My last two Rule Breaker columns about employee stock options (ESOs) sparked a great discussion on our Rule Breaker Strategies discussion board (check it out -- now you can read the whole thread at once rather than having to page through one by one), and a phone conversation with Amazon's VP for investor relations, Tim Halladay, who felt there was more to his company's story than visible just in the percentages of ESOs granted.

I have to admit Halladay disarmed me off the bat when he admitted his company was guilty as charged for being part of those caught up in not wanting to expense stock options. Strongly in its favor, Amazon now says it will expense them no later than January 2003.

Nothing but net
Halladay pointed me toward Amazon's ESO grants net of ESO cancellations, not least because the company in 2001 did two things that lowered that net number: It offered to exchange, on average, two existing (underwater) options for a new one, for a net cancellation of 18.7 million, and it additionally canceled another 13.4 million outstanding options.

He directed me also to CEO Jeffrey Bezos' letter to shareholders this year, in which he states: "Limiting share count means more cash flow per share and more long-term value for owners. Our current objective is to target net dilution from employee stock options (grants net of cancellations) to an average of 3% per year over the next five years, although in any given year it might be higher or lower."

Finding net dilution
Previously, I directed readers to a company's Form 14A proxy statement to compute the annual ESO grant number. Some companies make it easier in their annual report Form 10-K by providing their last three years' balance of granted but unexercised options at the year's start, and then that year's amounts
granted, canceled, and exercised. Look for a section on stockholder's equity entitled "Stock Option Activity," or the like.

For Amazon, there is a dramatic difference if we subtract the options canceled from those granted:

Year   Raw ESO Grant   Net of Cancellations
1999       9.6%             6.1%
2000       5.9%             0.3%
2001      12.7%             0.4%

Wow! And if subtracting cancellations improves Amazon's performance, does it affect all Rule Breaker holdings? Here are their most recent year numbers:

Company Raw ESO Grant   Net of Cancellations
Amazon     12.7%          0.4% 
Amgen       1.3%         -0.2%
AOL TW      4.4%*         3.7%
eBay        7.3%          5.8%
LendingTree 4.0%          1.8%
Millennium  4.7%          3.4%
Starbucks   2.7%          2.0%

Short holdings:
Sirius Satellite 8.1%     7.2%
Guitar Center    4.5%     4.5%
* The number for AOL is higher than last week and some 
are others slightly higher because the 10-K number
exceeded that derived from the 14A proxy statement
in the prior column.

Some, but not all, change markedly. The numbers differ significantly and favorably for Amazon, Amgen (Nasdaq: AMGN), and LendingTree (Nasdaq: TREE), but eBay (Nasdaq: EBAY) and AOL Time Warner (NYSE: AOL) still run afoul of our 3% established-company guideline. We like that our two short positions continue to look pretty bad.

Share buybacks 
On the Rule Breaker Strategies board, Motley Fool Community members addressed whether you could also make a case for subtracting the number of shares repurchased by a company, a number available in the notes section of financial statements. In a perfect world, shareholders love share buybacks because they increase their relative share of the business, but too often the company uses debt or cash to buy shares at any price to make things "look good" and to compensate for ESO grants.

Chinwhisker summed it up best, saying buybacks are better than a swift kick, but they don't solve the problem: "When or if the company buys back shares to cover this dilution, we just thank them and go on, because we realize that buying back these shares, though increasing our ownership in the earnings that could be paid out in dividends or reinvestments has the same effect in reducing earnings that could go out to pay dividends or reinvest in the company." [Italics added for emphasis.]   

Why regrant or exchange at all? 
If the company cancels options or buys back shares, that's fine. But wouldn't it be better to cancel them and not regrant, or buy back and not regrant? Also, doesn't Amazon's exchange or another company's repricing of existing options make it absolutely obvious that they're compensation, because it eliminates the "risk" of the risk/reward equation the employee was supposed to accept?

When I asked Halladay, he implicitly acknowledged the compensation argument and reiterated that developing companies that pay lower salaries must offer options to compete for talent. Amazon competes intensely for software developers with Microsoft (Nasdaq: MSFT), its neighbor across Seattle's Lake Washington. This little company has only about 5,000 vacancies. Given Amazon's relative riskiness as a business, Halladay explained that options were a very important part of his decision two years ago to go to Amazon from Microsoft, a strong, cash-rich company with a very generous stock options program.

ESOs: not forever
Fair enough. That's a central reason why our rule of thumb is to look for annual ESO grants of less than 3% of outstanding shares for established companies and a higher threshold of 5% for developing, still unprofitable companies, because the latter must fight harder for employees.

But that's not 5% forever. If the developing company survives and matures, it must increase total compensation and cut back on options.

As jackcrow put it, "In... a perfect world we would see three phases in a high-tech startup. Stage one: High ESO, because they don't have the cash to keep good talent. Stage two: ESOs are replaced with more traditional compensation. Stage three: ESOs grind to a near halt, and the company starts to pay dividends." I repeat my suspicion that the more you offer employees now, the harder it is later to cut back, to the detriment of shareholders.        

And now we're back where we always end up: How can anyone read this and not think that options are a form of compensation that should be expensed? Amazon will expense them no later than January 2003, and more and more companies are joining. 

About to break the rules again?
Not only that, but Amazon says it's considering "alternative equity vehicles to non-qualified stock options for [its] October grant." There should be some interesting news on its Oct. 24 conference call. 

Maybe Amazon will go the route of granting shares, rather than granting options. Based on his personal experience in startups, the tech world, and investing, Community member DirtyDingus explained why share grants, rather than options, are the only way to go for public companies. Among other excellent reasons, he points out they are immediately expensed and show their dilutive effect.

In the end
Perhaps it's best to let the past pass for Amazon and look to the future -- evaluate its decision on how to handle this year's grant and its plans to expense any options. Thankfully, the company stopped fighting the absurd battle that ESOs aren't expenses. Considering its avowed emphasis on free cash flow, Amazon should've given up that battle a long time ago. It's now made an excellent choice, and others should pay attention.

Great Foolishness  
Please don't miss Bill Mann's The Great PR Caper about the "is-it-fake?" company Hemispherx Biopharma (AMEX: HEB), and how SEC Chairman Harvey Pitt and Rep. Michael Oxley (R-Ohio) are bowing to the accounting industry and higher-up political pressure to cloud the nomination of reformer John Biggs to chair the new accounting standards board. Berkshire Hathaway (NYSE: BRK.A) CEO Warren Buffett yesterday followed Bill on the subject with a letter to The Wall Street Journal: "... Though the big auditing firms may long for a tail-wagging puppy to be chairman of the new accounting standards board, the American public wants and deserves a much-needed watchdog. John Biggs is an outstanding choice to fill that role -- knowledgeable, fair-minded, and investor-oriented."

Updated portfolio returns below. The Rule Breaker Portfolio leads both the S&P 500 (barely) and the Nasdaq for the year. Have a most Foolish week!

Tom Jacobs (TMFTom9) is more than just a pretty face behind this column. Along with a team of Motley Fool analysts, he's also serving up deeply researched, undiscovered stock ideas every month in The Motley Fool Select. Subscribe today! At press time, Tom owned no shares of companies mentioned in this story. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.

Rule Breaker Portfolio Returns as of 10/14/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week       8.65%**    7.15%   --       9.03%
Month      8.46%**    3.21%   --       4.14%
Year     -26.16%**  -26.71%   --     -37.42%
using IRR*** since 8/4/94 +20.55% +7.69% +9.55% +6.64%

*Dividends added. Or, danger ahead. Whatever.

**Please keep in mind that these figures will be distorted for the RB Port for the short period around which we add any cash (see next note!). Since July 2001, we consider depositing $12,500 in new cash each quarter unless we have enough available for new investments without it. 

***Compound Annual Growth Rate using Internal Rate of Return. This performance measure is more meaningful than total return because we began adding cash occasionally in July 2001. In a total return calculation, or ((Current Value - All Cash Deposited)/All Cash Deposited), cash added would show up as returns. And that wouldn't be cricket!