The "True" Cost Of Stock Options.
How do you value employee stock options (ESO)? This is possibly the central issue in the debate about whether these options should be expensed or whether this method of compensation can be left out all together from the income statement but noted in the notes of the financial statements. According to basic GAAP accounting rules, if a value can be placed on employee stock options, they should be expensed at the fair market value.
Proponents of expensing employee stock options say there are many models that can be used to accurately place a value on options. These options are a form of compensation that should be properly accounted for, like wages. Opponents argue these models are not applicable to employee stock options or that the corresponding expenses associated with this form of compensation are zero. This article will take a look at the argument of the opponents and then explore the possibility of a different approach to determining the cost of employee stock options.
Several models have been developed to value options that are traded on the exchanges, such as puts and calls, the latter of which is granted to employees. The models use assumptions and market data to estimate the value of the option at any point in time. Perhaps the most widely known is the Black-Scholes Model, which is the one most companies use when they discuss employee options in the footnotes to their SEC filings. Although other models such as binomial valuation were once permitted, current accounting rules require the aforementioned model. (Learn more in Get The Most Out Of Employee Stock Options .)
There are two main drawbacks to using these types of valuation models:
Assumptions - Like any model, the output (or value) is only as good as the data/assumptions that are used. If the assumptions are faulty, you will get faulty valuations regardless of how good the model is. The key assumptions in valuing employee stock options are the stable risk-free rate, stock volatility follows a normal distribution, consistent dividends (if any) and set life of the option. These are hard things to estimate because of the many underlying variables involved, especially regarding the assumption of normal return distributions. More importantly, they can be manipulated: by adjusting any one or a combination of these assumptions, management can lower the value of the stock options and thus minimize the options' adverse impact on earnings. Applicability - Another argument against using an option-pricing model for employee stock options is that the models were not created to value these types of options. The Black-Scholes model was created for valuing exchange-traded options on financial instruments (such as stocks and bonds) and commodities. The data used in these options are based on the expected future price of the underlying asset (a stock or commodity) that is to be set in the marketplace by buyers and sellers. Employee stock options, however, cannot be traded on any exchange, and option-pricing models were created because the ability to trade an option is valuable.
An Alternative Viewpoint.
Companies use stock buyback programs to reduce and therefore manage the number of shares outstanding: a reduction in shares outstanding increases earnings per share. Generally, companies say they implement buybacks when they feel their stock is undervalued.
Most companies that have large employee stock option programs have stock buyback programs so that, as employees exercise their options, the number of shares outstanding remains relatively constant, or undiluted. If you assume that the main reason for a buyback program is to avoid earnings dilution, the cost of the buyback is a cost of having an employee stock option program, which must be expensed on the income statement.
If a company does not have a stock buyback program, then earnings will be reduced by both the cost of the options issued and dilution. Even if we take buybacks out of the equation, options are a form of compensation that has a certain value. As a result they must be addressed in a similar fashion to regular salaries.
Stock options are used in lieu of cash wages, period. As such, they should be expensed in the period they are awarded. The cost of a stock repurchase program can be used as a way to value those options because in most cases management uses a repurchase program to prevent EPS from declining.
Even if a company does not have a share repurchase program, you can use the average annual share price times the number of shares underlying the options (net of shares expected to be un-exercised or expired) to derive an annual cost.

Fully Diluted Shares.
What are 'Fully Diluted Shares'
Fully diluted shares are the total number of shares that would be outstanding if all possible sources of conversion, such as convertible bonds and stock options, are exercised. This number of shares is important for a company’s earnings per share (EPS) calculation, because using fully diluted shares increases the number of shares used in the EPS calculation and reduces the dollars earned per share of common stock.
BREAKING DOWN 'Fully Diluted Shares'
How Earnings Per Share Is Calculated.
EPS is defined as (net income – preferred dividends) / (weighted average common shares outstanding). Any earnings paid to preferred shareholders as a cash dividend are subtracted from net income, because the ratio applies only to common shareholders. Weighted average common shares is the (beginning period balance + ending period balance) / 2. If a business can generate more earnings per common share, the company is considered to be more valuable and the share price may increase.
Assume, for example, that ABC Corporation generates $10 million in net income and pays all preferred shareholders a total of $2 million in dividends, so that the net income available to all common shareholders is $8 million. If the firm’s weighted average common shares outstanding total 1 million, the EPS is $8 per share. The $8 EPS is considered basic EPS, because the total is not adjusted for dilution.
Factoring in Fully Diluted Shares.
Full dilution means that every security that can be converted into common shares is converted, which means that there are fewer earnings available per share of common stock. Since EPS is a key measure of a company’s value, it’s important for an investor to review EPS. Several types of securities are converted into common stock, including a convertible bond, convertible preferred stock, stock options, rights and warrants.
As an example, assume that ABC issues 100,000 shares in stock options to company executives to reward them for reaching a profit goal. The firm also has a convertible bond outstanding that allows the bondholders to convert into a total of 200,000 shares of common stock, and ABC has convertible preferred stock outstanding, and those shares can be converted into 200,000 shares of common stock. Full dilution assumes that all of the 500,000 in additional common stock shares are issued, which increases the common shares outstanding to 1.5 million. Using the same $8 million in earnings to common shareholders, fully diluted EPS is ($8 million / 1.5 million shares), or $5.33 per share, which is lower than the basic EPS of $8 per share.

Do stock options diluted shares

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If a startup can always issue new shares, what value is there to stocks/options?
Since in most startups the board can issue more shares at will, what does it mean for an employee to own X% of the shares? When signing up, can an employee protect himself from the company printing more shares after he leaves the company in a few years?
Edit - A company can just give every share holder more shares, except for person X, whom they wish to dilute (without any investment going into the company). Is this situation possible/legal?
The short answer, probably not much. Unless you have a controlling interest in the company. If at least 50%+1 of the shareholder votes are in favor of the dilution then it can be done. There are some SEC rules that should protect against corporate looting and theft like what the Severin side is trying to make it appear as happened. However it would appear that Severin did something stupid. He signed away all of his voting right to someone who would use them to make his rights basically worthless. Had he kept his head in the game he could probably have saved himself. But he didn't.
If your average startup started issuing lots of stock and devaluing existing shares significantly then I would expect it would be harder to find investors willing to watch as their investment dwindled. But if you are issuing a limited amount stock to get leverage to grow bigger then it is worth it. In the bubble there were quite a few companies that just issued stock to buy other companies. Eventually most of these companies got delisted because they diluted them selves to much when they were overvalued.
Any company not just a startup can dilute its shares. Many if not most major companies issue stock to raise capital. This capital is then generally used to build the business further and increase the value of all shares. Most of the time this dilution is very minor (<.1%) and has little if any impact on the stock. There are rules that have to be followed as listed companies are regulated by the SEC. There are less regulations with private corporations. It looks like the dilution was combined with the buyout of the Florida company which probably contributed to the legality of the dilution.
With options they are generally issued at a set price. This may be higher or lower than the reported sell price of the stock when the option is issued. The idea is over time the stock will increase in value so that those people who hold on to their options can buy the stock for the price listed on the option. I worked at an ISP start up in the 90's that made it pretty well. I left before the options were issued but I had friends still there that were issued an option at $16 a share the value of the stock at the time of the issue of the option was about 12. Well the company diluted the shares and used them to acquire more ISP's unfortunately this was about the time that DSL And cable internet took off so the dial up market tanked. The value eventually fell to .10 they did a reverse split and when they did the called in all options. The options did not have a positive cash value at any time. Had RMI ever made it big then the options could have been worth millions. There are some people from MS and Yahoo that were in early that made millions off of their options. This became a popular way for startups to attract great talent paying peanuts. They invested their time in the business hoping to strike gold. A lot of IT people got burned so this is less popular among top talent as the primary compensation anymore.
Companies normally do not give you X% of shares, but in effect give you a fixed "N" number of shares. The "N" may translate initially to X%, but this can go down.
If say we began with 100 shares, A holding 50 shares and B holding 50 shares. As the startup grows, there is need for more money. Create 50 more shares and sell it at an arranged price to investor C. Now the percentage of each investor is 33.33%. The money that comes in will go to the company and not to A & B.
From here on, A & C together can decide to slowly cut out B by, for example:
Issuing more & more shares to A as bonus for his contribution over the years. "A" bringing in more personal money from outside and getting more shares at discounted price. Further dilution by issuing more shares to entity D and the money going into the company. All partners asked to bring in more money for new shares, and "B" not able to put in additional funds. "B" cashing out partly in the early days for smaller sum of money.
After any of the above the % of shares held by B would definitely go down.
It's called "dilution". Usually it is done to attract more investors, and yes - the existing share holders will get diluted and their share of ownership shrinks.
As a shareholder you can affect the board decisions (depends on your stake of ownership), but usually you'll want to attract more investors to keep the company running, so not much you can do to avoid it.
The initial investors/employees in a startup company are almost always diluted out. Look at what happened to Steve Jobs at Apple, as an example.

What Is the Formula for Calculating Diluted Earnings Per Share?
Calculating diluted earnings per share is a way to account for all shares a company might issue.
Earnings per share (EPS) is a common financial metric used to express the profitability of a company. However, to account for all of a company's obligations that could result in the issuance of additional shares, diluted earnings per share can be a much better metric to use.
Your broker can help you determine the EPS on your investments -- but if you don't have one yet, head on over to our Broker Center, and we'll help you get started. For now, here's what diluted EPS is and how to calculate it.
What is Diluted EPS?
Note: For accuracy, it is best to use a weighted average of the company's outstanding shares for the period.
However, this doesn't paint a completely accurate picture of the company's financial condition. Many companies have other existing obligations that could result in additional shares being issued. For example, if a company issues stock options to its employees or has any outstanding bonds that could be converted into common stock, then it could result in the issuance of more shares -- and the dilution of existing shareholders.
For this reason, it can be more useful to express financial metrics such as EPS using the "fully diluted" share count -- that is, the number of shares that would exist if all of these obligations were met. To calculate diluted EPS, we modify the share count in the EPS formula to account for the extra shares.
How to determine the effect of options.
First, multiply the number of issued stock options by the exercise price. This tells you how much would be paid in order to exercise the options.
Next, divide that result by the current market price of the stock to determine how many shares could be purchased for the exercise price of the options.
Finally, subtract this figure from the number of options outstanding to determine the excess shares that would need to be issued to meet these obligations.
This is the number you add to the outstanding share count to determine the number of shares that could exist if the options were exercised.
And then diluted EPS can be calculated using this result:
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