FOOL ON THE HILL
Rebutting Stock Option Defenders

Whitney Tilson takes on two recent articles in the press supporting current stock-option accounting. Despite the Enron debacle, it looks like the status quo will carry the day again. Investors, beware.

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By Whitney Tilson
April 17, 2002

I had intended to stop writing about stock options after critiquing them in my last two columns, but I feel compelled to rebut the self-serving, nonsensical arguments put forward by defenders of the status quo. In particular, I take issue with two recent op-ed articles published in The Wall Street Journal ("Stock Options Keep the Economy Afloat" (subscription required) by economists Burton Malkiel and William Baumol) and The New York Times ("Leave Options Alone" by venture capitalist John Doerr and FedEx CEO Frederick Smith).

Warren Buffett shredded all of the arguments put forward by these gentlemen in a brilliant op-ed of his own, "Stock Options and Common Sense," in last week's Washington Post, but I'd like to add my two cents. Let's go through the arguments one by one.

Difficult to measure the cost of stock options
The most common argument against expensing stock options is that their cost is impossible to measure with precision. Doerr and Smith argued "that there exists no remotely accurate way to calculate the expense," while Malkiel and Baumol agreed that "it is virtually impossible to put a precise estimate on [an] option's value."

In his piece, Buffett countered: "That is nonsense: I've bought and sold options for 40 years and know their pricing to be highly sophisticated. It's far more problematic to calculate the useful life of machinery, a difficulty that makes the annual depreciation charge merely a guess. No one, however, argues that this imprecision does away with a company's need to record depreciation expense. Likewise, pension expense in corporate America is calculated under wildly varying assumptions, and CPAs regularly allow whatever assumption management picks. Believe me, CEOs know what their option grants are worth. That's why they fight for them."

Double counting
Doerr and Smith argued that requiring companies to expense the cost of options on the income statement would lead to "inaccurate and misleading earnings per share" since options are already factored into the diluted share count. To understand how weak this argument is, consider the following: Let's say that a company, rather than issuing options to employees, instead sold them to investors, took in cash, and then paid the employees with this cash rather than directly with options. In both cases, the employees received the same economic value and the dilution is the same, so why should the accounting be any different?

Damage to high-tech companies
Malkiel and Baumol painted the frightening picture that requiring companies to expense options "may erase millions of dollars of corporate profits and push many high-tech companies into the red." I think a more accurate statement would be:

Many high-tech companies (and others that issue tremendous numbers of stock options) have shifted a large and ever-increasing portion of their compensation to options, resulting in artificially high reported earnings that mislead investors. By requiring companies to expense all elements of compensation equally, the reported profits of many companies will rightly be reduced, giving investors a more accurate picture of all companies' financials.

In any case, no genuine corporate profits will be erased, since there is no cash cost associated with options -- in fact, companies collect cash when options are exercised.

Damage to emerging companies
Malkiel and Baumol extolled the benefits of options to "new, entrepreneurial" firms that might not have sufficient cash to pay enough to "attract outstanding workers." True enough, but despite the hysterical claims of option defenders, no one is advocating outlawing options -- merely that their cost be reflected honestly in companies' financial statements.

I have made numerous investments in private and emerging public companies, and my experience is that investors in such companies care far more about cash inflows and outflows than reported earnings -- as they should. Thus, whether options were reported as an expense or not would have little or no impact on early-stage companies' ability to raise money.

Align incentives
Malkiel and Baumol argued that options can serve "to mitigate possible divergences between the interests of management and stockholders." There is some truth to this claim, but as I highlighted in my last column, options can also create many perverse incentives. If a company wants to align the interests of management and common stockholders, then it should set up mechanisms to ensure that management holds common stock rather than options. A major reason why companies don't do this is because stock grants must be expensed, whereas options need not be.

Option compensation is less costly than cash
Malkiel and Baumol claimed that option compensation is superior to cash compensation because the former is "only a redistribution of benefits between initial stockholders and the new, prospective management stockholders," whereas the latter "results in a net reduction in the firm's net cash." But dilution is just as much of a cost to shareholders as cash -- perhaps even more so because, in addition to the economic impact, voting power diminishes as well.

Benefits of options
Stripped of hyperbole, Doerr and Smith argued that even if options are an expense, they provide so many benefits that their cost should continue to be ignored lest the benefits be jeopardized. As I argued in my first column on options, "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!"

Conclusion
After the Enron debacle, I had high hopes that Congress or the Financial Accounting Standards Board might rectify the obvious mistake regarding how stock options are accounted for, but it appears that the narrow -- yet enormously powerful -- interests in favor of the status quo will carry the day again. That's too bad. Investors will have to be more careful than ever.

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. 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/.