Abstract
Barth, Hodder, and Stubben examine how the risk and expected return of existing shares varies as a function of the amount of outstanding employee stock options (ESOs), finding that the association is a negative one, consistent with ESOs being equity-like in character. They suggest that their approach could be used to address the question of how best to characterize other complex financial claims. The study is well executed and provides a thought-provoking contribution to the debate. However, it is far from obvious that the “debt or equity” question can be solved in this manner. Their approach effectively defines a liability as a financial claim that has characteristics akin to fixed-rate debt. I provide examples of the limitations of this perspective, starting by comparing ESOs that are settled with shares with those settled in cash. Whether a claim is treated as a liability or equity is of little consequence if it is simply a matter of balance sheet presentation. The real question is the implications for income measurement. I suggest progress might best be made if we start with Penman’s proposal that assets and liabilities be separated into operating and financial items, an approach which would include many claims that have equity-like characteristics, such as unvested ESOs, within the operating liability category. Once a claim ceases to be an operating item—e.g. when an ESO vests—the approach suggested in the paper can then be used to determine how it should be classified.
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Notes
This assumes we can unambiguously determine what is a duck (basic equity). The problem becomes much more complex in some other types of businesses that lack the kind of basic equity claim that exists in corporate entities—for example, those that are organized as cooperatives (López-Espinosa et al. 2012).
The value of fixed claims can, of course, vary with the firm’s fortunes: if the firm fares badly, then the possibility of default on those claims increases accordingly.
The assumption that both ESO holders and SAR holders will receive cash at t = 1 is made merely for analytical convenience. In the case of a continuing enterprise, ESO shareholders will have to wait (possibly a long time) for their investment to be returned as dividends, but the value of the shares they receive must rationally be a function of those expected dividends. Eventually, cash flows out of the firm to ESO and SAR holders alike; from a valuation perspective, the difference is simply one of timing.
It can be readily shown that the no-arbitrage fair value of the ESO can be written as \( nh^{eso} \left( {S_{0} - S_{1}^{b} /(1 + r)} \right) \) and that of the SAR as \( nh^{sar} \left( {S_{0} - S_{1}^{b} /(1 + r)} \right) \), where r is the risk-free rate of interest, the two values differing only by their hedge ratios, h eso and h sar: \( h^{eso} = \frac{{ESO_{1}^{g} }}{{S(eso)_{1}^{g} - S_{1}^{b} }}\quad {\text{and}}\quad h^{sar}\,=\,\frac{{SAR_{1}^{g} }}{{S(sar)_{1}^{g} - S_{1}^{b} }} \). For example, suppose the firm has 24 shares outstanding and has granted an ESO for one additional share with an exercise price equal to the current price of $5. Further suppose that A g1 = $150, \( A_{1}^{b} = \$ 50 \), and r = 5 %. The ESO will have a fair value of $0.88. On the other hand, if the firm had granted a SAR on the same terms, its fair value would be $0.77, i.e., 12.5 % less. The ESO grant involves a nontrivial 25 % dilution of the existing shareholders’ interests. The gap between the ESO and SAR values will be less if a smaller dilution occurs.
There is one other distinction that should be mentioned: the fact that a SAR is a cash-settled option means that the holder has the right to redeem their claim whereas the ESO holder doesn’t. A rationale that is used to justify classifying irredeemable preference shares as equity is that, unlike debt, the holders only have a residual claim. This right of redemption question plays no part in the REO approach.
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Peasnell, K. Discussion of “Financial reporting for employee stock options: liabilities or equity”. Rev Account Stud 18, 683–691 (2013). https://doi.org/10.1007/s11142-013-9236-9
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DOI: https://doi.org/10.1007/s11142-013-9236-9