Hi Tom - I was asked to respond here by pm.
Options are a complex and poorly understood beast.
First, terminology. We have shares outstanding, "Basic" and "Diluted" and "Fully Diluted".
Diluted generally include things that might become shares, like options or warrants for example.
Options exist in two states: exercisable (vested) and unexercisable (unvested). Diluted includes all those that are exercisable immediately, and "fully diluted" includes those that might become exercisable in the future.
If an example helps, look at CSCO 10K for 2000. Figures in M. They list Shares outstanding (Basic) as 6,917 and (Diluted) as 7,438. These are "weighted averages". Later in the report they show total options outstanding at the end of the period to be 971 M in total, of which 418 M are exercisable.
It is a little tricker than this because sometimes the company declares a loss and sometimes some of the options are underwater. Adding more shares has the "anti-dilutive" effect of reducing loss-per-share. So in this specific case, underwater options are excluded from the "diluted" count. Sometimes in this scenario a company will even declare that all unexercised options would be anti-dilutive if included. I have seen both ways. So you have to look carefully at the notes to see what they have included.
Next, let's talk about the "cost" of options to a shareholder. There are two costs. One is obvious, the other is very subtle.
First cost is just "dilution", as you addressed correctly. Doesn't matter whether shares arise out of stock options or by straight issuance (for example in a stock-based acquisition or warrant conversion etc.). Additional shares "dilute" existing shareholders. It's not so much about a market-cap thing as it is a "per share" thing.
A company theoretically owns assets and may distribute value. Each share represents a 1/n'th slice of earnings or assets or dividends or whatever. The bigger n gets, the smaller the slice for a fixed size pie. It is simple and straight forward.
The second, very subtle cost is a consequence of the "benefit" of stock options.
There are benefits to stock options.
First, there's the obvious delight to employees when they pay a little bit of money and get a lot more money back. This is where you hear a lot about "Black Scholes valuation". That's one of many ways of calculating the expected cash value in present dollars of an option to the optionee. This is a whole fascinating subject in itself!
There's also a benefit to the IRS, which collects taxes from the employee based on the difference between "strike" price and "market" price when the option is exercised. Mitigated slightly by a bit of tax refund the company gets on this same amount (more about this later).
Finally, there's the benefit to the company's cash flow, in two parts. First, they get straight cash from their employees who must pay the exercise price to the company. Second, they get a tax rebate from Uncle Sam. They get this because the difference between market price and exercise price is deemed to be a "cost" that the company has incurred, which the company can subtract from taxable earnings and thus lower its effective income. Sometimes even to zero.
These two effects add up. Back to Cisco. In FY 2000 10K you can see under cash flows that the cash contribution from option exercise was 1,564 M$ (financing activities) and from tax benefit 2,495 M$ (operating activities).
The total cash contribution 4,059 M$ is greater than the rest of the operating activities combined! Indeed, when you consider that CSCO's entire cash flow for FY 2000 was 3,321 M$ you will appreciate that stock option exercise kept it cash flow positive!
This cash flow impact is a big clue as to the other hidden "cost". I'll try to explain.
A growth company is typically valued based on its cash flow. The more cash flow per share, the more you should pay for it, or so the theory goes.
Well, what happens when some of this cash flow comes from stock issuance? From folks buying new shares? This is an important point. When an employee cashes in an option, they sell their share in the open market. Cash comes from the pocket of someone who has just purchased a share: it goes to the employee, who pockets some, pays the company, and pays the IRS, who pays some to the company.
So these buyers are actually injecting their own cash into the company. This shows up in the next quarters' cash flow, and helps boost the value of shares in the next quarter. And so on.
This is why stock options are often referred to as a "pyramid scheme". Existing shareholders have shares. New shareholders inject cash flow, which increases the "value per share", which increases the market price of a share, which increases the value of options which increases the company's cash flow on exercise and so on.
G&K folks will recognize a tornado when they see one. EE systems folks will recognize positive feedback with a time delay.
Fraudsters will recognize a "pyramid" scheme. The cash from the n'th shareholder benefits all n-1 shareholders.
Depending on the price-to-cash-flow ratio, and the percent of cash flow due to option exercise... well, things can get out of hand very quickly.
This is the most difficult of all of the "costs" of stock options to calculate, because it injects a hidden boost to the apparent value of the company, which is not sustainable forever. When it comes apart (as is happening right now to many tech stocks)... well, this can be very bad news.
Perhaps this was more detail than you asked for... but it's really only scratching the surface.
Hope I addressed your concern.
John. |
