Exotic Cuisines Employee Stock Options
As a new graduate, you've taken a management position with
Exotic Cuisines, Inc., a restaurant chain that just went public
last year. The company's restaurants specialize in exotic main
dishes, using ingredients such as alligator, buffalo, and ostrich. A concern you had going in was that the restaurant business is very risky. However, after some due diligence,
you discovered a common misperception about the restaurant industry. It is widely thought that 90 percent of new restaurants close within three years; however, recent evidence suggests the failure rate is closer to 60 percent over three years. So, it is a risky business, although not as risky as you originally thought.
During your interview process, one of the benefits mentioned was employee stock options.
Upon signing your employment contract, you received options with a strike price of $50 for 10,000 shares of company stock. As is fairly common, your stock options have a
three-year vesting period and a 10-year expiration, meaning
that you cannot exercise the options for a period of three years,
and you lose them if you leave before they vest. After the three-year vesting period, you can exercise the options at any time. Thus, the employee stock options are European (and subject to forfeit) for the fi�rst three years and American afterward.
Of course, you cannot sell the options, nor can you enter into any sort of hedging agreement. If you leave the company after the options vest, you must exercise within 90 days or forfeit.
Exotic Cuisines stock is currently trading at $24.38 per share, a slight increase from the initial offering price last year.
There are no market-traded options on the company's stock.
Because the company has been traded for only about a year, you are reluctant to use the historical returns to estimate the standard deviation of the stocks return. However, you have estimated
that the average annual standard deviation for restaurant company stocks is about 55 percent. Because Exotic Cuisines is a newer restaurant chain, you decide to use a 60 percent standard
deviation in your calculations. The company is relatively young, and you expect that all earnings will be reinvested back into the company for the near future. Therefore, you expect no dividends will be paid for at least the next 10 years. A three-year
Treasury note currently has a yield of 3.8 percent, and a 10-year
Treasury note has a yield of 4.4 percent.
QUESTIONS
1.
You're trying to value your options. What minimum
value would you assign? What is the maximum value
you would assign?
2.
Suppose that, in three years, the companys stock is
trading at $60. At that time, should you keep the options
or exercise them immediately? What are some important
determinants in making such a decision?
3.
Your options, like most employee stock options, are not
transferable or tradable. Does this have a significant effect on the value of the options? Why?
4.
Why do you suppose employee stock options usually
have a vesting provision? Why must they be exercised
shortly after you depart the company even after they vest?
5.
A controversial practice with employee stock options is
repricing. What happens is that a company experiences
a stock price decrease, which leaves employee stock
options far out of the money or underwater.� In such cases, many companies have underepriced� or restruck�
the options, meaning that the company leaves the original terms of the option intact, but lowers the strike price.
Proponents of repricing argue that because the option is
very unlikely to end in the money because of the stock
price decline, the motivational force is lost. Opponents
argue that repricing is in essence a reward for failure.
How do you evaluate this argument? How does the
possibility of repricing affect the value of an employee
stock option at the time it is granted?
6.
As we have seen, much of the volatility in a companys
stock price is due to systematic or market wide risks.
Such risks are beyond the control of a company and
its employees. What are the implications for employee
stock options? In light of your answer, can you recommend an improvement over traditional employee stock options?
1. To value your options, you can use an options pricing model such as the Black-Scholes model. The minimum value you would assign is the intrinsic value, which is the difference between the current stock price and the strike price of your options (if it is positive). If the current stock price is below the strike price, the intrinsic value is zero. The maximum value you would assign is the market value of the options, which could be above the intrinsic value if there is significant time value remaining until the options expire.
2. If the stock is trading at $60 in three years, you would compare the value of exercising your options at that time versus holding on to them. Consider the time value remaining on the options, as well as your view on the future stock price movement. Other factors to consider include any restrictions on selling the stock after exercise, taxes, and personal financial situation.
3. The fact that the options are not transferable or tradable can have a significant effect on the value of the options. It reduces their liquidity and makes them less valuable compared to options that can be bought and sold in the market.
4. Employee stock options usually have a vesting provision to incentivize employee retention and loyalty. By vesting over a period of time, the company ensures that employees stay with the company and contribute to its long-term success. Options must be exercised shortly after departure because the purpose of the options is to reward ongoing employment and align the interests of employees with shareholders. Allowing options to be exercised after departure could lead to a misalignment of interests.
5. The practice of repricing employee stock options is controversial because it can be seen as a reward for failure. Proponents argue that repricing is necessary to maintain employee motivation when stock prices decline significantly. Opponents argue that repricing undermines the intended purpose of options as an incentive for long-term performance. The possibility of repricing affects the value of an employee stock option at the time it is granted by increasing the uncertainty around its future value due to potential downward adjustments of the strike price.
6. The implications of systematic or market-wide risks for employee stock options mean that the value of options can be highly influenced by external factors that are beyond the control of employees. To improve on traditional employee stock options, companies could consider incorporating performance-based metrics tied to the company's specific performance rather than relying solely on stock price. This aligns the options more closely with the actions and results that employees can control and ensures a stronger alignment of incentives.