Financial Modeling - Employee Equity Options and Compensation

Question 1

What 3 types of equity based compensation?

Answer 1

1. Stock Grants
2. Restricted Stock Grants
3. Employee equity options

Question 2

What are stock grants?

Answer 2

Shares as part of compensation

Question 3

What are restricted stock grants?

Answer 3

Shares with some restriction on their claim, usually a time period

Question 4

What are employee equity options?

Answer 4

Options that allow employees to buy stock at a specific price over a certain period - usually also restricted to meet certain criteria.

Question 5

What are 4 reasons for increasing trends in equity base compensation?

Answer 5

1. Stockholder-manager alignment
2. Scarcity of cash.
3. Employee retention
4. Accounting and tax treatment

Question 6

What does agency theory say?

Answer 6

Managers accumulate too much cash, borrow too little, and make poor investment/acquisition decisions.

Question 7

How do you fix the problem in agency theory?

Answer 7

Equity based compensation may reduce the agency problem by making managers behave more like stockholders.

Question 8

Which companies have scarcity of cash?

Answer 8

Start-up firms don’t have cash so they offer equity based compensation

Question 9

What is employee retention?

Answer 9

Equity compensation comes with a requirement that the employee stay with the firm for a period of time to claim the compensation

Question 10

What are the advantages of equity compensation for accounting and tax?

Answer 10

1. For accounting stock grant is a compensation expense so companies can give more than cash and report higher earnings.
2. Tax laws provide tax benefits to firms that use options to reward employees.

Question 11

What are the effects of “stock grants” on valuation?

Answer 11

Stock grants are not a problem on valuation, compensation is expensed and shares outstanding increased.

Question 12

What are the effects of “employee options and restricted stock” on valuation?

Answer 12

1. Earnings measurement is a problem - they are now expensed but imperfectly
2. Shares outstanding are not adjusted; even diluted shares are not exactly right.

Question 13

What are 2 effects of employee options?

Answer 13

1. EXISTING options grants have the potential to dilute

2. Expected FUTURE option grants have the same potential and are harder to estimate.

Question 14

What is option overhang?

Answer 14

The number of employee options outstanding as a percent of the total outstanding shares.

Question 15

What 3 factors explain the use of options?

Answer 15

1. Age and growth potential of firm
2. Riskiness of firm
3. Market valuation of firms (because of tax advantage)

Question 16

Who uses options as compensation?

Answer 16

New economy does

Old economy, finance, and utilities use less.

Question 17

What age and growth companies use equity compensation?

Answer 17

Younger companies use equity compensation because they have less cash than more mature companies.

Question 18

Do safer firms or riskier firms use equity compensation?

Answer 18

Riskier firms use more than safer firms

Question 19

Which companies get a bigger tax advantage when using options compensation?

Answer 19

Firms that trade at high multiple of earnings will get a much bigger tax advantage using options as compensation

Question 20

What are the characteristics of option grants?

Answer 20

1. Usually issued every year.
2. Strike price is usually at the market price
3. Typically long term- 10 years is the norm
4. Usually a vesting period

Question 21

When options are granted they must be valued using an option pricing model, what are 3 option pricing models?

Answer 21

1. Binomial lattice
2. Black-scholes
3. Monte carlo simulation

Question 22

For accounting of options, the value of options can be spread over what?

Answer 22

the vesting period

Example:Thus an option grant with estimated value of $10 million and a 5 year vesting period can be spread over the 5 years at $2 million a year.

Question 23

When accounting options, if actual forfeiture rate is not equal to original estimate, how do you adjust?

Answer 23

Optional value is re-estimated in subsequent years and compensation cost adjusted to reflect the changes

Question 24

For the accounting of options, if the option terms are modified, when do you recognize it?

Answer 24

The firm has to recognize the change at the time of the modification

Question 25

What are the 2 options' effect on value?

Answer 25

1. Earnings effect | 2. Dilution effect

Question 26

What is the earnings effect?

Answer 26

Expensing of options REDUCES net income even though it's not a cash expense

Question 27

What is the dilution effect?

Answer 27

1. Shares are sold at less than market value and shares outstanding are increased. 2. Using fully diluted shares is only a rough proxy because some options will never be exercised due to employee departure and out of the money options.

Question 28

How do we incorporate option compensation into DCF valuation?

Answer 28

1. Using fully diluted shares to estimate value. 2. Estimating expected option exercise in the future 3. Treasury stock approach

Question 29

What are 3 problems of using fully diluted shares to estimate the value?

Answer 29

It will lead to too low an estimate of value per share for 3 reasons: 1. It considers all options outstanding, not just ones that are in the money and vested. 2. It does not incorporate the expected proceeds from exercise, which will comprise a cash inflow to the firm. 3. Does not build the time premium on the options into the valuation.

Question 30

What are problems with estimating expected option exercise in the future?

Answer 30

Requires a large number of estimate and assumptions. This approach is neither practical nor useful.

Question 31

What is the treasury stock approach?

Answer 31

Fully diluted shares are used and expected proceeds from the exercise are added to the value of equity

Question 32

How do we incorporate option compensation into DCF valuation?

Answer 32

Estimate the value of the options today, given today's value per share and including time premium

Question 33

What is the formula

Answer 33

Value of equity per share = estimated value of equity - value of employee options / primary shares outsanding

Question 34

What are the measurement issues in valuing employee options for vesting?

Answer 34

1. Non vested options are worth less than vested options. 2. Some options will never vest a. some will be out the money b. some will be forfeited if the employee leaves

Question 35

What are the measurement issues in valuing employee options for illiquidity?

Answer 35

1. Employee options are less liquid than traded options. | 2. Often employee options are exercised early.

Question 36

What are the measurement issues in valuing employee options for appropriate stock price to use?

Answer 36

1. It's counter intuitive to use current stock price because the relevant price is the value we're trying to derive 2. Circularity problem can be solved by using the Treasury stock method for current stock price in the models, then converge on proper value by iteration

Question 37

What are the measurement issues in valuing employee options for TAXATION?

Answer 37

When options are exercised, the firm can deduct the difference between the stock price at the time and the exercise price as an employee expense

Question 38

What are the measurement issues in valuing employee options for private firms?

Answer 38

You don't worry about private firms.

Question 39

How do you incorporate existing options into relative valuation (P/E for example)?

Answer 39

1. Value options at fair value, and add this value to the value of equity. 2. Divide by net income that has been adjusted for expensing. 3. Multiply the ratio by forecast net income that has been adjusted for expensing. 4. Use diluted shares.

Question 40

Firms are shifting away from options to what?

Answer 40

Restricted stock Although, young, risky companies will still use options, but when they get mature, they will use restricted stock for compensation,.

Question 41

What are the characteristics of restricted stock

Answer 41

1. Usually forfeited if the employee leaves within a certain period. 2. Usually can not be traded for another period of time. 3. Some are restricted to be granted contingent on the firm reaching a specified operating target.

Question 42

What is the accounting for restricted stock?

Answer 42

Subtracted as a compensation cost.

Question 43

How do you incorporate restricted stock into DCF valuation?

Answer 43

1. Like options, but valuation is easier | 2. When valuing restricted shares, illiquidity must be taken into account

Question 44

How do you incorporate restricted stock into relative valuation?

Answer 44

1. Already included in shares outstanding | 2. Only real concern is that they should have a slightly lower value than traded shares.