Exhausting Every Option

With the proposal put forth by a high-powered team of Cisco (Nasdaq: CSCO  ) , Qualcomm (Nasdaq: QCOM  ) , and Genentech (NYSE: DNA  ) , those who are paying attention are getting a great view into the lobbying game at its $3 dollar bill best.

The International Employee Stock Option Coalition, a high tech industry lobbying group in Washington D.C., is pressing the proposal as a superior way to price employee stock options than either the Black-Scholes method or binomial tree models upon which option pricing is normally based. The proposed model builds upon Black-Scholes by taking into account certain characteristics of employee stock options that make them different from other forms of options.

At odds is a contention that has gone on for more than a decade -- whether or not stock options granted to employees should be considered an expense for accounting purposes. The Financial Accounting Standards Board (FASB) tried a decade ago to have employee stock options treated the same as stock options utilized by companies for anything else: to expense them. The high tech industry in particular blocked this effort, and as such we've seen a torrid rise in the amount of employee (and particularly executive) compensation that has been in the form of stock options. Why wouldn't they? As far as the income statement goes, stock options might as well be free, and companies get a tax deduction when employees exercise them. FASB's efforts at the time were blocked in Congress, led by Senator Joseph Lieberman (D-CT). Instead of mandating employee stock option expensing, FASB meekly intoned in FAS 123 that accounting "best practices" would be to expense options. The number of companies that decided to follow these best practices was a pretty low non-zero number -- of the 500 companies in the S&P 500 as of 1999, only Boeing (NYSE: BA  ) and Winn-Dixie (NYSE: WIN  ) complied.

The general benefit of stock options, particularly in risky newly-founded, bleeding edge companies, is undeniable: companies that are cash strapped have a way of compensating their employees with something other than precious cash. The trouble is, the underlying stock from options is a legitimate form of currency, and the impact of those non-cash costs is not sufficiently represented on the balance sheet.

The folks who said that hell hath no fury like a woman scorned, though, obviously never met special interest groups that have a gravy train under threat. So when FASB floated the idea that it would once again seek to mandate that options be expensed, the heaviest users of stock options immediately fired up the propaganda machines, implying that FASB wanted to "take away" options (untrue), that option expensing would kill the entrepreneurial spirit (untrue), or that FASB was opposed to broad-based employee ownership (untrue). The best, though, was when Craig Barrett of Intel (Nasdaq: INTC  ) , insinuated that we were going to lose to China if FASB changed our policy on options.

I should repeat something that has been said many, many times throughout this debate: The only thing that's being talked about here is an accounting change. We're talking about shining a little disinfecting light on stock option programs so that companies like Brocade (Nasdaq: BRCD  ) won't grant 19% of their share float in a single year in options and pretend that such compensation is not a cost. Keep in mind -- no matter what is decided, the true economic impact of options programs WILL NOT CHANGE.

This latest proposal was developed by the three companies with assistance from accounting experts. Certain advisors to FASB have encouraged the board to consider the proposal -- I certainly hope they do as well. The proposal includes a component that links the volatility (a big component in option pricing) not to the past volatility of the company's stock, which is what is done with Black-Scholes, but rather to use one based upon the beta-adjusted volatility of the S&P 500. What this will do is greatly reduce the implied volatility that high-tech companies must reflect, thus reducing the cost they must report. Options are considered to be "long volatility," since the holders may generally exercise them at any point when the underlying share price exceeds the strike. A reduction in the assumed volatility for the underlying shares lowers the assumed price (and therefore reported expense) of the option.

This brings up a simple question for me: the S&P 500 comprises 500 of the largest publicly-traded companies in America. Is the S&P 500 an appropriate benchmark upon which to base option pricing for highly volatile micro-capitalization companies? And why would a series of beta and a benchmark be any more predictive for future volatility of shares than simply measuring the past volatility of those shares? All that happens here is that the future reported cost for the most volatile companies for options will be lower.

Ditto the component of the proposal that allows for a further discount in option pricing to be applied due to the fact that stock options, unlike market-traded options, create dilution. This is in fact true, but isn't it ironic that managements want a discount for the dilution that their own choice to compensate using stock options would create?

The proposal does bring up good points -- that employee stock options are not transferable and that they also have blackout periods when they cannot be traded. But these elements aren't news to FASB -- one of the core components of its request for comments is that it seeks alternative valuation measures to Black-Scholes, which fails to take certain characteristics of employee stock options into account. This was the purpose of considering the binomial model, this was why FASB didn't just say "use Black-Scholes" in the first place. This proposal in its totality and methodology, though, seems to make the reported expense of employee stock options in all circumstances lower than what would be reported as proposed in the FASB Exposure Draft, which would violate the accounting principle of fair value. I can't see FASB getting very excited about that.

But while the proposal may offer an alternative methodology for expensing, it also offers the technology lobbyists something even more valuable in Washington -- the outward appearance of co-operation. Should FASB come out of its meeting today and say that it will not consider the proposal, the technology lobby will be able to scream to government representatives that they have exhausted all non-legislative avenues of relief.

Yep, that's the way Washington works. The technology lobby has already managed to get a bill passed in the House of Representatives that would force the Securities and Exchange Commission to step in and block FASB. The Senate remains unmoved -- not that there aren't senators jumping up and down to get in the way of the chief accountants in the land over an accounting issue -- because Senator Richard Shelby (R-AL), who chairs the Senate Banking Committee, has repeatedly stated that he thinks Congress ought to stay out of FASB's way, and as such he has the broad power to keep the Senate bill from being voted upon at all.

What you see here is a last-ditch attempt from an industry that believes it has the most to lose from options expensing. I'll say the same thing that I've said all along -- I think this misses a real point. There are investors controlling combined investing dollars into the hundreds of billions who instinctively do not trust the financial statements of companies that use huge numbers of stock options and fail to expense them. We don't trust the ratios, we don't trust the numbers, and we make our own adjustments already. Accounting statements that reflect the economic impact of stock options are likely to make these companies more interesting to such investors, not less.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Interested in companies that are shareholder friendly? Take a gander at the offerings each month in Motley Fool's Income Investor, in which Mathew Emmert finds some of the best dividend paying companies around. A free trial is yours for the asking.

In his career, Bill Mann has both granted and received stock options. Bill owns shares of none of the companies mentioned in this story. For a full list of his holdings, please view his profile.


Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

DocumentId: 534395, ~/Articles/ArticleHandler.aspx, 4/17/2014 6:45:08 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement