FOOL ON THE HILL
The Stock Option Travesty

In a two-part column, Whitney Tilson argues that the use of stock options is out of control and suggests reforms. In today's column, he gives an overview of options, highlights their good qualities, and begins his analysis of their many problems.

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By Whitney Tilson
March 20, 2002

At one time, I was somewhat agnostic about stock options. While I have never agreed with the accounting for them, I felt that by giving options to management and employees of companies, it would help align their interests with those of shareholders. But what began as a good idea on a limited scale -- one that might have even benefited shareholders -- has morphed into a monster that has run amok, harming companies and shareholders tremendously. Immediate, significant reform is needed to curb stock option excesses.

The basics
Almost all major public companies in America issue stock options to management and/or employees. While there are different types of options (mainly qualified and nonqualified) and countless flavors of option programs, the key features tend to be the same: At regular intervals (often annually), a company issues certain employees a fixed number of options, generally with a ten-year life, a strike price at or near the current stock price, and a four- to five-year vesting period (meaning that employees can only convert 20-25% of each batch of options granted into stock each year). If the stock rises, employees over time can exercise their options, receive stock, and profit from the difference between the strike price they pay and the price at which they sell the stock.

The benefits
Since options will eventually expire worthless if the stock price doesn't rise, they can certainly motivate employees to focus on getting the stock price up. This can be a good thing if it's done legitimately through growth in the intrinsic value of the business, rather than through Enron-style smoke and mirrors.

Options also help a company retain its most valued employees -- presumably the ones who receive the most options -- because any employees who leave the company forfeit their unvested options. Finally, options can be a fair way to reward outstanding performance. Let's say management excels and doubles the profits of a company over time, triggered a doubling of the stock price. Isn't it reasonable that management should profit from this stock appreciation?

Given these notable benefits, what's the problem? My issues fall into three areas: dilution, bogus accounting, and perverse incentives.

Dilution
Dilution is such a critical issue, yet few investors seem to pay much attention to it. By owning a share of stock, you have an ownership stake in a company. The intrinsic value of that share is a function of only two things: the intrinsic value of the business and how many shares are outstanding. If the share count is rising, then the shares you own are losing value, all other things being equal.

Imagine for a moment that you own 100 shares of a business with 1,000 shares outstanding -- in other words, you are a 10% owner and are therefore entitled to 10% of any profit distributions, 10% of the proceeds if the business is sold, etc. Now, let's assume that management initiates a generous (to them) stock option program that increases the share count by 4% annually. In about 18 years, the share count will double to 2,000 and your stake in the business will have been cut in half. Even if the value of the business doubles over this period, you've done nothing but tread water. Management, of course, has done fabulously: While getting paid salaries and likely bonuses every year along the way, they now also own 50% of the company due to the options they've received (assuming they've held their shares).

Accounting for stock options
Accounting for stock options is completely insane. Despite the fact that they are obviously a form of compensation and obviously have a cost to shareholders, stock options do not have to be expensed according to generally accepted accounting principles (GAAP). Warren Buffett underscored this foolishness in his 1998 annual letter to Berkshire Hathaway shareholders when he asked the following three questions: "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"

The impact of stock options does, however, appear elsewhere in companies' financial statements, generally in three areas:

1) A rising share count, which leads to the dilution noted above.

2) When employees exercise their options, they must pay the company the strike price in order to receive shares. This cash intake generally appears on the cash flow statement in the section "Cash Flows from Financing Activities," under a heading like (from Dell's most recent 10-K) "Issuance of common stock under employee plans." For companies that issue lots of options, this amount can be material: Dell in its last fiscal year generated $404 million this way -- an amount equal to more than 18% of the company's $2.2 billion in net income.

3) Companies also receive a tax break when employees exercise options. Let's say an option has a strike price of $10 and the stock price is at $30. For every option exercised, as noted above, the company collects $10 from the employee -- but it also gets to deduct the $20 profit earned by the employee as a compensation expense, just as if it had paid the employee a $20 cash bonus. Fair enough, since this is clearly a form of compensation, but then why shouldn't this expense appear on the income statement, just like a cash bonus?! The tax savings for some companies are truly amazing: for Dell last fiscal year, it was $929 million (vs. $958 million of reported taxes paid on the income statement), and for Microsoft, it was $3.1 billion (vs. $4.1 billion of reported taxes on the income statement). As a taxpayer, do you smell a rat?

To summarize, options cost nothing in terms of cash or reported earnings, generate cash and tax deductions when they are exercised, create incentives for employees to stay, enrich management, and boost growth rates, margins, returns on capital, earnings, and, in all likelihood, the multiple the stock market places on these earnings. Given this ludicrous accounting, I wonder why companies don't issue far more options. For example, why should options only be used as a form of compensation? Why not pay other expenses like rent and advertising with stock options? It sounds silly, but theoretically a company could pay nearly all of its expenses with stock options and then report amazing (read: artificial) results.

It appears that companies have, in fact, figured out this game, with the result that the issuance of stock options is spiraling out of control: According to Business Week, "Today, the 200 biggest companies by revenue allocate more than 16% of their outstanding shares for options...double the percentage allocated a decade ago." But shareholders are paying the price, in the form of a massive transfer of wealth from the owners of companies (e.g., the shareholders) to management teams.

The most obvious, important solution is to require that companies expense the cost of options granted, but this proposal is not surprisingly encountering fierce resistance in Corporate America. Companies typically argue that it's hard to value options precisely, but this is rubbish: There are innumerable items in financial statements -- pension costs, allowances for doubtful accounts and so forth -- that cannot be known precisely, and thus are estimated. Also, companies are already required to report what earnings would have been were options expensed, but in a lame compromise adopted in 1995, such information is only reported once a year -- and is buried deep in the footnotes of the 10-K filing.

Finally, companies argue that if they are forced to account for the cost of options (even though this is a non-cash item), then they will issue fewer of them, which would stifle innovation, new business formation, and so forth. Well, if that's true, then let's unleash a tidal wave of innovation and new business formation by allowing businesses to ignore other costs like rent and cash compensation. Think of the profit margins if expenses didn't appear on the income statement at all!

Don't be fooled by these self-serving arguments. The bottom line is simple: Managements in many cases are making enormous fortunes from stock options at the expense of shareholders, yet there is little protest because the absurd accounting obfuscates their true cost.

I'll continue in my next column two weeks from now with a discussion of the many ways in which stock options do not, in fact, align incentives with those of shareholders.

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He did not own shares of any companies mentioned in this article at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.