Once reserved only for top management, stock options can now be found in compensation packages for employees at all levels. High technology companies with limited cash and elusive earnings were the first to expand options programs beyond the executive suite, as a way to supplement modest salaries to attract and retain sought after talent.
Stock options grant employees the right to purchase a given amount of company stock at a given price,the strike, or exercise, price,for a given period of time. As stock options do not require the company to make a cash outlay when granted, companies can attract new talent and motivate existing employees without depleting the firmrm’s cash. Options allow employees to share in the company’s future growth potential, which has been substantial at many technology firms as stock prices soared to new heights.
Today, companies ranging from the Fortune 500 to start-up Internet companies offer options to an estimated seven to 10 million employees. According to a ShareData Solutions survey, the percentage of companies with 5,000 or more employees granting options to all employees rose from 10 to 45 percent in the past three years. Almost three-quarters of companies with less than $50 million in sales offer options to all employees. The National Center for Employee Ownership reports that employees typically own between 5 and 15 percent of public companies, and 20 to 40 percent of privately-held firms. Biotechnology and computer programming companies allocate the most shares to nonmanagers.
A key issue for private companies is setting an appropriate strike price when they issue stock options. The strike price should be equal to the fair market value of the underlying stock at the time each series of options is issued. A strike price that is lower than the market price creates value for the employee that must be recorded on financial statements as additional compensation expense, reducing earnings. For a public company, per-share values are published in a number of places; however, such is not the case for private companies.
One of the more popular forums for private company valuation, in connection with stock options, is the initial public offering process. Because the SEC scrutinizes a company’s pre-IPO financial statements, companies should not rely on intuitive, “rule of thumb’ equity valuations. If the SEC believes there is too great a disparity between prior stock option strike prices and the equity valuation at the time of issuance, it will likely require the company to restate its financial statements to account for the additional compensation.
To reduce the likelihood of restatement, and the resultant headaches such can cause management and employees, companies should take a proactive approach to valuation. Build a strong, fact-based value estimate before issuing options, taking into account known significant events at the time of options issue, such as recent financial and operating performance, peer group analysis, and the price of recent preferred stock issues.
Simply put, the valuation process consists of transforming financial qualitative data and other quantitative data into a value for a company or its ownership interests. The more accurate and timely the data, the more supportable the appraisal result. Typical data to be considered includes financial statements; articles of incorporation and corporate bylaws; current budgets and longer-term projections; option agreements/other shareholder agreements; and informational publications, marketing brochures, etc., profiling the company and its services and/or products.
Keep in mind that valuation metrics have changed considerably in the last few years for tech and dot com companies. Earnings multiples won’t work unless the company is generating a profit. For many tech and dot com companies which are presently unprofitable, revenue multiples can be a relevant parameter.
In valuing a company, it is important to reflect the company’s value proposition. What would one tell potential investors in order to have them fund the company? Why should investors buy the company’s stock? The response should be a crisp, concise explanation of a company’s unique market opportunity and how it will exploit that advantage. Companies can even go so far as to prepare an executive summary of the business opportunity that describes their industry, the markets for their product or service, and why their company is better positioned than competitors to solve the problem or capitalize on the opportunity. This summary should be given to a valuation professional. Taking the time to craft this document provides a head start on preparing a well-reasoned and thorough valuation analysis.
Companies may prefer to hire an independent valuation professional to perform the analysis. In addition to providing the consultant with the data mentioned above, company officials should give as much information as possible about their marketplace. It is also best that such a professional be brought in right from the start. Often companies wait until they are close to an IPO date before hiring a valuation consultant to retroactively value their stock. This could raise questions with the SEC as to the validity and or supportability of these retrospective valuations.
Valuing a company is not a science. Careful attention to planning ahead and gathering accurate and timely data will greatly enhance the quality of the valuation analysis.
Steve Wagner, a principal with Deloitte & Touche, and John Taylor, a senior manager, work closely with technology and dot com companies, as well as other firms.
