Employee Stock Options

Presented by:

Gary LiangDaniel Lee

Joyce Yuen

Agenda

Employee Stock Option Definition Trend Pros and Cons Accounting Manipulation Outlook

Adobe SystemCisco 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 ESOsThe 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

Exercise Price

($/Share)Expiration

DateName 5% ($) 10% ($)

John T. Chambers 1,300,000 0.6506 17.86 9/29/2014 12,800,739 31,528,829

Charles H. Giancarlo 300,000 0.1501 17.80 8/12/2014 2,944,093 7,251,441

350,000 0.1751 17.86 9/29/2014 3,446,353 8,488,531

Richard J. Justice 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

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 ($)

Name Exercisable Unexercisable Exercisable Unexercisable

John T. Chambers 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.

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