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August 3, 2000

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Amazon

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Subject:  Options and the TMF Goldfinger Effect
Author:  howardroark

Assuming the reports of the option compensation add-on are accurate, the recent Amazon situation is a good example of how market prices and option compensation can act as a double whammy to shareholders, without ever hitting the P&L. Not only do they get hit with a reduction in market cap, but they suddenly have to pay more value to employees to prevent mass exodus to greener pastures.

According to the Seattle Times, Amazon claimed that that it wasn't doing this to boost morale and hedge attrition, but to "take advantage of current market conditions." {quote's from the Times, reporter is supposedly paraphrasing Patty Smith of Amazon). Now, you wouldn't expect them to call the move a desperate lunge to lock the doors before four more key employees moved to Alexandria and joined the Motley Fool, but the second part of that statement, if true, is extremely misguided. If you believe your share price is depressed, as implied, you do not take advantage of that condition by using it as currency. The only way to exploit a share dip is to purchase stock, not sell it. There's no way to determine the cost to the shareholders of this rumored grant with any reasonable precision, but let me take a WAG.

Both the Times and the Wash Tech article seemed to agree that the strike prices of the new options were $30. The Times is cryptic about the terms. It's either claiming that (1) employees receive 2/3 of only those options that vest in two years whose strike price is $29.75 or higher or (2) 2/3 of ALL options they own (regardless of vesting period) whose strike price is $29.75 , and the new options will vest in two years. Wash Tech just says employees get between 10-50% of their original grant by some unknown formula, but that the new options vest ratably over 5 years.

As of December, Amazon had around 80 million options out, at a weighted average exercise price of $27.75, not low enough to get the bonus. Those options generally vest somewhat ratably over five years (20% in year 1, etc.), and terminate 5 years after that. Some of the officer options, including Galli's forfeited options, had 15 or 20 year lives. In 1999, Amazon granted 31.7 million options at a weighted average exercise price of $63.62; because its stock price was above $29.75 for the entire year, it's fair to conclude that almost all have high enough strike prices to meet the criteria (say, 28 million of them). Amazon's 10K also shows that at least ~48 million of the options out have strike prices below $29.75, and won't be compensated. Let's assume Amazon issued another 15 million options this year so far, all above the key strike price.

Now, subtract (1) Galli's forfeited options of around 3.7 million and (2) 5 million estimated cancellation so far this year. You're left with 28 - 8.7 + 15 = 35.7 million eligible based on strike price. Now, let's assume the most strict deal, where Amazon only gives 2/3 of those eligible options which are vested or vest in two years. That would be around 60% of the 20.7 million pre 2000 options (because 1/5 already vested and 2/5 vest within two years), and around 40% of the 15 million 2000 options, total of around 18.4 million options handed out. Two thirds of that is 12.32 million. Estimate an average life of around 6 years, but reduce that to 5 years to account for attrition. Using Black-Scholes to value that grant (I'm ignoring dilutive and vesting effects because the only person left reading is TMFTippy for potential copyright violations and because Hammer89 is currently beating his dog out of frustration about the length of this inane post.)

Assumptions:


Strike Price: $30
Stock Price: $30
Volatility: 95%
Risk Free: 6.0%
Life: 5 years

The black box tells you that the average option premium is $22.6. Multiply that by the 12.32 million in estimated hand outs, and you've got a conservatively estimated $278.6 million in additional expense to shareholders from this one event alone. That's approximately equal to Amazon's gross profit in all of 1999. Not to say this is inherently a bad thing or a poor economic decisions, just that shareholders should watch it with interest, because it would show up as an operating expense if it was used to buy books or cement mixers, but will merely be footnoted in the 10K as employee compensation. What's even more insidious about the payout is that the option value inherently considers the risk that the options expire worthless, but that may in fact not be a risk at all, if Amazon were to issue replacement options routinely up devaluation.


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