Exotic Cuisines Employee Stock Options

Exotic Cuisines Employee Stock OptionsAs a newly minted MBA, you've taken a management position with Exotic Cuisines, Inc., a restaurantchain that just went public last year. The company's restaurants specialize in exotic maindishes, using ingredients such as alligator, buffalo, and ostrich. A concern you had going in was thatthe restaurant business is very risky. However, after some due diligence, you discovered a common isperception about the restaurant industry. It is widely thought that 90 percent of new restaurantsclose within three years; however, recent evidence suggests the failure rate is closer to 60 percentover three years. So it is a risky business, although not as risky as you originally thought.During your interview process, one of the benefits mentioned was employee stock options.Upon signing your employment contract, you received options with a strike price of $50 for10,000 shares of company stock. As is fairly common, your stock options have a three-yearvesting period and a 10-year expiration, meaning that you cannot exercise the options for threeyears, and you lose them if you leave before they vest. After the three-year vesting period, youcan exercise the options at any time. Thus, the employee stock options are European (and subject to forfeit) for the first three years and American afterward. Of course, you cannot sell theoptions, nor can you enter into any sort of hedging agreement. If you leave the company afterthe options vest, you must exercise within 90 days or forfeit.Exotic Cuisines stock is currently trading at $24.38 per share, a slight increase from the initial offering price last year. There are no market-traded options on the company's stock. Becausethe company has been traded for only about a year, you are reluctant to use the historicalreturns to estimate the standard deviation of the stock's return. However, you have estimatedthat the average annual standard deviation for restaurant company stocks is about 55 percent.Because Exotic Cuisines is a newer restaurant chain, you decide to use a 60 percent standarddeviation in your calculations. The company is relatively young, and you expect that all earningswill be reinvested back into the company for the near future. Therefore, you expect no dividendswill be paid for at least the next 10 years. A three-year Treasury note currently has a yield of3.8 percent, and a 10-year Treasury note has a yield of 4.4 percent.

1. You're trying to value your options. What minimum value would you assign? What is themaximum value you would assign?

2. Suppose that in three years the company's stock is trading at $60. At that time should youkeep the options or exercise them immediately? What are some of the important determinants in making such a decision?

3. Your options, like most employee stock options, are not transferable or tradable. Does this have a significant effect on the value of the options? Why?

4. Why do you suppose employee stock options usually have a vesting provision? Why must they be exercised shortly after you depart the company even after they vest?

5. A controversial practice with employee stock options is repricing. What happens is that a company experiences a stock price decrease, which leaves employee stock options farout of the money or "underwater.'' In such cases, many companies have "repriced'' or"restruck'' the options, meaning that the company leaves the original terms of the optionintact but lowers the strike price. Proponents of repricing argue that because the optionis very unlikely to end in the money because of the stock price decline, the motivationalforce is lost. Opponents argue that repricing is in essence a reward for failure. How doyou evaluate this argument? How does the possibility of repricing affect the value of anemployee stock option at the time it is granted?

6. As we have seen, much of the volatility in a company's stock price is due to systematicor marketwide risks. Such risks are beyond the control of a company and its employees.What are the implications for employee stock options? In light of your answer, can yourecommend an improvement over traditional employee stock options?