Employee Stock Options (ESOPs) and Restricted Stock:Valuation Effects and Consequences

1





Employee Stock Options (ESOPs) and Restricted Stock:
Valuation Effects and Consequences
Aswath Damodaran
Stern School of Business

September 2005

---

2



Management Options and Restricted Stock: Valuation Effects and Consequences

In the last decade, firms have increasingly turned to offering employees options
and restricted stock (often with restrictions on trading) as part of compensation packages.
Some of this trend can be attributed to the entry of young, cash poor technology firms
into the market, many of which have to use equity because they have no choice.
However, many larger market cap firms that can afford to pay cash compensation have
used stock based compensation as a way of aligning managerial interests with
stockholder interests. In this paper, we begin by looking at motives, good and bad, for
using equity based compensation, and trends over the last few years. We then turn to the
accounting rules, old and new, that govern how equity compensation is recorded and
reported. Finally, we consider how best to incorporate employee options and restricted
stock – both past and prospective – into discounted cash flow and relative valuation
models.

---

3

In recent years, many firms have shifted towards equity-based compensation for
their employees. It is not uncommon for firms to grant millions of options annually not
only to top managers but also to lower level employees. These options create a
potentially value decreasing overhang over common stock values. What used to be a
simple practice of dividing the estimated equity value by the number of shares
outstanding to arrive at value per share has become a daunting exercise. Analysts struggle
with how best to adjust the number of shares outstanding (and the value per share) for the
possibility that there will be more shares outstanding in the future. They attempt to
capture this dilution effect by using the partially diluted or fully diluted number of shares
outstanding in the company. As we will see in this paper, these approaches often yield
misleading estimates of value per share and we propose a sounder way of dealing with
employee options.
We also explore other forms of equity compensation, including the use of restricted
and unrestricted stock grants to management, and the effects of such grants on value per
share. Like options, these stock grants reduce the value of equity to existing stockholders
and have to be considered in valuation.
Equity Based Compensation

There are three forms of equity compensation. The oldest and most established
one is to give stock or equity in the firm to management, employees or other parties as
compensation. This second is a variant, with common stock and equity grants to
employees, with the restriction that these shares cannot be claimed and/or traded for a
period after the grants. The third is equity options, allowing employees to buy stock in
the firm at a specified price over a period; these usually come with restrictions as well.

In recent decades, equity-based compensation has become a bigger part of overall
employee compensation, initially at U.S. firms and more recently in other markets as
well. There are three major factors behind this trend:
1. Stockholder-Manager Alignment: As publicly traded firms have matured and become
larger, the interests of stockholders (who own these firms) and managers (who run
these firms) have diverged. The resulting agency costs have been explored widely in
the literature. In a seminal work, Jensen and Meckling argue that managers, acting in

---

4
their best interests, often take actions that destroy stockholder value.1 Researchers
have shown that managers, left to their own devices, accumulate too much cash,
borrow too little and make poor investments and acquisitions. Offering equity in the
firm to managers may reduce the agency problem by making managers think more
like stockholders.
2. Scarcity of Cash: The shift towards equity compensation was most pronounced at
technology firms in the United States. In particular, young technology firms entered
the market in droves in the 1990s, many with little to report in terms of revenues or
earnings. Given their cash constraints, the only way in which these firms could attract
and hold on to employees was by offering them non-cash compensation, usually with
the only currency of value that they had which was their own equity.
3. Employee Retention: Most equity compensation comes with a requirement that the
employee stay with the firm for a period of time (the vesting period) to lay claim to
the compensation. Employees who receive options or restricted stock as
compensation are therefore more likely to stay with a firm, especially if it represents a
large proportion of their overall wealth.2
4. Accounting and Tax Treatment: The move towards equity compensation has been
aided and abetted by accounting standards that have treated firms that use equity
based compensation much more generously (by reporting higher earnings) than firms
that use cash based compensation, and by tax laws that provide tax benefits to firms
that used options to reward employees.
Of the three forms of equity compensation, the use of common stock represents the
fewest problems from a valuation perspective. The value of the stock grant is treated as a
compensation expense (when the grant is made) and the number of shares increases in the
firm. Stock option grants and restricted stock create more difficult issues for analysts,

1 Jensen, M.C., Meckling, W.H., 1976. Theory of the firm: Managerial behavior, agency costs and
ownership structure. Journal of Financial Economics 3, 305-360.
2 An additional advantage of using equity options to compensate employees is that their value is likely to
be highest when the sector is doing well and alternative job opportunities are greatest for employees. Thus,
the cost of switching jobs will be greatest when the opportunity to do so is highest. For a more extensive
discussion of this motive and some empirical evidence, see P. Oyers and S. Schaefer, 2004, Why Do Some
Firms Give Stock Options To All Employees? An Empirical Examination of Alternative Theories, Journal of
Financial Economics, v75, pg 99-132.

---

5
both in terms of measuring earnings in any period and in coming up with values per
share. In the sections that follow, we will first look at equity options and then turn our
attention to restricted stock issues.
I. Employee Options
Firms use equity options to reward managers as well as other employees. There
are two effects that these options have on value per share. One is created by options that
have already been granted. These options, some of which have exercise value today,
reduce the value of equity per share, since a portion of the existing equity in the firm has
to be set aside to meet these eventual option exercises. The other is the likelihood that
these firms will use options on a continuing basis to reward employees or to compensate
them. These expected option grants reduce the portion of the expected future cash flows
that accrue to existing stockholders and thus the value per share today. In the sections that
follow, we will begin by looking at trends in the use of employee stock options and the
types of firms where option grants are largest. We will also examine the characteristics of
employee options and how they have been accounted for historically. We will close the
section by revisiting the debate on whether employee stock options should be expensed
and the new accounting rules that will govern option grants.
The Magnitude of the Option Overhang

The use of options in management compensation packages is not new to firms.
Many firms in the 1970s and 1980s initiated option-based compensation packages to
induce top managers to think more like stockholders. What is different about the more
recent option grants, especially at technology firms? One is that management contracts at
these firms are much more heavily weighted towards options than are those at other
firms. The second is that the paucity of cash at these firms has meant that options are
granted not just to top managers, but also to employees all through the organization,
making the total option grants much larger. The third is that some of the smaller firms
have used options as currency to meet operating expenses and pay for supplies.

---

6
Market Wide Trends

There are a number of different statistics that we can point to that show the
growth in equity option compensation. The simplest measure is the number of employee
options outstanding as a percent of the total outstanding shares, also called the option
overhang. The Investor Responsibility Research Center (IRRC), an independent watch
dog for shareholders, estimated that the overhang was 17% for the 1500 companies it
tracks (including the S&P 500, mid cap and smaller cap stocks) in 2003, up from 15.7%
in the previous year; the median value for the overhang was 16.3%, up from 14.8% in the
prior year. Figure 1 graphs the overhang, as computed by IRRC, from 1997 to 2004:

While smaller companies have higher numbers of options outstanding than larger market
cap companies, even the larger market cap companies in the S&P 500 reported an option
overhang of 16.4%. The pervasiveness of options can also be seen in the number of
companies that grant options to management and in the number where options
outstanding represent a very high percent of the outstanding stock. In 2003, for instance,
IRRC reported that almost 90% of the firms in their sample had some options overhang

---

7
and that 67 companies (about 4.6% of the sample) had more than a 40% overhang, up
from 3.6% in 2002 and 3% in 2001.

Another measure of the reach of options is the number of employees who receive
options as part of pay packages. The National Center for Employee Ownership estimated
that almost 3 million employees received options as part of compensation in 2000, up
from less than a million in 1990 and that about 10 million employees held stock options
in that year. This is backed up by the national compensation survey of the Bureau of
Labor Statistics in March 2003, which reported that about 8% of all employees received
options as compensation. The number was much higher for white-collar employees
(about 12%) than for blue-collar (6%) and service employees (2%). Notwithstanding
recent attempts to widen option grants, they remained heavily loaded towards top
management at firms. In 2002, for instance, the value of options granted to the CEO and
the top 5 managers at S&P 500 firms accounted for about 9.5% of the total option
grants.3

The decision by the Financial Accounting standards board to require all
companies to begin expensing options, starting in 2006, has begun to have an effect on
option grants. In 2004, IRRC reports a drop in the option overhang at all US companies
and notes that companies are reexamining their option grant procedures in light of
stockholder disapproval.
Who uses options?

The IRRC study, quoted in the last section, categorized firms into 10 economic
sectors and examined the magnitude of the options overhang in each sector. Technology
companies had the biggest average overhang of 24.4% in 2003, up from 20.8% in the
previous year. Utility and energy companies had the smallest overhang, averaging less
than 8% in 2003. These differences widened during the technology boom in the late
1990s, with the advent of internet and new technology firms. Hall and Murphy, in their
study of the problems associated with the use of employee stock options, report on option

3 Hall, B.J.. and K.J. Murphy, 2003, The Trouble with Stock Options, Working Paper, NBER. They note
that the CEO and top management share of options has dropped from about 15% in the early 1990s to less
than 10% in 2002.

---

8
grants at old economy and new economy firms from 1993 to 2002. Figure 2 summarizes
their findings:

The differences across sectors may not be surprising but it is worth examining why they
exist in the first place. In general, we can outline three factors that may explain these
differences:
a. Age and Growth Potential of firm: We would expect younger firms to use equity
options substantially more than older and more mature companies. After all, if not
having the cash to compensate employees is a factor behind the use of equity options,
younger firms are far more likely to be cash constrained than more mature firms.
b. Riskiness of firm: Riskier firms should be more likely to use equity options than safer
firms. While most securities become less valuable as risk increases, options become
more valuable. This is especially true if the market is over assessing the risk in a

---

9
company, since this firm’s options will be over valued by the employees receiving the
options.4
c. Market Valuation of firm: As we will see in the next section, there is a tax advantage
that accrues to firms that use equity options as compensation. Firms that trade at high
multiples of earnings will get a much bigger tax advantage from using options as
compensation.
None of these characteristics are static and they will change as firms move through the
life cycle. We would expect to see option grants, as a percent of outstanding stock, to be
greatest at young, risky firms, with high market valuations, and to decline as growth
levels off, cash flows increase and valuations come down to earth. Cisco provides an
interesting case study of this transition, with figure 3 reporting on options granted as a
percent of the outstanding stock every year from 1995 to 2004.

Cisco’s option grants as a percent of outstanding stock has decline from above 5% in
1995 and 1996 to about 3% in the 2002-2005 period. The value of option grants peaked

4 Bergman, N. and D. Jenter, 2003, Employee Sentiment and Stock Option Compensation, Working Paper,
MIT. They make the argument that overoptimistic employees over value option grants and that firms take

---

10
in 2000, at the peak of the stock market bubble, and has declined fairly dramatically
since.

While much of this discussion has centered on the granting of options by publicly
traded firms, it is worth noting that the use of equity options is widespread in private
businesses as well. The National Center for Employee Ownership surveyed 275 venture-
capital backed private businesses in the technology and telecommunications businesses.
Of these firms, 77% provided options to all employees while 23% provided them to only
select employees. If we couple this behavior with the fact that venture capital investors
themselves receive options on equity (often in the form of convertible bonds and
preferred stock), many young firms already have a substantial option overhang at the time
of their initial public offerings.
Characteristics of Option Grants
Firms that use options as employee compensation typically issue them each year,
with the strike price set equal to the prevailing stock price; employee options are usually
at-the-money when issued. While maturities vary across firms, these options are typically
long term, with a ten-year maturity representing the norm at issue. Naturally, at any point
in time, the options outstanding at a firm will represent varying maturities since they
were granted at different points in time. Firms that use employee options usually restrict
when and whether these options can be exercised. It is standard, for instance, that the
options granted to an employee cannot be exercised until they are vested. For this to
occur, the employee usually has to remain with the firm for a period that is specified with
the contract. While firms add this restriction to keep employee turnover low, it also has
implications for option valuation that will be examined later. Figure 4 reports on vested
and non-vested options at Cisco in 2005, broken down by exercise price.

advantage of this over optimism.

---