Title: Greg CallowMatt Faulkner Dana GiesMary Mumcuoglu Marcel NugentTracey Weiler
1Greg Callow Matt FaulknerDana Gies Mary
MumcuogluMarcel Nugent Tracey Weiler
Stock Options Management Compensation
- Management Compensation
- motivate employees to high levels of performance,
- help retain executives and allow for recruitment
of new talent, - base compensation on employee and company
performance, - maximize employees after-tax benefit and
minimize employees after tax cost, and - use performance criteria over which the employee
has control.
Stock Options Defined securities issued by a
company that carry the right, but not the
obligation, to buy a certain amount of shares in
the company at a predetermined price
- Lessons Learned
- No longer reserved for executive suite
- Still popular, even after the dot-com crash
- Can be expensive to exercise
- Two common types of plans
- Nonqualified stock options
- Qualified, or incentive stock options (ISOs)
- Its usually smart to hold options as long as you
can - There may be compelling reasons to exercise early
- Stock options arent your only option for
compensation
2Stock Options Management Compensation
- Greg Callow
- Matt Faulkner
- Dana Gies
- Mary Mumcuoglu
- Marcel Nugent
- Tracey Weiler
3Agenda
- Learning Objectives
- General Overview
- Controversy
- Accounting Treatment
- Lessons Learned
- Questions
4Learning Objectives
- Gain understanding of stock options and
management compensation - Recognize the differences between past and
current accounting treatment of stock options - Become familiar with stock option implications as
they relate to employee and employer
5Management Compensation
- Purpose
- motivate employees to high levels of performance,
- help retain executives and allow for recruitment
of new talent, - base compensation on employee and company
performance, - maximize the employees after-tax benefit and
minimize the employees after-tax cost, and - use performance criteria over which the employee
has control.
6How many of you have stock options in your
company?
How many of you would like to have stock options
in your company?
7Types of Plans
- Direct Awards of Stock
- Compensatory Stock Option Plans (CSOPs)
- Employee Stock Option Plans (ESOPs)
- Stock Appreciation Rights Plan (SARs)
- Performance-Type Plans
- Incentive Stock Options ISO
- Nonqualified Stock Options - NQS
8Stock Options Defined
- securities issued by a company that carry the
right, but not the obligation, to buy a certain
amount of shares in the company at a
predetermined price - The strike price is typically set near the market
price of the stock on the day the option is
granted - Employees must typically wait a specified vesting
period before being allowed to exercise the
option
9Stock Option Motivations
- The idea behind stock options
- To motivate employeesincrease performance
- To offer uncapped potential gain through
increased stock price - To allow companies to retain talent in the early
years - To foster a culture of employee ownership
- To align incentives between the employees and
shareholders of a company
10Shareholders vs. Managers
- Long term growth
- Investment growth
- Seek what is in the best
- interests of the company
- Bonus based on short
- term results such as
- earnings growth
- Seek what is in the best
- interests of themselves
Stock options attempt to better align interests
of employees with shareholders by maintaining a
long term growth potential
11In Practice
- Closely-held companies often issue stock options
- IPO driven
- Public companies
- Some industries, it has become standard practice
such as in high-tech
From 1997 to 2002, use of stock options in Canada
more than doubled from 25 to 59
12Can anyone think of the main reasons for what was
good in theory, but ended up being bad in
practice?
13The Good vs. The Bad
- Focus remained on quarterly performance rather
than on long term - Were allowed to sell stock after exercising
options - What do you think about amending option plans to
require employees to hold their shares for a year
or two after exercising them? - Tax laws allowed managements to manage earnings
by increasing the use of options instead of cash
wages - If a company wished to maintain its EPS growth
rate and they thought it might be difficult to do
so, they could implement new option programs thus
reducing growth in cash wages.
14The Ugly
- Option abuse has 3 major adverse impacts
- Oversized rewards given by servile boards to
ineffective executives - In earlier years, BODs allowed executives to
exercise and sell stock with less restrictions
than those placed on lower-level employees - Repricing options rewards underperformers at the
expense of the common shareholder - Repricing out of the money options in order to
keep employees from leaving - Who will reprice the shareholders shares?
15The Ugly cont
- 3. Increases dilution risk as more and more
options are issued - EPS dilution from an increase in shares
outstanding - Earnings reduced by increased interest expense
- Management dilution management spending more
time maximizing option payout and financing stock
repurchase programs than running the business
16The Ugly cont
Options only align the interest of employees with
shareholders if they are structured so that
flipping is eliminated and the same vesting and
selling rules apply to every employee, whether
C-level or janitor
17Accounting Treatment
- To Expense or Disclose?
- Should employers expense stock option costs in
calculating net income? - Employers already disclose the cost in the notes
to the financial statements and must show the
potential impact on earnings. - Expensing options significantly reduces EPS
- Companies can deduct for tax purposes
- GAAP doesnt require expense of options
Study by Bear Stearns in 02 estimates that, had
the fair value of stock options been expensed in
2001, aggregate diluted EPS for the SP 500 would
have been reduced 20 Similarly, according to
Standard Poors, expensing options would reduce
reported 2004 earnings among the SP 500 by 7.4
while the effect on many technology firms would
be much greater. For example, in an August 2,
2004, press release, Intel reported that its
second-quarter 2004 profit would have decreased
17 if it had expensed its stock options
18Accounting Treatment cont
Expensing voluntary Disclosure - mandatory
Expensing mandatory for public co.s
Expensing mandatory for US co.s
Expensing mandatory for private co.s
Fair value or disclose
Jan 1 2002
Jan 1 2004
Pre 2002
Jan 1 2005
Aug 1 2005
S. 3870 a) scholes b) binomial
US FSAB regulates
No standard under GAAP
ASB followed the US approach using the
fair-value-based accounting method. In 2002,
CICA Handbook Section 3870 set standards for the
recognition, measurement and disclosure of
stock-based compensation
19Canada
- Pre 2002 no standard under GAAP
- Jan. 1 2002 - CICA introduced section 3870
(Canadian Standard) Fair value of the stock
options is determined and recorded as
compensation expense over the vesting period of
the option - starting 2002 - Jan. 1 2004 mandatory expense for public
companies - Jan. 1 2005 mandatory expense for private
companies
20Impact to Cott Corp. Nortel
- Cotts NI before option compensation was 6.14 M
in 02 - Including the impact of options decreased NI to a
loss of 2.36 M, a decrease of 140
- Nortel reported a net loss of 5.631 B in 02
- Including the impact of options increased this
loss to 7.13 billion, an impact of nearly 27 or
1.5 B
21SFAS. No. 123 (US Standard)
- Pre 1995 choice was up to the company
- Then in 1995, the initial proposal surfaced that
would require companies to expense the total fair
value of options. - There was strong opposition.
- Status quo continued and they had a choice
- recognizing on the Income Statement or,
- disclosing in a footnote
- Amortize total fair value over vesting period of
the stock options (SFAS 123 Revised 2004) - August 1st 2005, required to recognize as an
expense on the Income Statement
22IFRS 2 (International Standard)
- Requires all entities to recognize share based
compensation as an expense - Fair value method is applied
- Improves comparability of financial reporting
around the world
23Disclosure
- Current Regulations include
- Separate description of multiple plans
- where companies have gt one stock-based
compensation plan - Which options-pricing model is used
- Including underlying assumptions
- Number and weighted average exercise price of
options - Outstanding at beginning and end of the year
- Granted during the year
- Exercised, forfeited or expired during the year
- Exercisable at the end of the year
24What potential solutions would you propose?
- Expensing is only one part, we also need
- ethical management
- governance
- controls
- disclosure
- Expensing Options Solves Nothing, William
Sahlman. Harvard Business Review, Dec. 02
25Accounting Treatment cont
- Real Debate centered around value
- Fair value option pricing models require many
assumptions, all of which vary over time - Black-Scholes Model
- Timing when the actual expense is incurred
- When awarded?
- When exercised?
The requirement of stock option expensing is the
most controversial standard ever proposed in
Canada and in the US (FASB).
26Valuation
- Pre S.3870
- Intrinsic approach
- Record expense as the amount that the market
price exceeded the exercise price at its grant
date - Where market was not gt exercise price, companies
were not required to record impact - Post S. 3870
- Fair value, using any method
- Black-Scholes
- Binomial
27Taxation
Taxation
- Benefits from stock options are included in
employment income in year in which they are
disposed - ? favourable to employees
- Also popular with employers because there is no
immediate cash cost - ? favourable to employers
28Future direction
- Eliminate options altogether
- Direct award of stock would eliminate the value
debate - Direct award of cash
- To reduce the dilutive effect, implement stock
repurchase programs
29Weaknesses
- Still not focus employees on long-term financial
goals - Little corporate governance
- Outside the scope of management controls
- Not immediate benefits
-
30Strengths
- Motivates and retains employees
- Cash is infused into companies when employees
exercise their options - Great upside (gain) benefit potential
31Its time to play Family Feud
32Lessons Learned
- No longer reserved for executive suite
- Still popular, even after the dot-com crash
- Can be expensive to exercise
- Two common types of plans
- Nonqualified stock options
- Qualified, or incentive stock options (ISOs)
- Its usually smart to hold options as long as you
can - There may be compelling reasons to exercise early
- Stock options arent your only option for
compensation
33Questions?