mgtoptions - 1 MANAGEMENT OPTIONS AND VALUE PER SHARE Once...

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1 MANAGEMENT OPTIONS AND VALUE PER SHARE Once you have valued the equity in a firm, it may appear to be a relatively simple exercise to estimate the value per share. All it seems you need to do is divide the value of the equity by the number of shares outstanding. But, in the case of technology firms, even this simple exercise can become complicated by the presence of management and employee options. In this chapter, you begin by considering the magnitude of this option overhang on valuation and then consider ways of incorporating the effect into the value per share. Management and Employee Options Firms use 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, most of which have exercise prices well below the stock price, 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. The Magnitude of the Option Overhang The use of options in management compensation packages is not new to technology firms. Many firms in the 1970s and 1980s initiated option-based compensation packages to induce top managers to think like stockholders in their decision making. What is different about 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 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 to meet operating expenses and pay for supplies.
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2 Figure 7.1 summarizes the number of options outstanding as a percent of outstanding stock at technology firms and compares them to options outstanding at non- technology firms. Figure 7.1: Options as % of outstanding stock 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00% 20.00% New Technology Old Technology Other Firms As Figure 7.1 makes clear, the overhang is larger for younger new technology firms. In Figure 7.2, the number of options as a percent of outstanding stock at Cisco, Motorola, Amazon, Ariba and Rediff.com are reported:
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3 Figure 7.2: Options outstanding as % of shares outstanding 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% Amazon Ariba Cisco Motorola Rediff.com Rediff.com has no options outstanding but the other four firms have options outstanding. Amazon, in particular, has options on 80.34 million shares, representing more than 22% of
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This note was uploaded on 01/29/2012 for the course FIN 6000 taught by Professor Banko during the Fall '11 term at University of Florida.

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mgtoptions - 1 MANAGEMENT OPTIONS AND VALUE PER SHARE Once...

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