Wayne -
(This is the way I think about it in its most vanilla form.
When a company issues shares, they receive the value of those shares in cash to invest. The additional cash should contribute to the future net income of the company in an amount that makes EPS better or the same as it would have been without the secondary offering. (hopefully)...)
No problem here.
...(When a company substitutes options for cash compensation, they do not pay out in cash the theoretical value of those options. Reported earnings automatically rise by that amount...)
No, this is a problem. Reported earnings ARE higher than if no options were used, but the pretax amount by which they are higher is the amount of wages forgone. Not only does the theoretical option value not matter, even the concept that there is a VALUE is in violation of the Austrian 'Subjective Theory of Value'. Value, cost and price are three entirely different things, which are often confused.
The theoretical option value does have some application, but only when it is part of a market exchange in which everything is converted to prices. The employee option does not trade on a market, but is accepted in lieu of some amount of foregone salary. If the company grants 10 options instead of what would have been $50K of additional salary, the only valid observations are the following: The employee believes that his subjective marginal utility of 10 option contracts is greater than that of an additional $50K in salary. The company believes that its marginal utilities are just the opposite. There is no information about the degree of inequality, or any way to quantify it.
(...When those options are exercised, the company receives some proceeds from the person that exercised the options...)
Probably about the same amount of proceeds as from the secondary, the exercise price, but at a later time. The company also receives a tax credit at about the same time.
(...The combination of the proceeds from the exerciser and the original extra cash (plus gains) should be enough to retire the share. So at the end (let's say) 10 years, the company will be in the exact position it would have been had it given cash instead of options...)
I see no reason to assume 'exact' here, nor any necessary requirement to retire the share.
(...Thus the earnings were overstated initially...)
At the time of grant, and the initial earnings report, the final results will eventually be determined by a combination of future happenstance and future active decisions.
(...If they do not buy back the shares, they have the full proceeds of a share issuance right now, not 10 years ago when they didn't expense the option.)
If we compare the secondary and the option grant, the following sequence occurs -
1. At T0, the ATM option grant gives the advantage of reduced current salary expenses and the secondary gives the proceeds of a current stock price. For increasing stock price, both cases represent actual dilution. For decreasing
stock price, the secondary is still dilution, but the option grant is merely the pocketing of the reduced salary expense by the company.
2. At T1, the time of option exercise, the company receives the proceeds of the exercise price sale and a tax credit, assuming increased stock price.
3. At any time, the company is free to buy back its stock for any reason, independent of the past. It is equally free to invest in some other company's stock.
Thanks, Don |
