Effect of Employee Stock Option Plan (ESOP) in Valuation

Neha Bahadur

Contents

Equity based compensation Employee Stock Option Plan (ESOP) Effects on valuation Incorporating effect of ESOPs in Valuation Summary

Contents

Equity based compensation

Employee Stock Option Plan (ESOP) Effects on valuation Incorporating effect of ESOPs in Valuation Summary

Equity Based Compensation

Types
Free issue of Common Stock/equity Restricted Stock Units
Common stock & equity grants with restriction on claim, trade for a time period 1. 2. 3. 4. 5. Stockholder-Manager Alignment Scarcity of cash - Compensation Employee Retention Reward Accounting & Tax Treatment

Reasons

Employee Stock Purchase Plan (ESPP) Phantom Equity Plan

Share Appreciation Rights

Factors affecting the use of options by firms:

1. Age & growth potential of the firm Riskiness of firm

Equity Stock Option Plan (ESOP)

2.

Contents

Equity based compensation

Employee Stock Option Plan (ESOP)

Effects on valuation

Incorporating effect of ESOPs in Valuation

Summary

Employee Stock Option

Life Cycle of Option grants Employee Stock Option:
A right but not an obligation Granted to an employee To apply for the specified security of a company At a predetermined price Of vesting, non-vesting nature Right to dispose of shares by selling in the market / back to the company Grant of Options

Vesting of Options

Exercise of Options

ESOP Objective
Attract, encourage and retain talented employees Compensation in terms of ownership and profit share Nurtures entrepreneurship Allotment of Shares

Sale of shares

Key Terms
Grant Date

Maturity Period
Vesting Period Vesting Conditions Exercise Period Exercise Price

Reload Feature
In the money, at the money, out of the money

Contents

Equity based compensation Employee Stock Option Plan (ESOP)

Effects on valuation
Incorporating effect of ESOPs in Valuation Summary

Effects on Valuation
Earnings Effect
Employee options are compensation and are treated as a part of expense

Firms granting options as part of compensation report lower earnings

Future Earnings
Most firms will continue to grant options, thus affecting future earnings

Dilution
Increase in the number of shares due to options which have been granted and are still outstanding* Value of equity per share reduces

* Many firms, repurchase stock and set them aside to cover option exercise rather than issuing new shares to
avoid dilution. Such actions still affect value per share by affecting future cash flows.

Contents

Equity based compensation Employee Stock Option Plan (ESOP) Effects on valuation

Incorporating effect of ESOPs in Valuation

Summary

Incorporating effect of ESOPs in valuation

Approach 1 Use fully diluted number of shares to estimate per-share value
Divide the estimated value of equity by the fully diluted number of shares It considers all options, not just ones that are in the money and vested Example

Drawbacks:
Does not incorporate the expected proceeds form the exercise, which will comprise a cash inflow to the firm Does not build in time value of exercise of options into the valuation

Value of Equity (USD Millions) Primary Shares (Millions) Options outstanding Fully Diluted shares Value per share (Primary) Value per share (fully diluted)

Company XYZ 65622 6487 1436 7923 10.12 8.28

Some variants used in practice: Include only in the money and fully vested options

Build expected cash flows assuming firms will go out and buy back stock to cover the exercise

Incorporating effect of ESOPs in valuation

Approach 2
The limitation of not incorporating expected proceeds from exercise of options in the previous approach gets taken care of in the following approach

Treasury Stock Approach

The number of shares is adjusted to reflect options that are outstanding, but expected proceeds from the exercise are added to the value of the equity

Drawbacks:
Does not build in time value on the options into the valuation

Example
Number of Options outstanding Average Exercise Price (USD) Proceeds from Exercise (USD Million) Value from Equity (USD Million) Proceeds from Exercise Total Value Fully Diluted Number of shares Value per share (USD) Company XYZ 1436 25.02 35928.72 65622 35,928.72 101,550.72 7923 12.82

Incorporating effect of ESOPs in valuation

Approach 3 Valuing Options
Estimate value of options today, given todays value per share
Correct approach??? Incorporates time value on Options

Value of Equity per share = (Estimated Value of equity Value of Employee Stock options outstanding) / Primary number of shares outstanding

Option Valuation Various Methods

Black Scholes model Binomial model Simulation models Market Prices

How much does the model matter?

Biggest single component determining option value is the life of the option Using stated life of the employee options like in Black Scholes yields a very high value The use of expected life to calculate employee option value does not give dissimilar result using different models

Incorporating effect of ESOPs in valuation

Valuing Options Black Scholes Model
Value per Option = SN(d1) Ke ^ (-rt)*N(d2) Where, S = Current stock price t = Time until expiration K = Option striking price r = Risk free interest rate e = Exponential term (2.7183) N = Lognormal distribution

Assumptions:
The underlying assets pays no dividends / interests during its lifetime Only for European options Risk free rate is fixed during the life of an option Financial markets are efficient with zero market costs

d1 = (ln (S/K) + (r + s^2/2)*t) / st d2 = d1 - st Where, s = Standard deviation of stock returns

Modifications to Black Scholes Model to capture the effect of dividend distribution in future Value per Option = e^(- D * t)*S * N(d1) K * (e^( r * t) * N(d2))

Where, D = Expected dividend yield annualised

Incorporating effect of ESOPs in valuation

Measurement Issues for Employee Stock Option Valuation

Vesting
Firm granting a combination of vested and non-vested options pose a problem while examining options outstanding Models do not incorporate the possibility that employees may leave a firm before vesting and forfeit the value of their option

Illiquidity
Options are non-tradable Illiquidity induces employees to exercise options early and give up time premiums determination of maturity period

Which stock price to use in the model?

Value options using estimated value per share which creates circular reasoning

Non-traded/Private Firms
Current price per share and variance in stock prices cannot be obtained if firm not publicly traded

Incorporating effect of ESOPs in valuation

Example Option Valuation
Option Pricing Model Number of Outstanding Shares Average Exercise Price Estimated Standard Deviation (Volatility) Average Stated Maturity Maturity adjusted for early exercise Current Stock Price Value per Option Value of Options Outstanding Company XYZ 1436 25.02 0.45 5.17 2.58 14.88 2.27 3256.27

Using Black Scholes model

Value of Equity per Share

Less

Value of Equity (USD Million) Value of Options Outstanding Adjusted value of Equity Primary Shares Outstanding Value per Share (USD)

65622 3256.27 62365.73 6487 9.61

Incorporating effect of ESOPs in valuation

Factors effecting the price of Call options Factor, a rise in: Current Price Strike Price Time to expiration Volatility Risk-free rate Effect on Call Options + _ + + +

Approaches Summary
Approach Type
Use fully diluted number of shares to estimate per-share value

Advantages
The most simple method to be used

Disadvantages
Does not incorporate the expected proceeds form the exercise, which will comprise a cash inflow to the firm Does not build in time value on the options into the valuation

Value/ Share

USD 8.28

Estimate expected option exercises in the future and build in expected dilution

Incorporates the expected proceeds from the exercise options Incorporates the expected proceeds from the exercise options Most Comprehensive approach

Complex, requires high level of permutation & combination Not Practically possible Does not build in time value on the options into the valuation USD 12.82

Treasury Stock Approach

Valuing Options

Input parameters pose measurement problems

- Current stock price - Volatility - Maturity Period

USD 9.61

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