Cisco Proposes Market Test for Options Value

Cisco Systems has proposed issuing a special security that would mimic employee stock options as a way to create a market-based valuation of the awards. Cisco has presented the idea to the Securities and Exchange Commission. SEC Chair William Donaldson has expressed interest in the idea. Cisco has said it will not issue the security unless the SEC indicates that it would approve using a market price for the new investment as a way to value employee options.

Under the proposal, Cisco would create a new derivative security whose terms would be the same as its employee options. Derivative securities are investments whose values is derived from their relationship to an underlying security, in this case Cisco common shares. Like employee options, the securities would have a fixed term, would have an exercise price equal to the price of common stock when the derivative security is bought, and could not be exercised until a defined period of time has elapsed. Moreover, investors could not hedge their investments against the options, effectively limiting their potential loss or gain. These options would thus be considerably more restrictive than conventional traded options and therefore would sell for a greater discount to common shares. Cisco would issue a limited number of these options and would make them available only to certain institutional investors.

Cisco argues that the price the market sets for these options would be the value it should use when it accounts for the cost of employee options. The security creates an interesting dilemma for the company in that it would generate more equity investment if the price it obtained for the options were high, but that would then mean it would take a higher charge against earnings for its employee options.

Analysts had mixed reactions. On the one hand, some were intrigued by the idea of creating a true market value for employee options rather than a guess based on arcane formulas with multiple assumptions. On the other hand, some argued that because of their restrictions, the options would not be very appealing to investors and would carry a relatively low price. Supporters of the proposal contend that if the restrictions make the options less valuable to investors, they should be equally less valuable to employees and should be accounted for as such. Opponents respond that this is just another way the tech sector is trying to play down options value.

If the proposal does get approval, it is unlikely to be imitated by all but the largest companies. However, the data generated from these markets could provide a model for valuing all options. Over time, smaller companies might also find ways to issue the securities under some kind of underwriting umbrella that would make the costs lower.