Management options COntrol and liquidity

impli-ILLUSTRATION 7.1 Options Outstanding Table 7.1 summarizes the number of options outstanding at each of the firms that we are valuing, with the average exercise price and maturity o

We also consider two other issues that may be of relevance,especially when valuing smaller technology firms or privatebusinesses The first issue is the concentration of shares in thehands of the owner/managers of these firms and the conse-quences for stockholder power and control This effect isintensified when a firm has shares with different voting rights.

The second issue is the effect of illiquidity When investors in afirm’s stock or equity cannot easily liquidate their positions,the lack of liquidity can affect value This can become anissue, not only when you are valuing private firms, but alsowhen valuing small publicly traded firms with relatively fewshares traded.

M a n a g e m e n t a n d E m p l o y e e O p t i o n s

Firms use options to reward managers as well as otheremployees These options have two effects on value per share.One is created by options that have already been granted.These options reduce the value of equity per share, since aportion of the existing equity in the firm has to be set aside tomeet these eventual option exercises The other is the likeli-hood that these firms will continue to use options to rewardemployees or to compensate them These expected optiongrants reduce the portion of the expected future cash flowsthat accrue to existing stockholders

T h e M a g n i t u d e o f t h e O p t i o n O v e r h a n g

The use of options in management compensation packages

is not new to technology firms Many firms in the 1970s and1980s initiated option-based compensation packages to inducetop managers to think like stockholders in their decision mak-ing What is different about technology firms? One difference

is that management contracts at these firms are much moreheavily weighted toward options than are those at other firms.The second difference is that the paucity of cash at these firmshas meant that options are granted not just to top managersbut to employees all through the organization, making thetotal option grants much larger The third difference is thatsome of the smaller firms have used options to meet operatingexpenses and to pay for supplies

Figure 7–1 summarizes the number of options outstanding

as a percent of outstanding stock at technology firms and pares them to options outstanding at nontechnology firms

com-C h a p t e r 7 • M a n a g e m e n t O p t i o n s , C o n t r o l , a n d L i q u i d i t y 227

As Figure 7–1 makes clear, the overhang is larger foryounger new technology firms In Figure 7–2, the number ofoptions as a percent of outstanding stock at Amazon, Ariba,Cisco, Motorola, and Rediff.com are reported

Rediff.com has no options outstanding, but the other fourfirms have options outstanding Amazon, in particular, hasoptions on 80.34 million shares, representing more than 22%

of the actual shares outstanding at the firm (351.77 million).Motorola, reflecting its status as an older and more maturefirm, has far fewer options outstanding, relative to the number

of outstanding shares

Firms that use employee options usually restrict when andwhether these options can be exercised It is standard, forinstance, that the options granted to an employee cannot be

exercised until they are vested For vesting to occur, the

employee usually has to remain for a period that is specified in

a contract Firms do this to keep employee turnover low, but

the practice also has implications for option valuation, as weexamine later Firms that issue options do not face any taxconsequences in the year in which they make the issue Whenthe options are exercised, however, firms are allowed to treatthe difference between the stock price and the exercise price

as an employee expense This tax deductibility also has cations for option value

impli-ILLUSTRATION 7.1

Options Outstanding

Table 7.1 summarizes the number of options outstanding at each of the firms that we are valuing, with the average exercise price and maturity of the options, as well as the per- cent of the options that are vested in each firm.

C h a p t e r 7 • M a n a g e m e n t O p t i o n s , C o n t r o l , a n d L i q u i d i t y 229

While Amazon has far more options outstanding as a percent of the outstanding stock, Ariba’s options have a much lower exercise price, on average In fact, Ariba’s stock price

of $75 at the time of this analysis was almost eight times the average exercise price of

$6.77 The average maturity of the options at all of these firms is also in excess of six

combination of a low exercise price and long maturity make the options issued by these firms very valuable Fewer of Amazon and Ariba’s options are vested, reflecting the fact that these are younger firms which have granted more of these options recently

O p t i o n s i n E x i s t e n c e

Given the large number of options outstanding at manytechnology firms, your first task is to consider ways in whichyou can incorporate their effect into value per share The sec-tion begins by presenting the argument for why these out-standing options matter when computing value per share andthen considers four ways in which you can incorporate theireffect on value

Why Options Affect Value per Share Why do existing options affect

value per share? Note that not all options do In fact, optionsissued and listed by the options exchanges have no effect onthe value per share of the firms on which they are issued Theoptions issued by firms do have an effect on value per share,since there is a chance that they will be exercised in the near

or far future Given that these options offer the right to viduals to buy stock at a fixed price, they will be exercisedonly if the stock price rises above that exercise price When

indi-TABLE 7.1 Options Outstanding

they are exercised, the firm has two choices, both of whichhave negative consequences for existing stockholders Thefirm can issue additional shares to cover the option exercise.But this increases the number of shares outstanding andreduces the value per share to existing stockholders.2 Alterna-tively, the firm can use cash flows from operations to buy backshares in the open market and use these shares to meet theoption exercise This approach reduces the cash flows avail-able to current equity investors in future periods and makestheir equity less valuable today

Ways of Incorporating Existing Options into Value Four approaches are

used to incorporate the effect of options that are already standing into the value per share However, the first threeapproaches can lead to misleading estimates of value

out-1

1 Use fully diluted number of shares to estimate

per-share value The simplest way to incorporate the effect

of outstanding options on value per share is to dividethe value of equity by the number of shares that will beoutstanding if all options are exercised today—the fullydiluted number of shares While this approach has thevirtue of simplicity, it will lead to too low an estimate ofvalue per share for two reasons:

■ It considers all options outstanding, not just onesthat are in the money and vested To be fair, thereare variants of this approach where the shares out-standing are adjusted to reflect only in-the-moneyand vested options

■ It does not incorporate the expected proceeds fromexercise, which will comprise a cash inflow to thefirm

Finally, this approach does not build in the time mium on the options into the valuation either

pre-C h a p t e r 7 • M a n a g e m e n t O p t i o n s , C o n t r o l , a n d L i q u i d i t y 231

ILLUSTRATION 7.2

Fully Diluted Approach to Estimating Value per Share

To apply the fully diluted approach to estimate the per-share value, use the equity values estimated in Chapter 6, “Estimating Firm Value,” for each firm in conjunction with the number of shares outstanding, including those underlying the options Table 7.2 summa- rizes the value per share derived from this approach.

The value per share from the fully diluted approach is significantly lower than the value per share from the primary shares outstanding This value, however, ignores both the pro- ceeds from the exercise of the options as well as the time value inherent in the options.

2

2 Estimate expected option exercises in the future

and build in expected dilution In this approach, you

forecast when in the future the options will be cised and build in the expected cash outflows associ-ated with the exercise, by assuming that the firm willbuy back stock to cover the exercise The biggest limi-tation of this approach is that it requires estimates ofwhat the stock price will be in the future and whenoptions will be exercised on the stock Given that your

exer-TABLE 7.2 Fully Diluted Approach to Estimating Value per Share

objective is to examine whether the price today is rect, forecasting future prices to estimate the currentvalue per share seems circular In general, thisapproach is neither practical nor particularly useful forreasonable estimates of value

cor-3

3 Adjust for outstanding options, but add proceeds to

equity This approach, called the Treasury Stock

approach, is a variant of the fully diluted approach.Here, the number of shares is adjusted to reflectoptions that are outstanding, but the expected pro-ceeds from the exercise (exercise price × number ofoptions) are added to the value of equity The limita-tions of this approach are that, like the fully dilutedapproach, it does not consider the time premium onthe options and there is no effective way of dealingwith vesting Generally, this approach, by underesti-mating the value of options granted, will overestimatethe value of equity per share

The biggest advantage of this approach is that itdoes not require a value per share (or stock price) toincorporate the option value into per-share value Asyou will see with the last (and recommended)approach, a circularity is created when the stock price

is input into the estimation of value per share

ILLUSTRATION 7.3

Treasury Stock Approach

In Table 7.3, we estimate the value per share by using the treasury stock approach for Amazon, Ariba, Cisco, Motorola, and Rediff.com.

Note that the value per share from this approach is higher than the value per share from the fully diluted approach for each of the companies with options outstanding The differ- ence is greatest for Amazon because the options have a higher exercise price, relative to the current stock price The estimated value per share still ignores the time value of the options

4 Value options by using an option pricing model The

correct approach to dealing with options is to estimatethe value of the options today, given today’s value pershare and the time premium on the option Once thisvalue has been estimated, it is subtracted from theequity value and divided by the number of shares out-standing to arrive at value per share

Value of Equity per Share = (Value of Equity – Value of Options Outstanding)

/ Primary Number of Shares Outstanding

In valuing these options, however, you confront fourmeasurement issues

a

a Vesting Not all of the options outstanding are

vested, and some of the nonvested options mightnever be exercised

b

b Stock price The stock price to use in valuing these

options is debatable The value per share is aninput to the process as well as the output of theprocess

c

c Taxation Since firms are allowed to deduct a

por-tion of the expense associated with oppor-tion cises, there may be a potential tax savings when theoptions are exercised

exer-d

d Nontraded firms Key inputs to the option pricing

model, including the stock price and the variance,cannot be obtained for private firms or firms on theverge of a public offering, like Rediff.com Theoptions must nevertheless be valued

These options are discussed in more detail below.a

a Dealing with vesting: Recall that firms grantingemployee options usually require that theemployee receiving the options stay with the firmfor a specified period, for the option to be vested.Consequently, when you examine the options out-standing at a firm, you are looking at a mix ofvested and nonvested options The nonvestedoptions should be worth less than the vested

C h a p t e r 7 • M a n a g e m e n t O p t i o n s , C o n t r o l , a n d L i q u i d i t y 235

options, but the probability of vesting will depend

on how in-the-money the options are and theperiod left for an employee to vest While therehave been attempts3 to develop option pricingmodels that allow for the possibility that employeesmay leave a firm before vesting and forfeit the value

of their options, the likelihood of such an rence when a manager’s holdings are substantialshould be small Carpenter (1998) developed a sim-ple extension of the standard option pricing model

occur-to allow for early exercise and forfeiture and used it

to value executive options

b

b Arriving at a stock price to use: The answer towhich stock price to use may seem obvious Sincethe stock is traded and you can obtain a stock price,

it would seem that you should be using the currentstock price to value options However, you are valu-ing these options to arrive at a value per share thatyou will then compare to the market price to decidewhether a stock is under- or overvalued Thus, itseems inconsistent to use the current market price

to arrive at the value of the options and then usethis option value to estimate an entirely differentvalue per share

There is a solution You can value the options

by using the estimated value per share Doing socreates circular reasoning in your valuation Inother words, you need the option value to estimatevalue per share and value per share to estimate theoption value We would recommend that the valueper share be initially estimated by the treasurystock approach and that you then converge on theproper value per share by iterating.4

There is another related issue When optionsare exercised, they increase the number of sharesoutstanding, and by doing so, they can have aneffect on the stock price In conventional optionpricing models, the exercise of the option does notaffect the stock price These models must be

adapted to allow for the dilutive effect of optionexercise We examine how option-pricing modelscan be modified to allow for dilution in Chapter 11,

“Real Options in Valuation.”

c

c Taxation: When options are exercised, the firm candeduct the difference between the stock price atthe time and the exercise price as an employeeexpense, for tax purposes This potential tax bene-fit reduces the drain on value created by havingoptions outstanding One way in which you couldestimate the tax benefit is to multiply the differ-ence between the stock price today and the exer-cise price by the tax rate; clearly, this would makesense only if the options are in-the-money.Although this approach does not allow for theexpected price appreciation over time, it has thebenefit of simplicity An alternative way of estimat-ing the tax benefit is to compute the after-tax value

of the options:

After-Tax Value of Options = Value from Option Pricing Model (1 – Tax Rate)

This approach is also straightforward andallows you to consider the tax benefits from optionexercise in valuation One of the advantages of thisapproach is that you can use it to consider thepotential tax benefit even when options are out-of-the-money

d

d Nontraded firms: A couple of key inputs to theoption pricing model—the current price per shareand the variance in stock prices—cannot beobtained if a firm is not publicly traded There aretwo choices in this case One is to revert to thetreasury stock approach to estimate the value ofthe options outstanding and abandon the optionpricing models The other choice is to stay with theoption pricing models and to estimate the value pershare from the discounted cash flow model Thevariance of similar firms that are publicly tradedcan be used to estimate the value of the options

C h a p t e r 7 • M a n a g e m e n t O p t i o n s , C o n t r o l , a n d L i q u i d i t y 237

ILLUSTRATION 7.4

Option Value Approach

In Table 7.4, we begin by estimating the value of the options outstanding, using a

All options, vested as well as nonvested, are valued and there is no adjustment for nonvesting

In estimating the after-tax value of the options at Amazon and Ariba, we have used their prospective marginal tax rate of 35% If the options are exercised prior to these firms reaching their marginal tax rates, the tax benefit is lower since the expenses are carried forward and offset against income in future periods.

You can now calculate the value per share by subtracting the value of the options standing from the value of equity and dividing by the primary number of shares outstand- ing, as in Table 7.5.

out-The inconsistency referred to earlier is clear when you compare the value per share mated in Table 7.5 to the price per share used in Table 7.4 to estimate the value of the options For instance, Amazon’s value per share is $32.33, whereas the price per share used in the option valuation is $49 If you choose to iterate, you would revalue the options by using the estimated value of $32.33, which would lower the value of the options and increase the value per share, leading to a second iteration and a third one, and so on The values converge to yield a consistent estimate The consistent estimates of value are provided in Table 7.6.

esti-For Motorola and Ariba, the difference in value from iterating is negligible, since the value per share that we estimated for the firms is close to the current stock price For Cisco, the value of the options drops by almost 40%, but the overall effect on value is muted because the number of options outstanding as a percent of outstanding stock is small The difference in values is greatest at Amazon, for two reasons First, the value per share was significantly lower than the current price at the time of the valuation Second, Amazon had the highest value for options outstanding as a percent of stock outstanding