Red Hat IPO

Doug Henwood dhenwood at
Sun Aug 15 10:16:02 PDT 1999

William S. Lear wrote:

>Jordan and Doug can correct me if I am wrong, but the IPO price is
>settled long in advance is it not?

I'm no insider, but my impression is that price ranges are established in advance, but the exact price and quantity aren't set until just before the offering.

Speaking of the stock market, there's an interesting piece in the biz section of today's NYT by Gretchen Morgenson, who's gone from being Steve Forbes's flack in the '96 campaign to being one of the more prominent journalistic skeptics about the bull market.



New York Times - August 15, 1999


By Gretchen Morgenson

NEW YORK -- Even though the NASDAQ composite index rallied late last week, it is down 8 percent from its July 16 high, close to the 10 percent drop that Wall Street considers a correction.

These stocks deserve a rest. At its peak, the NASDAQ was up 31 percent this year, compared with the 22 percent rise in the Dow at its high and the 15.4 percent increase in the Standard & Poor's 500-stock index.

But the NASDAQ has dropped further than the other indexes, raising a troubling issue that was hidden as the market rose: Hanging over the market are an immense number of shares in big NASDAQ stocks, including top technology companies, in the form of option grants awarded to executives and employees.

Companies of all kinds have issued oceans of options in recent years. As long as stocks were rising, option holders hesitated to exercise them, waiting for even further gains. Now, with many stocks -- especially NASDAQ stocks -- well off their highs, transforming paper profits into real gains is mighty tempting.

How big is the overhang? Bob Gabele, director of insider research at First Call/Thomson Financial, calculated all the option grants made by companies in the NASDAQ 100 stock index from 1994 to 1998. A staggering 4 billion shares were granted, worth $220 billion at recent prices. That amounts to roughly 9 percent of the market value of the entire NASDAQ 100 index.

"This is an avalanche-in-waiting," said Baruch Lev, professor of accounting and finance at New York University's Stern School of Business. "And this avalanche may fall at the worst time of all."

If the market slows or a recession hits, expectations for these shares will fall, Lev said. Employees who can exercise their options and sell shares will do so, thereby depressing an already declining market.

An option grant is exercisable only if its so-called strike price is lower than the prevailing market price. But given the hefty gains registered by NASDAQ every year since 1994 -- the index is up almost sixfold -- most option grants are exercisable now.

Cisco Systems said in its 1998 annual report that the average strike price of its option grants -- 1.562 billion shares -- was $25.23. Cisco stock closed Friday at $63.5625.

Companies report their option grants in the footnotes to their financial statements. To calculate the overhang, take the number of shares provided for in those grants and divide it into the total shares the company has outstanding.

It doesn't take much of a fall in stock prices to make option holders itchy, said Steven E. Hall, managing director at Pearl Meyer & Partners, a compensation consulting firm. When stocks plunged last fall, Hall said, "everybody got stomachaches looking at their stocks. All of a sudden people started saying, 'Maybe I don't want as much of my pay in stock."'

Studying the effect of declining stock prices on option grants at 60 companies, Hall found that a 15 percent drop in stock price translated to a 25 percent decrease in the value of options held by chief executives.

Corporate America's love affair with options worked well as stocks rose. Giving options in lieu of cash keeps employee costs down and helps financially strapped start-ups. But when stock prices no longer rise, companies will be forced to pay more in cash to workers, driving up costs.

Lev points to another concern about an options avalanche. "Firms in the last four to five years increased debt significantly, mainly to repurchase stock so they can provide it to managers and employees," he said. "So debt is very high, the market slows down, people are dumping their shares. There is a significant risk here."

More information about the lbo-talk mailing list