Two Last Things On Assumption of Stock Options

In our previous post – which started to get long and unwieldy (ah – the need for an editor – where are those guys when you need them) – we didn’t cover two critical issues: (1) What happens if the acquisition is in cash vs. public stock vs. private stock, and (2) Who pays for the “basis” of the stock options?

The form of consideration of the acquisition can be a many spendored thing. We’re going to ignore tax considerations for this post (although you shouldn’t – we just don’t want this to be 12 pages long.) If I’m an employee of a seller, I’m going to value cash differently than public stock (restricted or unrestricted?) differently than public stock options differently than private stock (or options). If the buyer is public or is paying cash, the calculation is pretty straightforward and can be easily explained to the employee. If the buyer is private, this becomes much more challenging and is something that management and the representatives of the seller who are structuring the transaction should think through carefully.

The “basis” of the stock options (also known as the “strike price” or “barter element”) reduces the value of the stock option. Specifically, if the value of a share of stock in a transaction is \$1 and the basis of the stock option is \$0.40, the actual value of the stock option at the time of the transaction is \$0.60. For some bizarre reason, many sellers forget to try to recapture the value of the barter element in the purchase price and allow the total purchase price to be the gross value of the stock options (vested and unvested) rather than getting incremental credit on the purchase price for the barter element.

Yeah – a little confusing, but lets assume you’ve got a \$100 million cash transaction with \$10m going to option holders, 50% of which are vested and 50% are unvested. Assume – for simplicity – that the buyer is assuming unvested options but including them in the total purchase price (the \$100m) and that the total barter element of the vested stock is \$1m and the barter element of the unvested stock is \$3m. The vested stock has a value of \$4m (\$5m value – \$1m barter element) and the unvested stock has a value of \$2m (\$5m value – \$3m barter element). So – the option holders are only going to net \$6m total. Often the seller will catch the vested stock amount (e.g. vested options will account for \$4m of the \$100m) but the full \$5m will be allocated to the unvested options (instead of the actual value / cost to the buyer of \$2m). This is a material difference (e.g. the difference between \$91m going to the non-option holders versus \$94m).

Of course, all of this assumes that the stock options are in the money. If the purchase price of the transaction puts the options out of the money (e.g. the purchase price is below the liquidation preference) all of this is irrelevant since the options are worthless.

• Dave Jilk

This might be clarified for some by pointing out that in a typical company sale, the “price” is often agreed to before any of these details are worked out. Consequently, the seller has to reduce the net consideration to shareholders (and vested optionholders). Another option would be to say that the price is the price and the buyer ALSO has to assume the options, but apparently it isn’t typically negotiated that way. So when you say “recapture” the value of the barter, you’re assuming a particular process that the negotiation typically follows.

• Steve

Anyone have any idea why a company would want to issue options to the market at a strike price which effectively puts them immediately 'in the money' to the tune of 20-25%? [i.e. if you were to convert to shares today, you would pay 20-25% less than if you bought an actual ordinary share in the market].
What's the advantage to existing shareholders?
Pros and cons anyone?
Thanks.

• In a private company, if there is preferred stock that is owned by investors, there is an opportunity (and a goal) by the company to price the common stock lower than the preferred stock (since the preferred stock has rights that the common stock doesn't have.) As a result, the options (which are almost always for common stock) get priced lower than the preferred stock. The amount of the discount varies widely by the stage / state of the company.

• Steve

Sorry, I don't understand the rapport. My question relates only to ordinary shares and options thereon; nothing to do with preference shares/preferred stock.
New options are being issued/offered to the market at a huge discount to common stock price on the market. My concern is this will cause ordinary share price to drop [by size of discount], hence I am wondering what is benefit to holder of a full ordinary share. Why would company seek to benefit OPTIONholders at expense of ordinary shareholders? Or am I missing something?

• If there are no preferred shares, then I have no idea why the options would be priced at a discount to the share price.

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