Re: Your analysis
You may be better than me in calculating B-S, but from your post, you make it pretty obvious that you either didn't read my entire post or you know very little about options and how they are taxed. In fact, other than the B-S (which I will assume you are correct on without checking), almost every other number in your post is flat out wrong.
It would be well worth your time to find an explanation of B-S on the net because your calculations are drastically wrong. If the stock price and exercise price of the option is 36, the employee controls 537 shares (t = 4 years, volatility = 60%, interest rate = 6%, time = 4 years). If the stock price doubles and his marginal tax rate is 40%, the after tax profit on his $10,000 investment is $13,198, not the $2000 that you quoted (or the $600 for the speculator without options).
You say the employee with options controls 537 shares with an exercise price of 36. I said he controlled about $20,000 of stock, for which he would have to pay $20,000. Since 537 shares times $36 per share equals $19,332, we are pretty close. You came up with an after tax profit of $13,198. I'm guessing here, but I think you made your calculation like this (if not, please let me know how you did do the calculations):
537 shares x $36 per share = $19,332
$19,332 doubled = $38,664
$38,664 x 40% tax = $15,466
$38,664 - $15,466 = $23,198 total
$23,198 - $10,000 investment = $13,198 profit
Here is the correct calculation:
537 shares x $36 per share = $19,332
$19,332 doubled = $38,664
$38,664 - $19,332 exercise price = $19,332 pre tax
$19,332 x 40% tax = $7,733
$19,332 - $7,733 = $11,599 after tax cash
If you want to say this equates to an after tax profit of $1,599, I guess you could, but it is a meaningless number. All I was doing was comparing two hypothetical employees, one who got options and one who got cash.
I agree with you that B-S results in fewer shares as the option term is extended. However, if you want to use a ten year term, I would argue that the stock could easily more than double during the option term.
The IRS wins either way. They collect $15,466 on the profit of 537 options or $10,627 on the profit of 369 options. Use the IRS as a "sanity check".
As I calculated above, the IRS doesn't get $15,466, they only get $7,733. But this is only half of the equation. The company gets a tax deduction for the same amount as the employee picks up in income. Using a 40% tax rate, they save $7,733, and the IRS nets zero. (My 40% rate includes federal and state taxes, and the offset is approximate, not exact). I never use the IRS as a sanity check, as they often drive me insane.
There's another possible problem with your analysis. You seem to be assuming that the 537 or 369 shares that the company purchases at the time of the option grant offsets the option sale. In reality, the company incurs no liability unless and until the option is exercisable and the stock price is greater than the strike price. If the stock price goes down, the employee has limited his possible loss to $10,000 plus 4 years of interest. The company could lose $13,284 for 369 shares or $19,332 for 537 shares, plus the loss of income of 6%/year investing in T-bills ($2,625) rather than speculating in the stock market.
I wasn't assuming that the company was trying to offset the option sale. I was assuming that they were trying to prevent an increase in fully diluted shares outstanding. Since unexercised options are included in this number, the company must purchase an offsetting amount to prevent the fully diluted shares from increasing. If the stock price goes down, the employee ends up with nothing. Assuming the stock price went down from $36 to $30, he could exercise his 537 options by paying $19,332. This would be a stupid move, because he could buy $537 shares on the market for only $16,110. The option expiration would have no effect on the company.They wouldn't lose $19,332 unless the stock, and not the option became worthless. In that case, whether they gave out no options or millions of options wouldn't matter. They would be out of business in either event.
Since the potential loss to the company ($19,332+$2,625) is nearly double the potential loss to the employee ($10,000+$2,625), a prudent company will not purchase shares at the time options are granted. Wind River is doing so and they're telling you that they believe the stock is currently undervalued. They also granted boatloads of options without "offsetting" purchases and sold millions of shares in 1996 when the price was 18.
Everyone loses if the stock goes down; the company, the employee,, and the outside stockholders. In 1996, when they granted boatloads of options without offsetting purchases, I don't believe they had a cash position that made it prudent for them to fight the dilution. In 1996 the stock was worth $18, in 1998 it is worth $36. Some companies have done better, some have done worse.
They were drastically wrong the last time they speculated in the stock market and lost many millions of dollars, so do you think they're right this time?
Yes, I do think they are right this time.
Actually, this whole discussion of options has little to do with the original question that started the topic, which was not whether or not WIND should grant options. It was whether the level of options is excessive, since options are a fact of life. My vote is that they have not been excessive. I am happy with how the company is being run. |
