# Employee Stock Option Plans Employee stock options are a widely because it is generally accepted and the used instrument to align interests of absolute standard The formula goes as

Document Sample

```					Employee Stock Option Plans
Employee stock options are a widely          because it is generally accepted and the
used instrument to align interests of        absolute standard. The formula goes as
managers and shareholders. Especially in     follows:
early-stage companies employee stock
options are one good remedy to console       V=exp(-dT)SN(d1)-exp(-rT)KN(d2),
the founders for the dilution they had to    d1=(ln(S/K)+(r-d+σ2/2)T)/(σ√T),
go through in the fund raising process.      d2=d1- σ√T,
Every time a company issues employee
stock options (and the corresponding         Where S is the share price, K the strike
conditional shares) it has to value them     (usually equal to the share price at issu-
for accounting and tax purposes. This is     ance), T is the maturity, r the interest
typically the CFO’s or the valuation guy’s   rate, d the dividend yield, and σ the
task. We therefore give here a short         volatility of the share price. The interest
primer on what there is to do.               rate and the dividend yield are here con-
tinuously compounded, so one has to
The Stock Option Plan                        transform the discretely compounded
interest rate rd in the following way:
The company issues options to their
employees. The options are usually only      r=ln(1+rd)
vested after a certain blocking period.
The employees can then execute the           N(.) is the normal distribution (in Excel
option at the moment of their choice or      it’s NormSDist).
sometimes within predefined execution
windows until maturity of the option;        The price of one option of the ESOP
but usually only as long as they are still   with Black-Scholes amounts to USD
with the company.                            47.09.

Let’s assume the following Employee          Early Execution
Stock Option Plan (ESOP): The share
price is at USD 120 (2,500,000 shares        Tradable options are only executed at
outstanding), 20,000 options are issued      maturity (or at dividend payments1) be-
with a strike of USD 120, a 3 year block-    cause you can always sell them at a bet-
ing period, expiring after 10 years. The     ter price than what you get by executing
long term risk-free interest rate is 4%,     them. For employee stock options this
the company on average pays a dividend       doesn’t hold because you cannot sell the
of 3% of the share price, and the volatil-   option. Various reasons lead to early
ity of the share price is 43%.               execution of the option; the holder
thinks that the share price is at a high
Black-Scholes
Black-                                       and is going to fall in the future, maybe
the holder plans to change employer
For financial options the Black-Scholes      and wants to cash in all his options
formula applies. Employee stock options      while he still can do so, or maybe he just
don’t fulfil a number of conditions of
the Black-Scholes formula, e.g. they are
1
not tradable, but the formula is applied      Villiger, Ralph, „Valuation of American Call
Options." Wilmott 2006, March.
needs to buy his fiancée a ring. There-      the option is 32.8% lower than the
fore we can assume that the options are      Black-Scholes price. This number is sig-
executed all over the life-time between      nificant for the CFO as he has to make
the end of the blocking period until ma-     less provisions for the ESOP. It is there-
turity. With this additional assumption      fore worthwhile to spend a bit time to
an option of the ESOP is worth 11%           run a sophisticated valuation.
less, i.e. USD 41.88.
ESOP for private companies
Fluctuation
Within biotech companies we face vari-
Of course employees don’t stay forever       ous difficulties. First, we do not have a
in the same company and some fluctua-        share price at every moment, but only at
tion naturally occurs. For the valuations    financing rounds. The price for the ESOP
of ESOPs it is important to estimate how     calculation can be derived from the last
many options won’t be executed be-           financing round provided no significant
cause the holders are not in the com-        event happened meanwhile. Otherwise a
pany anymore. If we assume a yearly          new valuation has to be performed.
fluctuation rate of 4%, i.e. 4% of em-       Second, we do not have a volatility since
ployees participating in the ESOP leave      we do not have a historical share price
the company each year, then the aver-        development. For early stage companies,
age value of an option becomes USD           in particular biotech companies, this
31.95, corresponding to a 32% value          volatility can amount to 100%-200%,
reduction with respect to the original       which then increases the value of the
Black-Scholes price.                         ESOP enormously. As far as possible we
recommend using volatilities of compa-
Dilution                                     rable companies. The huge volatility is
mainly a consequence of the clinical
Finally, the execution of the options        success and the subsequent large value
share capital is not increased. Current      tions also provide good approximations
shareholders therefore get diluted. This     for the volatility.
dilution can be considered in the valua-
tion by assuming that the options are        For a calculation sheet of such ESOPs
actually warrants. If the company has N      please        visit   our       website
shares outstanding and the company           http://www.avance.ch/shop/excels.html.
issues n options, then this means that       For setting up an ESOP tailored to your
the value of the option satisfies the fol-   company you can contact our partners
lowing equation:                             at         JT       AssetCompensation
(www.jtassetcompensation).
V=V((NS+nV)/(N+n), K, d, r, T, σ)

In our example the expected dilution
reduces the value a bit more down to
USD 31.66. All in all the correct value of

```
DOCUMENT INFO
Shared By:
Categories:
Stats:
 views: 233 posted: 8/5/2009 language: English pages: 2
How are you planning on using Docstoc?