A derivative that allows outside investors to take views on the value of employee stock options is drawing interest from equity derivatives and corporation financing officials following recent approval from the Securities and Exchange Commission. The derivative, called an employee stock option appreciation rights security or ESOARS, aims to mimic stock options granted to employees.
When investors buy ESOARS they are buying exposure to a pool of employees' stock options over a certain time-frame. The payout an ESOAR investor receives is based on the payout employees in the pool receive by redeeming in-the-money stock options. For example, if a company grants stock options to a pool of 100 employees and issues 10 ESOAR contracts linked to this pool, each ESOAR will receive 10% of the pooled gains when employees cash in their options. The gains made in the pool depend on how much higher the company's stock price is compared with the option strike price, and also on the number of options exercised. If employees in the reference pool leave the company and forfeit their stock options, ESOAR investors are reimbursed for their share in those employees' stock options with interest.
One head of equity derivatives structuring in the U.S. said, "When I saw that the SEC approved this, I made a clipping to pass to my staff." He added it is most likely to be of interest to smaller companies that are not yet profitable and where stock options are a larger part of compensation packages.
Originally launched last year by Salt Lake City-based bank Zions Corp. the SEC ruled in late January that companies can now use the price fetched in a public ESOAR auction as the market value used to book compensation expenses. Investors can bid on ESOARS in a bidding process modeled after the treasury market. Previously, corporations had to book their stock options' value using Black-Scholes or other quantitative models.
Larger firms including Morgan Stanley and Rabobank are also looking at ESOARs. "Everyone on the Street is working on this," said one equity derivatives official, who predicted that other companies will turn to issuing ESOARs either this quarter of next.
The auctioning off of ESOARS may provide lower values, which would be advantageous to corporations as it would lower their perceived liability for balance sheet reporting purposes. Zions ran a test issue last June of ESOARs, involving 57 investors, and yielded option values that amounted to 68% of the value calculated for Zion's employees' options using the Black-Scholes model. Zions now has plans to run similar auctions and market ESOARS for other companies and investors, according to an official at the firm.
Michael Littenberg, a partner in the corporation finance department at law firm Schulte Roth & Zabel in New York, explained that ESOARS are a niche product given the additional factors involved in analyzing employee compensation packages in addition to the bet that a company's stock will go up. He added that since the SEC approved the method at the end of January he has been fielding calls from clients interested in how it works.
Secondary Market?
Large investment banks have made initial steps into this area. Last week, Google submitted filings about an initial test of a transferable stock option program led by Morgan Stanley. That program gives employees with vested stock options the ability to sell the options in an online auction to financial institutions.
