l4 Stock Options 2011

Copyright SDA Bocconi, protocollo xxxx

Lecture 4: Employee Stock Options

Alonso Peña, SDA Professor

Banking and Insurance Department

Copyright SDA Bocconi, protocollo xxxx 2 2

Part 1:

Introduction

Part 2:

Case Study

Contents


Part 1: Introduction


Definition

An employee stock option is a call option on the common

stock of a company, issued as a form of non-

cash compensation.

Restrictions on the option (such as vesting and limited

transferability) attempt to align the holder's interest with

those of the business' shareholders

Introduction Stock Options


Definition

If the company's stock rises, holders of options experience

a direct financial benefit.

This gives employees an incentive to behave in ways that

will boost the company's stock price.

Employee stock options are mostly offered to management

as part of their executive compensation package. They

are also offered to other staff, especially by businesses that

are not yet profitable.



Overview

Employee stock options (ESO) are non-standardized, over-

the-counter options that are issued as a private contract

between the employer and employee.

Over the course of employment, a company

issues vested or non-vested ESOs to an employee which

are struck at a particular price, often the company's current

stock price.



Overview

Depending on the vesting schedule and the maturity of the

options, the employee may elect to exercise the options

before maturity, obligating the company to sell the

employee its stock at whatever stock price was used as the

strike price.

At that point, the employee may either sell the stock or hold

on to it in the hope of further price appreciation.



Differences with exchange-traded options

Strike: The strike price is non-standardized and is often the

current price of the company stock at the time of issue.

Alternatively, a formula may be used, such as sampling the

lowest closing price over a 30-day window on either side of

the grant date. Often, an employee may have ESOs struck at

different times and different strike prices.

Quantity: Standardized stock options typically have 100

shares per contract. ESOs usually have some non-

standardized amount.



Vesting: Often the number of shares available to be

exercised at the strike price will increase as time passes

according to some vesting schedule. Vesting only occurs

during the duration of the employment.

Duration: ESOs often have a maturity that far exceeds the

maturity of standardized options. It is not unusual for ESOs to

have a maturity of 10 years from date of issue, while

standardized options usually have a maximum maturity of

about 30 months.

.



Non-transferable: With few exceptions, ESOs are generally

not transferable and must either be exercised or allowed to

expire worthless on termination of employment.

Over the counter: Unlike exchange traded options, ESOs

are considered a private contract between the employer and

employee. As such, those two parties are responsible for

arranging the clearing and settlement of any transactions that

result from the contract.



In addition, the employee is subjected to the credit risk of the

company. If for any reason the company is unable to deliver

the stock against the option contract upon exercise, the

employee may have limited recourse. For exchange-trade

options, the fulfillment of the option contract is guaranteed by

the credit of the exchange.



Tax issues: There are a variety of differences in the tax

treatment of ESOs having to do with their use as

compensation. These vary by country of issue but in general,

ESOs are tax-disadvantaged with respect to standardized

options.


Copyright SDA Bocconi, protocollo xxxx 13 Copyright SDA Bocconi 2007

13

Valuation

The value of an ESOs closely follows the valuation

techniques used for standardized options. The same models

used in valuing standardized options, such as Black-

Scholes and the binomial model, are also used for ESOs.

Often, the only inputs to the pricing model that cannot be

readily determined is the estimate of future realized volatility

on the underlying, and the appropriate interest rate to use.



Part 2: Case Study


Helvetia Holding, a pharmaceutical company located in Boston,

Massachusetts, spent nine months identifying the scientist it

wanted to head corporate-wide research and development

activities, but the candidate was also being pursued by Zentrum

Inc., an equally important U.S. pharmaceutical company located

just minutes away. Knowing that Zentrum was offering an

outright salary of $550,000, Helvetia countered with a total

compensation package worth $600,000: $400,000 in outright

salary and $200,000 worth of stock options.

Cse Study Helvetia Holding job offer*

* These selections are from: John Marthinsen, Risk Takers: Uses and Abuses of Financial Derivatives (2nd Edition), Addison Wesley; 2 edition, 2008. Chapter 2.


Imagine the surprise of Helvetia's human resources chief if

the scientist turned down Helvetia's offer, because she found

Zentrum's deal to be financially more attractive.

You might ask:

"How can two people put such different values on something

so seemingly cut and dried as an option's price?"

Cse Study Helvetia Holding job offer


To understand the answer to this question, let's roll back the

clock to the day before Helvetia made its employment offer. It

is highly likely that the director of human resources

understood very well the benefits, costs, risks, and returns of

call options, but he had no idea how to value them.

For that he relied on Helvetia's treasury department. Imagine

that the following conversation between Daniel Weiss,

Helvetia's human resources chief, and Tom Benson,

Helvetia's assistant treasurer, took place the day before the

offer was made.



Daniel Weiss: Tom, thank you for coming on such short

notice, but I need to know, as quickly as possible, the market

price of a call option on a Helvetia share. Can you help me,

and how long do you think it will take you to figure this out?

Tom Benson: I'd be glad to help, Daniel, and once we agree

on a few details, it will take me only a minute or so to enter

the information into my computer and figure out the market

price of the option, but first I need some information from

you. The price of any option depends on six major factors:

current share price, the exercise (or strike) price, maturity,

expected share price volatility, risk-free interest rate, and

expected dividends . . .



. . . I came prepared with most of this information, but I

need to know from you the maturity and strike price.

Daniel Weiss: All right. Helvetia's current share price is $50,

so could you tell me the price of a five-year call option that

has a $50 strike price?

Tom Benson: Fine, then you want to price a five-year, at-

the-money call option. That's all I needed to know. Let me

just summarize in the next table the six variables we will be

using in our calculations, just to make sure that what I am

entering into my computer is transparent to you.



Black Scholes input data:

Current share price: $50

Strike price: $50

Maturity: 5 years

Volatility: 35%

Risk free interest rate: 4.75%

Dividends: $0





Daniel Weiss: Just for comparison sake, could you tell me

the price of a 10-year call option with the same $50 strike

price?

Tom Benson: With a 10-year maturity, an at-the-money call

option should have a market price of $27.84.

Daniel Weiss: OK. Give me just a second to write down this

information. That was much easier than I thought it would

be. Thanks for your help, Tom.



Armed with this knowledge, Daniel Weiss could now make his

offer to Jennifer Smith, a research professor at M.I.T. and head of

R&D at BioPharm Associates in Wellesley, Massachusetts. Weiss

figured that, if an at-the-money, five-year stock option was worth

$19.49, and he wanted to compensate Smith with $200,000 worth

of stock option benefits, then the compensation package should

include 10,262 stock options To ease the math and sweeten the

deal, Weiss rounded the offer at 10,500 call options. The next

morning, he called Jennifer Smith and made his offer. As he

explained the offer to her, Weiss stressed that Smith would get

raises each year and additional stock options in proportion to her

salary.



It took Smith only a day to come to the conclusion that

Helvetia's offer was not as financially attractive as Zentrum's

offer, and by the time she called Daniel Weiss, she had

already accepted Zentrum's contract. Weiss was staggered.

He was so sure she would accept his offer that he had

already notified the CEO to include her name in Helvetia's

organization chart. How could Helvetia's offer of over

$600,000 not be as attractive "financially" as a competing

offer for $550,000?

Weiss asked Smith if he could call her later that day. . .



Daniel Weiss: Dr. Smith, we are very disappointed to have lost

you to our competitor. Are you sure there is nothing we can do

to change your mind?

Jennifer Smith: Thank you, Daniel, but no. I've accepted the

Zentrum offer, and I'm happy with my decision.

Daniel Weiss: I have Tom Benson on the line with me, just so

he can help me piece together what went wrong. You will

remember that Mr. Benson helped me value your stock options.

Did I tell you that we used the Black-Scholes formula to do our

valuation?



Tom Benson: Hello, Dr. Smith. Thank you for allowing me to

be a part of this conversation. I'm as interested as Mr. Weiss

in understanding how you arrived at your decision.

Jennifer Smith: I realize you both must think I'm crazy-

especially when Nobel prizes were given to the gentlemen

who discovered and developed the Black-Scholes formula, but

all I can say is that what the formula says Helvetia's options

should be worth is not what I feel they are worth to me. Here's

how I arrived at my conclusion…



Jennifer Smith: First, let me preface my remarks by admitting

that I had some help making up my mind. After our call

yesterday, Daniel, I phoned an old friend, John, who is now

teaching at a nearby college. John and I met last night for

dinner, and he sorted out some of the technical details for me.

The first question I asked him was if there was any way I

could lock-in immediately the $200,000 of stock option

compensation that Helvetia was offering.


Copyright SDA Bocconi, protocollo xxxx 28 Copyright SDA Bocconi 2007

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Daniel Weiss: That sounds logical enough. What was his

answer?

Jennifer Smith: He explained that my call options gave me

the right to buy Helvetia shares for $50 any time after the

three-year vesting period. One way to lock in the value of the

options would be to sell short the Helvetia shares-which I

now understand means that I would have to borrow shares,

sell them at the current market price, and agree to pay them

back in the future.



Daniel Weiss: I've heard of short selling but never really

understood what it meant. Usually, when I think of someone

making a profit, I think in terms of buying something today

and then selling it in the future at a higher price. What you

would be doing is just the opposite: selling Helvetia shares

today and then buying them in five years at the price

guaranteed by your stock options. It's sort of like closing the

loop-selling now and then buying later.



Jennifer Smith: Exactly! But once I sold the shares short

and collected the proceeds, I'd have to invest the funds in a

safe asset (like a U.S. government bond). My Helvetia

options had five-year maturities, so I based all of my

calculations on investing the funds until maturity.

Daniel Weiss: But, Dr. Smith, would it be legal or ethical to

sell short Helvetia's shares in this way?



Jennifer Smith: Imagine my surprise when I found out that,

even if I wanted to, I could not sell short the Helvetia shares.

Apparently, there are rules in the United Sates that put tight

restrictions on short sales of stocks by employees.

Daniel Weiss: Ah, yes. Now I remember discussing this issue

with our corporate counsel. If my memory is correct, Section

16-C of the 1934 U.S. Securities and Exchange Act prohibits

officers and directors from selling shares in their companies if

they do not already own the securities. There could also be

insider-trading issues



Jennifer Smith: Yes, that's true, but Daniel, my main point

is that even if I could short the Helvetia shares, I figured that

the most I could lock in-assuming Helvetia shares rose in

value, which I'm sure they will-would be only about

$137,100, and to do that, I'd have to wait five years! Here's

how I did my calculations.



Jennifer Smith: If I sold short 10,500 Helvetia shares at $50

per share, I'd receive $525,000, which then I could invest for

five years. Currently, a five-year U.S. government bond

yields 4.75%, so $525,000 invested at a compound annual

rate of 4.75% would grow to $662,109 in five years. At the

end of the five years, if Helvetia's share price rose above

$50, I would exercise my options, spend $525,000 to buy

back and return the 10,500 shares that I borrowed, and have

$137,109 remaining.





Daniel Weiss: Dr. Smith, you have been very thorough, patient,

and generous with your time, but, some time today, I'm going to

have to explain to my boss how we lost you, so please answer for

me just one question. How was it possible for Helvetia to offer you

over $50,000 more than Zentrum but for you to feel that the

Zentrum offer was financially more attractive? Is it just because

Zentrum was offering you a sure thing, and we were offering you a

degree of uncertainty? Did you consider that the uncertainty of our

offer also contained the opportunity to strike it rich and become a

millionaire?



Jennifer Smith: I can assure you that becoming a millionaire

didn't escape my attention, but the fundamental problem I had with

Helvetia's offer, was that the price you put on the options was not

equal to the value I put on them. Even after figuring in the

advantage I would have over anyone outside the company with

regard to timing the exercise of my options, your offer came up

short.



Daniel Weiss: We-and by "we" I mean Mr. Benson and I-did

not put an arbitrary price on the options. We used the Black-

Scholes formula, which is used by virtually everyone. I have

always thought that it was considered widely to be an

unbiased and highly accurate way of valuing options.

Jennifer Smith: My second major question last night to John

was: "What is this Black-Scholes formula, and how is it coming

up with an option price that seems so out of whack with my

instincts?" Its precision alone was unnerving. Any formula …



… that says an option should be worth exactly $19.49 made me

skeptical-or should I say, nervous. As a scientist, I knew that the

Black-Scholes formula had to be based on a set of .. I also knew

that, in the course of one evening, I had no chance of

understanding all the intricacies of option pricing models, so I took

a simpler and more direct route. All I wanted to know was whether

the assumptions behind the Black-Scholes formula made Helvetia's

options look more desirable or less desirable to me. It was a simple

plus and minus evaluation, and at the end, I asked myself whether

the difference was large enough to nullify the $50,000 advantage of

Helvetia's offer. For me, the Helvetia offer came up short, so I

accepted the Zentrum offer.



Daniel Weiss: I find it amazing that you did all this work in one

evening. Now, I am doubly disappointed that you will not be

working with us.

Jennifer Smith: Here's what I discovered from John. The

Black-Scholes formula was designed for tradable, short-term

options rather than non-tradable, nontransferable, long-term

options, like Helvetia was offering me. John said that you

probably based your option prices on past market statistics,

plugged the six important parameters into the Black-Scholes

formula, and assumed that these factors would remain constant

over the maturity of my options.



Daniel Weiss: Yes. That is exactly what we did.

Jennifer Smith: Well, I figured that, with just slight

modifications in your assumptions and their constancy over

time, my options could be worth either far more or far less

than the Black-Scholes formula estimated.

Daniel Weiss: I understand. You questioned not only the

factors we entered into the formula but also their stability

over time, and because of this risk, you turned down our

offer.



Jennifer Smith: Take volatility, for instance. I now

understand why volatility is important to option pricing, but

we have just come out of a tumultuous economic and

political period. This increased volatility raised the Black-

Scholes price of the options you offered me, but curiously, it

lowered their value to me.

Daniel Weiss: What is your prediction about the future?



Jennifer Smith: Looking forward, I anticipate calmer conditions-

which mean lower volatility-and my expectations have a bizarre,

reverse effect on the price of Helvetia's options. It lowers their

Black-Scholes price but raises their value to me. Sorry, Daniel

and Tom, but I don't see how increased volatility and uncertainty

help me. For me to place a higher value on Helvetia options, I

would need to believe that they would grow at a steady positive

rate, so I could exercise them in three to five years at a profit.

Increased volatility is a threat to me, because the period of time

when I would be allowed and want to exercise them might

coincide with a gigantic dip in the share price. Who knows?



Daniel Weiss: Dr. Smith, on behalf of Mr. Benson and me, I

want to thank you for your time, openness, and honesty.

This conversation has been a real eye-opener for me, but it

may take some time for me to digest it all.

Jennifer Smith: It was my pleasure. I'm sure I would have

enjoyed working at Helvetia.


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l4 Stock Options 2011