Stock Options and the Limitation with the Case of e-Bay

1
Stock Options and the Limitation with the Case of
e-Bay
2
Q1. the agency theorists rationale for using
stock options to align the interests of
shareholders and managers?
3
Multiple Purposes of Stock Option

• By introducing management incentives
• - Raise management efficiency resulting in
  shareholders profits
• Lower agency costs and increase in management
  transparency by making people in the company the
  shareholders
• Securing human resources
• Ventures inducing high calibres
• Large caps retaining key management
• - Financial institutions aligning the interests
  between managers and shareholders
• Increase employees welfare for
• Enjoying tax incentives
• Tax benefits to the firms, especially venture
  firms
• Lower income tax to the receivers

4
Situational Outputs

• Market Performance
• Stock option did not contribute to the management
  achievement and market performances
• - Lower performance than the average in the
  floors
• - No correlation between stock growth rates in
  the market and stock option
• Company Practice
• Exploited the tax system for a few special
  insiders
• A way of risk-free bonus, no downward payments
• some times corruption like Back Dating
• Giving potential shareholders status is a matter
  of future (uncertain) and no contribution to the
  company value
• Lu Gusner in IBM bought IBM stocks in the market
  !!

5
Wide-spread practice with limitation

• For the current shareholders, it is the costs in
  PL accounting, which result in lower dividends
  given to agents who did not invest (Microsoft)
• It is against the fair treatment of current
  shareholders due to lower strike price
• It is against minority interests in keeping
  exclusive rights to the management team and
  special relates in running the company
• The chance of conflicts between the receivers and
  non-receivers making lower morals or incentives
  to work (Netscape)
• - This situation may force able people to leave
  the company

6
eBay should keep going !

• Major Sources of Problems
• - Industry Generic Business Achievement
  Organizational Stage
• Lack of internal resources,
• market situation
• Industry cycle and venture economy
• Rapid technology life cycle and steep experience
  curve
• Opportunistic humans behaviors

7
Q2. Should eBay expense the stock option and
report a loss?
8
Issues regarding the expensing of stock options

• There are two main issues surrounding the
  recording of an expense when an option is awarded
• Does the expensing provide a level playing field
  in accounting for management compensation?
• Would the recording of an expense when an option
  is awarded improve corporate governance?

9
Stock Option Expensing

• Expensing will provide a level playing field so
  that companies that use cash bonuses and
  companies that use stock options each have an
  expense on the income statement
• Pros
• Matching accounting principles having
  costs-benefits in the time
• Making the EV appropriate and the economic system
  stable
• Allowing control information on corruption by
  management
• Corporate governance will be improved by reducing
  or eliminating incentives to inflate income and
  earnings per share
• Cons
• Already known information in the footnotes of
  financial reports
• Making rapid decrease in business performance
  winding up many side effects
• Uncertainty in the calculations of option costs
  (limitation of model)

10
Who are they?
Approvers Disapprovers
High Bowers Warren E. Buffett, Alan Greenspan, Senator Carl Levin, John McCain President Bush, Senator Joe Lieberman
Institutions Arthur levitt (former SEC chairman), IASB Harvey Pitt (SEC Chairman)
Researchers /Interest groups 80 percent of U.S. financial analysts, Association for Investment Management and Research, Council for Institutional Investors Association for Financial professionals, Financial Executives International, National Venture Capital Association, U.S . Chamber of Commerce
? A power game to keep their interests using
narratives
11
Better Direction

• According to accounting principals, Accrual-Based
  Accounting (GAAP) and for the better market
  system, it is better to have stock Option
  expensing in the beginning of development
• The goal of a company is to maximize its value
• The shareholders want to have reliability about
  the financials and the accounting numbers
• Achieving better performance through adjusted
  stock option plans using
• - Industry index, evaluation by the compensation
  committee, devils advocate to control risks
  (Enron case), etc.

12
Q3. Why Black-Scholes fails to solve the agency
problem?
13
No Consideration Managemental Practice

• Risk Taking Attitude
• The management will be inclined to grow the
  company rapidly hence making the company more
  risky especially when options are out-of-money)
• If the risky strategy does not live up to
  expectations (the more debt more risky, a lower
  value)
• Externalty
• Inordinate compensation in the bull market by
  external factors, meaning free riders
• Other problems with Black-Scholes
• Potentially overstates the value of employee
  stock options
• The model also assumes that the options can be
  traded in the market

14
Issues and assumptions regarding the option
pricing models

• Frictionless markets
• No transaction costs, no tax and perfect
  liquidity
• No dividends, fixed date (European Option)
• Continuous trading
• - Trades can be performed at any time and in any
  amount. Even discrete models frequently assume a
  continuous limit
• Unlimited short selling and borrowing are
  possible and the proceeds are immediately
  available
• There are no arbitrage opportunities
• Both the buyer and the seller of the underlying
  property are driven only by profitability of the
  trade

15
Relationship between corporate governance, IOS
and control variables
Corporate Governance
Control variables Performance Size Ownership
Risk
Investment Opportunity Set
Option Valuation
16
A better direction
Stock Prices
Stock Prices
Floating Exercise Prices by stock incex,
industry index, competitiors performance, etc.
Exercise Prices
Time
Exercising date
Issuing Date
Number of Stocks
Numbers of Stocks based on long term performance
like ROI, EVA, etc.
Time
Issuing Date
Exercising date
17
Arguments agains expensing options

• The playing field is already level. A company
  using cash bonuses as management incentive
  compensation has a reduction in net income and a
  resultant reduction in earnings per share. When a
  stock option has been awarded and the strike
  price is in the money, the additional shares
  become outstanding for purposes of calculating
  earnings per share. Since earnings per share is
  calculated by dividing net income by weighted
  average shares outstanding, as the shares
  outstanding increase, the earnings per share
  decrease. To require a company to record an
  expense for the option, and subsequently increase
  the shares outstanding is a double hit to
  earnings per share.
• Regarding improved corporate governance, it is
  difficult to believe that the management or the
  Board of Directors of Enron would have limited
  the number of options simply because of the
  requirement to record an expense. Management that
  is truly unscrupulous is concerned strictly about
  personal gain and not about the companys income
  statement.
• During recent years, each time that earnings
  management is scrutinized, analysts regularly
  state, follow the cash. Ignore entries that are
  purely accounting and have no cash impact. Such
  is the nature of recording an expense when an
  option is awarded. This is an accounting entry
  with no cash impact. It is very likely that
  analysts will remove the option expense from the
  income statement to obtain a clear view of the
  companys performance. This would likely lead to
  companies including a pro forma income statement
  which excluded the option expense. As a footnote
  to the follow the cash guideline, it is
  interesting to note that, not only is there no
  cash impact from the expense option, there is
  positive cash flow to the company. At the time
  the option is exercised, the employee must pay
  for the shares received.
• Hi-tech companies have traditionally issued
  options to multiple levels of employees with two
  purposes in mind attract high quality employees
  to the company and motivate workers at all
  levels. If hi-tech companies were required to
  record an expense at the time options are
  granted, many employees at all levels would most
  likely lose the options.
• Source http//gbr.pepperdine.edu/024/options.html
  

18
List of sources that you can take a look at

• http//gresslemcginley.com/expensing_stock_options
  .pdf
• http//gbr.pepperdine.edu/024/options.html
• http//www.savingcapitalism.com/corpgov.pdf