Introduction
Overhang refers to potential dilution in the value of equity investments due to stock options pending conversion to equity shares. The dilution would have an effect on the earnings per share and the return on investment per share.
Understanding Overhang
In the case of a company which has high outstanding options, the company has to generate more business and increase the earnings per share to minimise the dilutive effects of options.
An overhang is usually represented by a percentage calculated as stock options granted plus the remaining options to be granted divided by the total number of shares outstanding.
For example, a company already has 20,000 outstanding stock options and has plans to distribute another 20,000 options. The company has 1,00,000 shares outstanding. The total overhang is (20,000+20,000)/1,00,000 = 40%. The options overhang decreases after a public offering of shares.
Factors to Consider
Due to the dilutive effects of stock options, companies generally prefer to give employees performance-based options instead of traditional stock options.
Small-cap companies generally grant the highest number of stock options for attracting talent, as compared to large companies.
Companies which have significant employee ownership tend to perform better financially.
In a case where a company has a high options overhang, the management of the company may take on more risk, more debt to expand the business, and pay fewer dividends. The stock prices may be volatile due to the incremental debt and reduced dividends.
A company, which has strong financial performance and pay higher dividends, would see less stock price volatility.
As the options overhang has a negative influence on the price of a stock, the company's human resource team devises strategies to include the options in the compensation of employees.
