 10-15%. For tech firms, the reductions would be even more substantial. Even without expensing, firms are required to disclose information about options in a footnote to their financial statements. Must show “diluted” earnings per share.

16. Arguments Against Expensing View options as a dilution of ownership rather than as a cash expense  it is sufficient to fully disclose options so markets can determine implications of grants on future dilution How to value restricted options? There are standard methods available for valuing traded options: Black-Scholes formula is most famous But applying standard methods to employee stock options does not quite work (employee stock options cannot be traded) How often would firms have to update the valuation?

17. Current Status After a decade of debate, FAS 123(R) is now going into effect Large public companies with fiscal years beginning after 6/15/05 must start expensing options grants Others must start by 12/15/05 Firms have fair amount of lattitude Valuation (e.g., P&G will use a binomial lattice model, Qualcomm will use Black Scholes) Prospective v. retrospective recognition Will see some big earnings “hits”

18. Other Effects of Stock Options It is extremely difficult to determine if options grants improve firm performance – they are correlated, but perhaps not causal Evidence suggests that firms with options programs tend to repurchase more stock and pay fewer dividends Options are rarely dividend protected (if pay dividend, it reduces stock price and thus value of option) Firms often repurchase stock to undo the dilution from option grants

19. Employee Stock Purchase Plans Employer –sponsored plan that allows employees to purchase company stock with after-tax income In a typical plan, contributions are made by payroll deduction over a 6-month period Then contributions are used to buy stock at 15% discount off the lower of the price at the beginning or the end of the period Lots of variation in the details!

20. Employee Stock Ownership Plan A qualified plan that is invested entirely in company stock If certain requirements are met, the plan can be used the employer as a means of raising funds on a tax-favored basis Can borrow money indirectly from a bank and repay the loan with fully deductible repayment amounts – structured as contribution to ESOP