(The ESOARs themselves are not employee stock options: they’re a derivative instrument that provides a payout to investors based on the trading price of the shares on the date employees exercise their options, less the strike price of their options. From the trading price of the ESOARs, a market price for the options themselves can be wheedled. And then used to value the options granted to the employees for 123R purposes.)
It’s an interesting concept. Over the years, much bitter rhetoric has been spewed over the use of option pricing models in calculating option compensation expense: for instance, models are too “theoretical” (as if all theories are somehow inherently wrong or evil), or they don’t take into account the non-portability of employee options. And don’t forget the endless hand-wringing over needed “guidance” for calculating volatility. What Zions Bancorporation is doing here is trying to create a mechanism that brings market pricing to the task - they’re building a market that should bring collected investor wisdom to the task of pricing employee stock options. If you support fair value reporting, it’s a little hard not to like the idea. (Unless you think that the fair values are coming from a rigged market. More on that later.)
If it catches on with other companies, Zions might generate a handy profit on the process as well if it successfully manages others’ ESOAR offerings.
The firm floated an experimental issue of the securities last June, to road-test the methodology. As documented in this submission to the SEC, they fashioned the ESOAR instruments around the blueprint described by the SEC’s chief economist and chief accountant\ when they torpedoed Cisco’s plan for developing instruments that would do the same thing.
And as evidenced by this letter from Chief Accountant Conrad Hewitt, they met their goal: in future option grants with simultaneous ESOAR issuances, they’ll be allowed to use the implied option prices they beat out of the ESOARs to value the options. (That is, assuming they fix the forfeiture aspect of the ESOARs. That was the only technical objection of the chief accountant, and it was a minor one.)
The test issuance done last June yielded option values that amounted to 68% of the value calculated using the Black-Scholes option pricing model. A trading platform snafu at the end of the auction (computer failures that frustrated the bidding process) may have kept the price of the ESOARs and embedded option prices artificially low. Zions puts forth the possibility that the prices might have been 72% of the Black-Scholes value.
Now for the questions.
Was the market fair? By all indications in the summary document, it sounded - fairly fair. The firm seems to have done a good job of making sure that the bidding participants were sufficiently sophisticated, with an adequate net worth cushion. The bidding process was modeled after the treasury market, and it’s actually better (in my view) in that the bidders were able to get “feedback” on others' bids. The bidders could see the others’ prices, unlike the sealed bids of the treasury market.
One concern: employees were allowed to bid in the process, although they were restricted to a small portion of the offering. To keep all appearances of a conflict of interests off the table, however, they should be barred.
Another concern: who were the market participants? Kind of a knotty question, in that bidders for other securities don’t usually have their identities revealed. But what if some of the institutional investors in such an offering are really the firm’s investment bankers trying to help their client manage their compensation expense to a low number? Would that make the market “fair”? Would the option prices embedded in the ESOARs represent “collected wisdom” or “accumulating chits?” There’s no existing disclosure mechanism that I can think of that would force this kind of identity disclosure to be made in the option compensation footnotes. Or anywhere else.
That’s not to imply this happened in the Zions offering; it’s just worth noting that such information would help instill investor confidence that the option value figures aren’t being jerked around.The information about the market is important because if the figures are consistently lower than the Black-Scholes estimated figures, then one might wonder about the way the ESOARs auction was done - and the validity of the implied option values. Or, one might wonder if the Black-Scholes model really has as much explanatory value as investors have attributed to it for the last 34 years.
Now for the riddles.
Riddle 1: If these instruments don’t routinely provide a price that’s less than what the option-pricing models provide, then what’s their unique selling proposition? Why would companies go to the expense of issuing ESOARs? Maybe if ESOARS are going to earn equity classification on the balance sheet, there’s some additional equity financing benefit added to the effort. But it seems like it would only be a sliver of equity, maybe way out of proportion to the effort involved in bringing them to market. Maybe the models are so repugnant to some issuers that they’d prefer anything to using the models.
(Another distinct possibility: maybe there’s a reason I can’t think of yet. Send ‘em in. While it appears that the prime purpose of creating ESOARs is to develop a market-based method for valuing employee stock options, I’d be surprised if there weren’t other value propositions that Zions has in mind.)
Riddle 2: Suppose these instruments become popular because the option price demonstrated by collected market wisdom routinely undercuts the price of the models. (Let’s assume that the markets are fair.) Or they become popular because there enough CFO types who just despise the models.
If the instruments become more popular and draw more investors, might they not use option pricing models to rough out their bids? And if they do, don’t the prices embedded in the options become more and more like what the CFO could calculate on his or her own using Excel?
Riddle 3: If the answer to the questions in Riddle 2 above is “yes,” why would a firm go through the bother of issuing ESOARs?
Financial innovation doesn’t always turn out the way you expect. Remember ““Americus Trust PRIMEs and SCOREs?”?” PRIMEs stood for “prescribed right to income” and represented an income stream based on a pre-determined part of a stock price plus dividends; SCOREs stood for “special claim on residual equity” and represented the gravy over the pre-determined price of the stock used in fabricating the PRIME. Both pieces would be cashed out at the end of specified term. I remember in the mid-1980’s (at five years old, I was terribly advanced) how these instruments were going to revolutionize finance; now they’re dead. Remember USUs: ““unbundled stock units”?”? (NY Times Select: $ needed. Written in 1988 by Floyd Norris in his late teens, as a cub reporter.) They carried the concept one step further, breaking a stock into three pieces: essentially, a bond-alike, a warrant and a preferred stock-alike. None were ever issued; I don’t think they passed SEC muster.
ESOARs seem to have mounted that regulatory hurdle, though each auction will have to “be analyzed to determine whether it results in an appropriate market pricing mechanism.” (That’s a condition in Hewitt’s letter that seems to have been underplayed by the press, by the way. The letter didn’t grant quite the blanket permission that it may seem.)
It remains to be seen whether ESOARs soar - or whether they become the next PRIME, SCORE or USU.