ESOARS Eeyore

There is an interesting article in today’s Merc about a new financial instrument called ESOARS (Employee Stock Option Appreciation Rights Securities). They are derivative financial instruments based on employee stock options (ISOs).

From Seeking Alpha:

Theyâ??re essentially asset-backed securities that represent hoped-for cash payments from the exercise of employee stock options. That makes them all or nothing kind of securities: no exercise of options, no cash to be passed through to the security holders. So, the pricing of these things will be an exercise in option modeling. And they wonâ??t be traded in any secondary market after the offering, so the offering will be a pretty critical measure of the value of the securities.

The problem with ISOs is that companies now have to take a charge for their Fair Market Value (FMV), but there are no good ways to determine what that actually is. Even for publicly traded companies with liquid options markets, ISOs are extremely difficult to value, which is why there was such an uproar over being required to expense them.

When I first read the article, I thought that these instruments were going to be packages of ISOs from a range of companies that would like to establish a market for their ISOs to better estimate FMV. However, after looking at the prospectus, it turns out that this offering is for ISOs on Zion Bank.

We are offering [98,770] units of our Zions Bancorporation Employee Stock Option Appreciation Rights Securities, Series 2007 (the â??ESOARSâ?¢,â? and each unit thereof, an â??ESOARSâ?¢ Unitâ?). ESOARSâ?¢ are securities that entitle holders to receive specified payments from us upon the exercise, if any, from time to time of stock options comprising a reference pool of stock options that we have granted to our employees.

There’s more here.

I hope this goes well for them because it would be a good way to really determine FMV for ISOs, but I am not optimistic. The information asymmetry that exists is going to severely discount the price for ESOARS. That’s great for the company that issues them because they can take a smaller charge against their earnings.

But unless you’re a large cap company, like Zion or Cisco, Google, Microsoft, etc. offering this kind of instrument could be prohibitively expensive which leaves the smaller companies with the Black-Sholes pricing alternative, which is generally believed to overstate FMV. So, the big companies would have a way to reduce their option expense, while the smaller guy has take the bigger expense.

I’m not an Eeyore, but something doesn’t seem right about that.


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