Option Pool Question
Hi guys, I'm trying to get some clarity on how management option pools work. Take the following example:
Assumptions:
Equity Value at close of $100 Year 5 Equity Value of $200 A $20 dividend recap in year 3. A 5% Management Option Pool.
My Method
Upon exit, the company's cash inflow from management would be $4.21, calculated as 5.26% ((5%/(1-5%)) x $80 ($100 - $20))
This would leave the company with a a post-exercise Equity Value of $204.21 ($200 + $4.21). This $204.21 would be distributed 95% to the sponsor, giving him exit equity proceeds of $194. After adding in the $20 dividend, the sponsor has total proceeds of $214.
5% would go to management, giving them exit equity proceeds of $10.21. Subtracting the $4.21, this leaves management with net proceeds of $6.
Alternate Method
The WSO model seems to contradict my methodology, instead calculating proceeds from management of $4.0 ($80 * 5%), giving a post-exercise equity value of $204.0. Then, to calculate management's ownership %, they take $204 multiplied by 4.76% (5% / (1+5%), giving management gross proceeds of $9.71, and net proceeds of $5.71.
My method seems like it's correct, but I'd appreciate any input anyone can provide.
Always worrisome when WSO has bad math and then posters confirm their bad math.
Always do these including share counts. Let's assume 100 shares, so equity value / share at close is $1. We issue 5.263 options (100 / (1-5%) total shares) to management, struck at $1 / option.
Now here's the critical part - option pools are made to align sponsors and management. That means most sponsors are not in the business of providing an option pool, then screwing management. So when options are struck at the sponsor's entry price, then a div recap happens that takes value out of the business (without any benefit to the option holders), the option pool is most of the time made whole by reducing strike by the amount of the dividend. OR more options are issued, but this is less common.
Our dividend is $20, or $0.2 per share. Therefore, options are now struck at $0.8.
At exit, equity value of $200, add cash from options exercise of $4.21 (5.263 x $0.8), distributed equity value of $204.21. Per share value for all of $1.94 ($204.21 / 105.26). Sponsors 100 shares = $194, option pool gets $10.21, less $4.21 cash paid to exercise, option pool gets $6.