Employee Stock Options

1. Employee Stock Options Presented by: Gary Liang Daniel Lee Joyce Yuen

2. Agenda • Employee Stock Option • Definition • Trend • Pros and Cons • Accounting • Manipulation • Outlook • Adobe System • Cisco System

3. What is ESO? An employee stock option is a Warrant on a company's own stock issued as a form of non-cash compensation.

4. Characteristics of Warrant • Warrant is an option issued by a corporation • Granting the purchaser the right to acquire shares • The transaction results in a cash inflow to the corporation in exchange for a NEW issue of common shares.

5. The Era of ESO Poitras (2004) –Executive Stock Option Disclosure: Is FAS 123 Adequate?

6. Recent Trend of ESO - S&P 500 Companies Figure source:http://www.equilar.com/newsletter/september_2006/ect_sept_2006_article2.html

7. Why ESO? • Agency Problem • Moral Hazard • Occur from separation of ownership and control • Effort is unobservable, managers may shirk on effort • ESO aims at aligning executives’ and employees’ interests with shareholders • Long term incentive for execs and employees

8. Why ESO? (cont.) • No Cash Requirement • especially good for growing companies or companies with high intellectual capital • Accounting incentive (before 2004)

9. Why ESO? (cont.) • Personal tax incentive • No income taxed until exercised • When taxed, categorized as capital gain (only 50% taxable) • Deferred dilutions of earnings and voting controls • Rising share price motivates employees to work harder and longer

10. Critiques of ESOs The main criticisms against executive stock options: (i) The difficulty of accounting, expensing options in particular; (ii) The opportunity cost of options for the granting firm higher than the value of options to undiversified executives; (iii) Giving executives extra incentives to manipulate accounting information; (iv) Rewarding executives excessively in the boom market; (v) Failure to penalize bad performance by resetting option price in the down market (vi) Encouraging executives to take excessive risks at the cost of the shareholders. Reference: Chongwoo Choe, Xiangkang Yin (2006). Should Executive Stock Options Be Abandoned? Australian Journal of Management, 31(2), 163

11. Accounting of ESO (1972) • Accounting Principle Board 25 (1972) • Expense will be the fair value amount or the intrinsic amount • Loophole: if a firm sets the exercise price of the option equal to the Market price at grant date, then $0 expense is recognized

12. Accounting of ESO (1995) • Financial Accounting Standard Board 123 (1995) • Financial Accounting Standards Board (FASB) encouraged the use of fair value methods & mandated disclosure in the notes, but firms could still use the intrinsic method

13. Accounting of ESO (2005) • FASB 123 (2005 - revised) • FASB made fair value method of expensing stock options mandatory for all annual and interim reports after June 15, 2005 • Effects: • Sliced 20% of reported income (Business week, 2003)

14. Valuations of ESO • Intrinsic Value = Market Price at grant day – exercise price • Fair value of stock options = “intrinsic value + time value”: • The Lattice Model (e.g. Binominal Model) • Black-Scholes Model • Other valuations

15. Choice of Valuation Model The majority of public and private companies apply the Black-Scholes model, however, through September 2006, over 350 companies have publicly disclosed the use of a lattice model in SEC filings. Source: http://en.wikipedia.org/wiki/Employee_stock_option

16. Black-Scholes and Lattice-Binominal Not Accurate! • Black-Scholes • Assume free transferability, but not for ESO • Assume non-contingent exercisable option, but ESO void as soon as holders leave the company • Contain lots of estimations • Lattice-Binominal • Can be applied to more different kinds of options • Still contain estimations

17. Black-Scholes Model • C(S,T) = S*N(d1) – K℮-rt*N(d2) • Lots of estimations in the valuation, another loophole for manipulation?

18. The “Power” of Estimations • Capital One Financial, 2002 • Reduce option life from 8.5 to 5 years • Cut option cost $29.3 million • Broadcom Corp., 2002 • Reduce volatility from 90% to 70% • Save $79 million

19. Evidences from Academic Studies • One out of five companies in the Standard & Poor's 500-stock index reduced option life, stock volatility, or both, in 2002, increasing actual or pro forma earnings in the process. • Jack T. Ciesielski, The Analyst's Accounting Observer • Compared accounting assumptions used to value options in 2002 with actual historical trends and found that many companies underestimated both volatility and the risk-free interest rate. • Derek Johnston-Wilson, Colorado State University

20. Other Management Manipulations • Other Management manipulation • Management controls over stock option grants • Stock repurchase instead of dividends • Misrepresentation of company performance • Executives influence the restrictions of the stock options in their own favour • Forfeiting profitable but risky businesses

21. Back-Dating • Proposed by Erik Lie (2005) in his study • dates on which options are granted to executives are chosen with the benefit of hindsight to be past dates when the stock price was particularly low • SEC investigated the issue, big time • Included Jack Welch, GE and Donald Tyson, Tyson Food • Silicon Valley firms (30-40)

22. Back-Dating • Lynn Turner, a former SEC chief accountant, suspects it's a fairly common practice and ‘bigger than most people realize.’ Adds a Silicon Valley lawyer who asked not to be named: ‘I’d be surprised if there was even one public tech company that did not employ this practice in those [bubble] years.” • Randall and Erik Lie, 2005

23. Outlook for ESO • Loopholes still exist • Decreasing trend due to changing accounting requirements • Among the S&P 500 companies, stock option grants dropped 26% in 2005 • Substitutes: Restricted Stocks • In 2005 the S&P 500 companies increased such awards by 44%

24. Recent Trend of ESO – S&P 500 Companies Figure source: http://www.equilar.com/newsletter/september_2006/ect_sept_2006_article2.html

26. Company Overview • Adobe Systems Incorporated offers business and mobile software and services worldwide • It operates in five business segments: Creative Solutions, Knowledge Worker Solutions (KWS), Mobile and Device Solutions (MDS), Enterprise and Developer Solutions (EDS), and Other • Stock Symbol:NASDAQ NM: ADBE • Doesn’t have any debt • Doesn’t pay a dividend

27. How Adobe Grants Stock Options • Based on relative position • Based on responsibilities • Based on performance • Based on anticipated future performance • Grants options at a exercise price equal to that day’s closing price

29. Executive Compensation Summary

32. Past Financial Statements

39. 2006 Financial Statements

43. Stock Options Outstanding

44. Assumptions to Value Options and Employee Stock

46. Company Overview • Worldwide leader in networking for the Internet • Founded in 1984 by a group of computer scientists from Stanford University. • Stock Symbol:NASDAQ NM: CSCO (Common Stock) • IPO:Cisco went public on February 16, 1990 at a split-adjusted price of about 6 cents. • Employees:As of the end of Q2 FY 2007 (January 27, 2007) Cisco has 54,563 employees worldwide.

47. COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURNAMONG CISCO SYSTEMS, INC.,THE S & P INFORMATION TECHNOLOGY INDEXAND THE S & P 500 INDEX

48. Compensation Components • The three material elements of Cisco’s executive officer compensation are: (i) base salary, (ii) variable cash incentive awards and (iii) long-term, equity-based incentive awards.

49. Option Grants in 2006

50. Option Exercises and Holdings