Tuesday, 16 October 2012

Warrants and Employee stock options

STOCK OPTION  WARRANTS

          A warrant is a right given to the holder to buy shares in a company at a fixed price mentioned in the warrant, until tehdate of expiry, irrespective of the market price. The price, the holder has to pay, is generally lower than the expected market price during conversion. The company issues fresh shares in leu of the submitted warrants as described later.

         A warrant can be attached to a bond, which can be detached and traded in the market, or can be issued without being attached to any securities.

         A warrant always has a market value, which is derived from the following parameters

1. Price, the holder has to pay to convert the warrants into fresh shares from the company.

2. The profit of the warrant holder, if he chooses to submit the warrants. This is the difference between the price the holder has to pay, and the current market price of the shares.

3. The time remaining for the warrants to expire.

         Various models are used to value the warrants from the above parameters.

DETACHABLE WARRANT ISSUED ALONG WITH A BOND

Consider a 100 bonds issued at 100 par, with a warrant for buying a share at 110 of 100 par stock for a total of $10000. At the time of sale, the bonds sell for 102and the warrants have a market value of $30.

Here the total consideration of $10000 for the bond means that it also has a discount attached to it as the interest rate for such bonds are much lower when compared with bonds issued without warrants.

In order to value that discount, we proportion the total consideration in the ratio of the market values of bonds and warrants. As we know both values, we use the proportional method. Or else, incremental method can be used.

According to the proportional method, the price apportioned for the bond is 7727 and for the warrant is 2273.

This proportion of the warrants is used as the discount on the bond issue. This is because, the discount account is used to compensate for the lower interest rate. And the lower interest rate is accepted by the buyers, because of the profit expectation from warrant conversion, which is exactly equal to the market value proportion of the warrant.

 The journal entries are

cash                                                     7727
discount                                               2273
bonds payable                                                                 10000

cash                                                     2273
paid in capital- stock warrants                                           2273

on conversion

cash                                                    11000
paid in capital-stock warrants               2273
common stock                                                                  10000
paid in capital in excess of par                                            3273
  
when retired

paid in capital - stock warrants             2273
paid in capital- expired stock warrants                                2273

from the entries we can find that the common stock is created at 132.73 a share including the additional paid in capital.

If the market value of the shares is close to the value of fresh shares (132.73 in the above situation) issued in leu of the warrants, then the warrants and the bond are priced exactly as required on the market ie, the bond holder, will get the exact discount (as a profit in the warrant conversion) as required by the prevailing market interest rates.


If the market value of the shares is much more, then the bond holder makes a profit equal to the difference between the value of fresh shares created with the additional paid in capital and the market value of the shares. 



The losers are the existing shareholders as the earnings has to be spread over a greater number of shares. But if the market value of the shares is the same as the value of fresh shares created with the additional paid in capital, then the price paid on the conversion, along with the discount paid at the time of the bond purchase ($13273 in the above case)  creates a capital which will soon restore the earnings to a value which will compensate the dilution, when warrants are converted.

STAND ALONE WARRANTS

 Stand alone warrants are rights to buy share of a company at a pre designated price until the date of expiry , irrespective of the market price. They are not attached to any debt or equity instruments.

Consider the following example

100 warrants are issued with a right to buy 100 shares, 100 par at a designated price of 110. The market value of the warrants is $30 per warrant.

No journal entries are made to record the warrants, unlike in the previous case of those attached with bonds. This is because, no cash is given or apportioned (as in the previous case) for the market value of the warrants.

When converted

cash                                                   11000
common stock                                                            10000
paid in capital in excess of par                                      1000

Thus we see that the fresh shares issued against the warrants have a value of only 110 per share, no additional paid in capital is formed which incorporates the apportioned market value of the warrants, unlike in the previous case.

This means that even if the market value of the shares is the sum of   the amount given at conversion and the market value of the warrant ie per share $140 ( $110 +$30), the warrant holder makes a neat profit of $30 per warrant.

The losers are the then existing shareholders,who loses due to dilution in the EPS. There is no additional cash given for the market value of the warrant as apportioned as discount in the previous case of warrants attached with bonds. Therefore there is no additional capital to overcome the deficit in the EPS  as argued in the previous case.

One method to record the lost value to the existing share holders is by expensing the market value of the warrant, similar to the treatment of Employee stock options as given below.

Warrant expense                             3000
Paid in capital-stock warrants                                   3000

But since this expense is not spread between the service years as the ESOPs, this expense becomes too large to be absorbed in the net income of a single year.

WARRANTS WITH STOCK OFFERINGS

Warrants are issued with IPOS or FPOS or Private placements or offered to existing share holders . Here also, like the warrants issued with debt securities, they are apportioned a value proportional to their market value. Consider the following.

An IPO, FPO or Private Placement of 1000 shares 100 par, is offered at an issue price of 160, and a warrant per share, convertable to a share apiece, at $165. The market price of the warrant is $10 and market price of the share is $175, then

The total consideration of $160000 is divided in the ratio of 175:10, and $151351 is apportioned to stock and $8649 is apportioned to the warrants,

Cash                                                    151351
common stock                                                                         100000
paid in capital in excess of par                                              51351

cash                                                    8649
paid in capital-stock warrants                                                8649

when the warrants are converted,

cash                                                    165000
paid in capital-stock warrants         8649
common stock                                                                         100000
paid in capital in excess of par                                              73649

suppose the common stock outstanding is $100000, with additional paid in capital of $60000, additional warrants are issued, a warrant per a share outstanding, the market values shares and warrant prevailing is $175 and $10,

Then the total common stock equity (including the additional paid in capital) $160000 is divided in the ratio of the market values, ie, 175:10 apportioning  $151351 to shares and $8649 to the warrants. The entry is

paid in capital in excess of par      8649
paid in capital-stock warrants                                              8649



EMPLOYEE STOCK OPTIONS

Employee stock options are similar to stand alone stock option warrants, except they are given to employees  as compensation.

The difference is, the value of the ESOPS is recorded as an expense, instead of just mentioning in a memorandum.

The total value of the ESOP which is valued during the measurement date, is split and spread evenly between the service period. The measurement date is the date when the options are valued ie how much the value of the option is which has to be expensed, and at what price the employee can purchase the stock. It is also the date at which how much shares the employee is entitled to recieve is determined. THe service period starts from the date of grant to the date from which the employee can start exercising the options. There is also an expiry date when the options lapse.

Consider the following example

Options are granted to purchase 1000 shares of 10 par  @ $45 and the market price on grant date is $50. So the value of the options at the grant date is (50-45)*1000=$5000. If the service period is 5 yrs, then it is spread evenly across 5 yrs..
   The journal entry for each year is

    Compensation expense            1000
    Paid in capital- ESOP                                 1000

When excercised

    cash                                         45000
    paid in capital-ESOP                5000
    common stock                                            10000
    paid in capital in excess of par                     40000


Now if the market price when the options are exercised, if the market price is $50 itself, then the loss for the existing share holders is $5000, which is recognized evenly. But if the market price is  and can be a lot higher, say $120, then the loss is ($120-$50)*1000+$5000= $120000. This is because, $50 is the value of the fresh shares issued including the additional paid in capital, and also $5000, the value of the options, is not paid by the employee, but is expensed.

The basic assumption for accepting this loss is that the employees will work hard to increase the value of the company so that the market price of the stock is increased consequently

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