Outstanding Employee Stock Options Research Articles

Financial Reporting for Employee Stock Options: The Importance of Differentiating Compensation from Proceeds

ABSTRACT Prior research finds a negative relation between outstanding employee stock options (ESOs) and common equity risk, suggesting that outstanding ESOs share characteristics with equity rather than liabilities. We extend this research to examine whether this relation is attributable to (1) the expected value of the cash proceeds to be received upon ESO exercise (“ESO-Proceeds”), or (2) the expected value of compensation to be paid to ESO holders for services provided (“ESO-Compensation”). This distinction is important because the question of whether outstanding ESOs share characteristics with liabilities or equity inherently pertains to ESO-Compensation, not ESO-Proceeds. Our findings indicate that the negative relation observed in prior research is attributable to ESO-Proceeds rather than ESO-Compensation, which is inconsistent with ESOs possessing characteristics of equity. Our study illustrates the importance of differentiating ESO-Compensation from ESO-Proceeds when addressing financial reporting questions related to outstanding ESOs.

The Effect of FASB Statement No. 123R on Stock Repurchases: An Empirical Examination of Management Incentives

This study examines management’s response to the change in accounting for stock option-based compensation imposed by SFAS No. 123R, whose implementation is expected to reduce reported income. To cope with this impact, management may be motivated to decrease the use of stock options as part of compensating employees and engage in stock repurchases in an attempt to increase the value of outstanding employee stock options. Our findings demonstrate a significant negative relation between stock options granted and shares repurchased in the aftermath of SFAS No. 123R, particularly for the S&P 500 firms known for their heavy use of employee stock options. Furthermore, evidence of a contemporaneous increase in repurchases and leverage in the post SFAS 123R period may suggest that some of the buybacks may have been funded with debt. Our findings are robust to the inclusion of traditional determinants of share repurchases.

The Effect of FASB Statement No. 123R on Stock Repurchases: An Empirical Examination of Management Incentives

This study examines management’s response to the change in accounting for stock option-based compensation imposed by SFAS No. 123R, whose implementation is expected to reduce reported income. To cope with this impact, management may be motivated to decrease the use of stock options as part of compensating employees and engage in stock repurchases in an attempt to increase the value of outstanding employee stock options. Our findings demonstrate a significant negative relation between stock options granted and shares repurchased in the aftermath of SFAS No. 123R, particularly for the S&P 500 firms known for their heavy use of employee stock options. Furthermore, evidence of a contemporaneous increase in repurchases and leverage in the post SFAS 123R period may suggest that some of the buybacks may have been funded with debt. Our findings are robust to the inclusion of traditional determinants of share repurchases.

Discussion of “Financial reporting for employee stock options: liabilities or equity”

Barth, Hodder, and Stubben examine how the risk and expected return of existing shares varies as a function of the amount of outstanding employee stock options (ESOs), finding that the association is a negative one, consistent with ESOs being equity-like in character. They suggest that their approach could be used to address the question of how best to characterize other complex financial claims. The study is well executed and provides a thought-provoking contribution to the debate. However, it is far from obvious that the “debt or equity” question can be solved in this manner. Their approach effectively defines a liability as a financial claim that has characteristics akin to fixed-rate debt. I provide examples of the limitations of this perspective, starting by comparing ESOs that are settled with shares with those settled in cash. Whether a claim is treated as a liability or equity is of little consequence if it is simply a matter of balance sheet presentation. The real question is the implications for income measurement. I suggest progress might best be made if we start with Penman’s proposal that assets and liabilities be separated into operating and financial items, an approach which would include many claims that have equity-like characteristics, such as unvested ESOs, within the operating liability category. Once a claim ceases to be an operating item—e.g. when an ESO vests—the approach suggested in the paper can then be used to determine how it should be classified.

Financial reporting for employee stock options: liabilities or equity?

This study seeks to determine whether employee stock options share key characteristics of liabilities or equity. Consistent with warrant pricing theory, we find that common equity risk and expected return are negatively associated with the extent to which a firm has outstanding employee stock options, which is opposite to the association for liabilities. We also find the following. (1) The association is positive for firms that reprice options and less negative for firms that have options with longer remaining terms to maturity, which indicates that some employee stock options have characteristics that make them more similar to liabilities. (2) Leverage measured based on treating options as equity has a stronger positive relation with common equity risk than leverage measured based on treating options as liabilities. (3) The sensitivity of employee stock option value to changes in asset value mirrors that of common equity value and is opposite to that of liability value. Also, we find that, unlike liabilities, employee stock options have substantially higher risk and expected return than common equity. Our findings are not consistent with classifying employee stock options as liabilities for financial reporting if classification were based on the directional association of a claim with common equity risk and expected return. Rather, our findings suggest the options act more like another type of equity.

The Effects of Employee Stock Options on Credit Ratings

ABSTRACT: This paper examines whether outstanding employee stock options (ESOs), which represent the firm’s contractual obligation to deliver shares upon ESO exercise, affect firms’ credit ratings. I hypothesize that outstanding ESOs play two information roles—(1) suggesting equity infusion, and (2) predicting share repurchases—that help credit-rating agencies evaluate the issuing company’s debt service ability. Consistent with these hypothesized roles, results indicate that the present values of expected cash proceeds and tax benefits from ESO exercise have favorable effects on credit ratings. In contrast, the present value of the expected cost of ESO-related share repurchases has an unfavorable effect on credit ratings and this unfavorable effect is more pronounced for firms with a greater tendency to repurchase shares. The after-tax fair value of outstanding ESOs, which summarizes the effects of the above three ESO-related cash flows, is negatively associated with credit ratings. Taken together, these findings are consistent with credit-rating agencies incorporating the information conveyed by outstanding ESOs regarding potential equity infusion and ESO-related repurchases in their credit risk assessments and assigning lower credit ratings to firms with greater values of outstanding ESOs.

Valuing Multiple Employee Stock Options Issued by the Same Company

Stock options issued to employees has become a significant component of total compensation in many firms. Although option pricing technology has evolved remarkably over the years, valuing employee stock options (ESOs) still presents numerous challenges, and there is no model that is generally accepted in practice. Simply treating ESOs as if they were plain vanilla (American) stock options fails to take proper account of a number of their particular features. Along with vesting rules and the uncertainty they entail, these features include the fact that the equity of existing stockholders will be diluted when the ESOs are exercised. In that sense they resemble warrants rather than traded option contracts. Also, the fact that ESOs are issued on a regular basis means there are typically a number of outstanding ESOs with differing maturities and strike prices, which introduces interaction among them in valuation and in optimal exercise strategy. In this article, Dennis and Rendleman present a lattice technique to value ESOs that takes account of the effects of dilution and optimal exercise for a firm that has a diverse set of ESOs outstanding. Their approach increases computational efficiency substantially over the standard solution technique for a lattice model, but realistic problems still can become intractable as the number of time steps and options grows. Fortunately, the results indicate that in most cases, the effect of dilution and interaction among exercise decisions is present but relatively small.

The Treatment of Outstanding Employee Stock Options in Mergers and Acquisitions

This technical note summarizes the tax treatment of alternative methods available to the acquirer to compensate owners of the target's employee stock options. The summary includes changes in the tax law as of 2005.

On the Effect of Employee Stock Options on Credit Risk - A Credit Rating Agencies' Perspective

This paper empirically examines whether and how credit rating agencies incorporate the information contained in outstanding employee stock options (ESOs) when assessing the credit risk of the issuing company. I hypothesize that outstanding ESOs play two informational roles in credit risk assessments - signaling equity infusion and predicting future repurchases - that help credit rating agencies evaluate the cash flow implications at the settlement of ESO contracts. My empirical analyses show that the fair value of outstanding ESOs has a negative impact on the issuer's credit rating after controlling for information risk, operating risk, incentive effects, and other known factors that affect perceived credit risk. This adverse impact is more pronounced for companies that repurchase shares in response to ESO exercise and is robust to the control of the endogenous choices of option issuance and ESO-related repurchases. Moreover, I find that the fair value change in outstanding ESOs subsequent to the grant date is incrementally informative about credit ratings beyond the grant date fair value. Collectively, these findings are consistent with the hypothesis that credit rating agencies incorporate in their credit risk assessments the information conveyed by outstanding ESOs about potential cash outflows associated with ESO-related repurchases. I do not find, however, that the present value of the expected proceeds from option exercise is associated with credit ratings. This latter finding suggests that credit rating agencies do not attach additional valuation on ESOs' promise to create future equity beyond the information that has been reflected in the fair value of outstanding ESOs.

Employee stock options, EPS dilution, and stock repurchases

We investigate whether corporate executives’ stock repurchase decisions are affected by their incentives to manage diluted earning per share (EPS). We find that executives increase the level of their firms’ stock repurchases when: (1) the dilutive effect of outstanding employee stock options (ESOs) on diluted EPS increases, and (2) earnings are below the level required to achieve the desired rate of EPS growth. We also find that executives’ repurchase decisions are not associated with actual ESO exercises, suggesting that they are driven by incentives to manage diluted but not basic EPS, and strengthening our earnings management interpretation.

Employee Stock Options, Residual Income Valuation and Stock Price Reaction to SFAS 123 Footnote Disclosures

This study provides a theoretical analysis and empirical investigation of the valuation implications of employee stock options. I extend the residual income model to incorporate the effects of employee stock options, and then empirically test the model using data related to employee stock options collected from companies' financial statements. I show that the value obtained from the traditional residual income model based on reported earnings must be adjusted for the value of outstanding options and expected stock option expense. The empirical results are consistent with the model, indicating the existence of a cross-sectional negative association between share prices and both outstanding employee stock options and expected stock option expense. In addition, I examine the market's response to the disclosures of stock option information around firms' 10-K filings with the SEC. I find that SFAS 123 footnote disclosures at 10-K filings communicate useful information about employee stock options to investors.

Purchase versus Pooling in Stock-for-Stock Acquisitions: Why Do Firms Care

We investigate firms' financial reporting policies with respect to business combinations, particularly the choice between the purchase and pooling-of-interests methods. To control for potentially confounding effects related to the method of acquisition financing, we focus on a sample of stock-for stock acquisitions. We provide evidence that the accounting method choice is jointly determined by the size of the step-up, i.e., the premium paid over the book value of the acquired firm and which is recognized under the purchase method, and proxies for economic benefits derived from accounting-based contracts. In particular, we find that, when the business combination involves a large step-up to the target's net assets, CEOs with earnings-based compensation plans are more likely than others to incur the costs of qualifying for pooling and avoid the earnings 'penalty' associated with the purchase method. However, we find no association between stock-based compensation and the purchase-pooling choice, suggesting managers are not concerned about implications of large step-ups for firms' equity values. We also find no support for the prediction that top executives' preference for pooling is greater when their job security is relatively low. Finally, consistent with the favorable balance sheet effects of the purchase method, we find that the likelihood of pooling decreases with the acquirer's debt-equity ratio, a proxy for debt contracting costs. We also predict and find an association between the purchase-pooling choice and potential costs related to meeting the restrictive pooling criteria. In particular, we find that firms for which the pooling requirement of no share repurchases appears to be binding (firms that have already announced a share repurchase plan and/or have a large number of outstanding employee stock options) are less likely than others to use pooling. However, we do not find that firms for which the requirement of no post-acquisition divestitures of the target's assets may be binding are less likely to use pooling.

Market valuation of employee stock options

This study investigates whether investors incorporate the value of a firm's outstanding employee stock options into its stock price. I estimate the outstanding options' value for a sample of firms for which outstanding fixed options exceed 5% of outstanding common shares in 1988. I find a negative correlation between the value of outstanding options and a firm's share price. The correlation is stronger (i) for the option's intrinsic value than for the option's time value, (ii) for options that are later in their vesting stage than earlier in their vesting stage, and (iii) for large firms than for small firms. In addition, the FASB's method for calculating compensation expense has no explanatory power in the presence of this paper's calculation of the options' value.