Saturday, July 8, 2006

A Primer on "Spring-Loading" and "Back-Dating" Options

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The last few weeks have seen a large number of stories of companies who have "back dated" executive stock options. For those of you who've been living in a cave (or simply weren't all that familiar with options), an executive stock option give the executive the right to purchase (i.e. "call") the underlying stock at a fixed price (referred to as the the "exercise" or "strike" price) at some predetermined point in the future. The exercise price is typically set at or near the stock price at the time the option is issued or granted.

Thanks to research by Eric Lie (the link brings you to one of his web pages where he explains the issues), we now suspect that many firms have been "backdating", or playing around with the timing of their options. In backdating, the company issues options and set their grant date prior to the actual issue date so that it falls on the date where the company's stock was at the lowest point in some recent interval. To see why this is important, consider the following scenario:
  • Acme Corp issues options to it's CEO, Willy Kiyohtay today when the stock price is $50 per share.
  • However, during the last month, Acme's stock has dropped as low as $44 per share (on June 21).
  • So, Acme "back-dates" the options to 6/21 (i.e. it makes the date of the option grant 6/21 instead of 7/7).
  • As a result, the options now have an exercise price of $44 (the price on the date they were supposedly "issued") instead of the $50 exercise price they would have had if Acme had played it straight up.
  • So, instead of Willy K having a contract that gives him the ability to purchase shares at $50, he has now has the right to purchase shares at $44.
This doesn't mean that the options are worth $6 more if issued at an exercise price of $44 than they would be if issued at an exercise price of $50. This is because executive stock options typically aren't exercisable for some time (anywhere between 1 and 5 years). In order for the options to be profitable, the stock price would have to be higher than the exercise price after the vesting period. But, the back dating means that 1) there's a greater chance that the option will be "in the money" (i.e. the stock price will exceed the exercise price), and 2) The profit (the difference between the stock price and the exercise price) will be greater in all cases where the option is in the money.

O.K. that covers back-dating. Now, let's move on to the concept of "spring-loading". Think of springloading as the "forward looking" close cousin of back-dating. In back-dating, the grant date (and therefore, the exercise price) is manipulated based on price patterns in the stock in the recent past. In contrast, spring-loading is a "forward-looking" strategy. In spring-loading, a company times its option grants so that they occur just before a "good-news" announcement that they know about but others don't. So, a spring-loaded option would end up with an exercise price that reflects the stock price before the announcement, and will end up immediately "in the money" following the stock price increase from the announcement.

Here's an example: assume that the company's stock is currently $50 per share. However, the company executives know that the company has just gotten FDA approval for a new drug that will reverse pattern baldness, cure erecticle dysfunction, make you lose 20 pounds, and refinance your mortgage all in one fell swoop (the company researchers had been internet spammers in a previous life). So, the executives issue stock options in the period sometime before the announcement of the approval is made. Since options granted have an exercise price that's equal to the stock price at the time of issue, the options will therefore have an exercise price of $50. But, once the announcement is made, the stock price might move to $55 or $60 or (based on the market for cures of hair loss, "performance issues", and low-interest mortgages), even higher. If the stock price went to $60, for example, the options would be in the money to the tune of $10.

So, while the concept (and the end result is similar), back-dating creates an in-the-money option by looking backward to manipulate the exercise price, and spring loading does it by looking forward and taking advantage of positive information that hasn't yet been revealed to the general public. Of course, an option could be both spring-loaded and back dated. In the example above, the company both spring-load and back date the options by issuing the options before the approval announcement while setting the grant date to some point in the recent past.

For a good piece in today's Wall Street Journal article on spring-loading, click here (note online subscription required), and for some general information on options, click here.

Isn't finance fun?

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