Fully Diluted Shares: Treasury Stock Method
From M&I Equity vs Enterprise Value Question 6: "Let's say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $5 each - what is its fully diluted equity value?
The answer basically says that we take $1000 from the current basic shares. But then it says that when the options are executed, 10 additional shares go to the company so that it has 110 shares outstanding. This confuses me, as I thought that if the company is exercising the options, the company is essentially buying its 10 options at a lower price (giving shareholders $50, which are subsequently reinvested). But then wouldn't that reduce "shares outstanding" by 10 since "shares outstanding" refers to what shareholders, not the company, has of shares? Or are we assuming that these shares outstanding are treasury stock? Thank you in advance.
The key mistake you're making is thinking that that the options are being exercised by the company. This is not the case; they're owned and being exercised by employees. A company itself doesn't hold its own options and exercise them. When the options are exercised, the 10 additional shares aren't going to the company; they're going to the employees who exercised them. The company receives $50 from that event and uses that $50 to buy back as many shares as it can, which is 5 in this case. That's why the final diluted share count is 105 (100+10-5)
You say that the company would receive 50 dollars, which means that the shareholders must be buying options. This makes sense: the shareholders would want to buy options when cheaper than market price/“in the money” I think was the terminology I found on the web.
So is this the process: the investors buy 10 options, so there are 110 shares outstanding, then the company buys back 5 shares of stock from the shareholders using its newfound cash for 105 outstanding). (Whereupon I am admittedly confused why the company just decides to buy back shares). Thanks for the patience.
Buying options is not the same thing as exercising options, and it's not the only way to get options. You're confusing options activity in the market with stock-based compensation. There need not be investors directly involved here. It's all about employees.
When employees receive stock-based compensation in the form of options, they aren't buying it. (When we talk about options in the context of share dilution, we're only talking about call options) A call option is just an agreement between a buyer (employee in this case, who doesn't actually spend money to buy the option) and the seller (the company, who isn't actually selling anything but is instead using the option as a means of compensation for labor): up until a certain expiration date set by the seller, the buyer can purchase a share of the company at $X price. $X is the exercise price, or strike price. If the company's shares are worth over $X in the market, the employee can exercise the option to buy a share at $X price and make an instant profit that is equal to the difference between $X and the current market price of the company.
So this is the process that is required by GAAP for companies to calculate fully diluted share count for calculating diluted EPS
Thanks for that explanation! You've got a talent for it!
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