New Paradigm Investing
Stock Options

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By howardroark
March 25, 2002

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I'm sorry I don't have time to reply specifically to the many interesting thoughts in this multi-(t)h(r)eaded option compensation discussion. I've read most of the posts, though, and I'd like to throw out a few somewhat random responses to some of things I've read.

First, I deeply question the logical foundation underneath the argument that stock options ought not be given sunlight on the income statement for fear that it will crash an essential silicon valley incentive structure. This isn't the first time this argument has been made. I remember several years ago when both the FASB and Arthur Levitt tried in vain to impose P&L recognition of stock option expense. There was fierce opposition from the same Congress (and many of the same Congress people, specifically) who are now happy to stand atop the truth-in-accounting soapbox and burn their Enron and Anderson flags, who screamed with the finance and economics sophistication of a seventh grader that the FASB was going to destroy technology by demanding greater disclosure. Admittedly, more reasonable and informed people (e.g., John Chambers) offered less offensive, but in my opinion no less wrongheaded, versions of the same argument.

The argument fails, in my view, in a way that few arguments manage to fail. It fails not only because of a flatly unproven and almost certainly incorrect assumption (that option compensation expensing would destroy a valuable incentive mechanism or hinder technological entrepreneurship) but also because that same poor assumption, if true, would actually offer the most damning argument against the suggested sheltering of the income statement.

Markets are rather sophisticated (give or take your occasional bubble). They read footnotes and use pricing models to calculate contingent costs and adjust for cancellation rates. They don't punish Boeing or Winn-Dixie or LVLT for choosing to expense option compensation, and they react badly to option repricings. They will not jump for joy when earnings growth in the post-SFAS 142 era spikes without the weight of goodwill amortization. They would not likely dive for cover were an economic cost suddenly given a new (and correct) location and format on SEC filings. But if they would so react...if it were true that markets -- providers of capital and bearers of risk for fiduciary entrepreneurs -- would make a different allocation decision given a more honest accounting treatment, that would of course be the best reason to demand P&L disclosure. The cornerstone of public markets is accurate, objective and honest information so that free markets can best offer their consensus judgment and determine their own risk aversion. The "don't tell because we'll get in trouble argument" usually only works for the secret keepers, and often not even for them.

So why even expense options if the markets know anyway? There are many good reasons, not the least of which being that any informational imbalance will disproportionately affect less sophisticated investors, those who don't have the time or experience to translate and model the footnotes. When any cost is more difficult to model, it's the players with the best cryptographers that reap the rewards, and that is often not the retail investor.

An equally important reason is that even minor subterfuge creates costs. Informational costs for one, since accounting does not play its usual transaction-simplifying role. We have to take extra time to measure the P/E of the S&P500, to compare profitability across companies and industries, to value firms, etc. But more importantly, suboptimal disclosure negatively affects long term capital costs Every fraction of an inch taken from a philosophy of optimal disclosure and handed to the footnotes in the name of painting a more attractive face to the statements is a yard added to the cost of debt and equity capital. Another way to look at the cost of that capital is the risk that investors perceive and are willing to bear in foregoing resources in favor of capitalist enterprise, a measure that some see as the most important driver behind long term increases in technology, efficiency and productivity. The cloudier the window into businesses, the more expensive the gap between business and the capital it needs to exist.

A final reason for expensing option compensation is the accountability it may provide to option programs, particularly when it comes to executives. Those great capital markets, which can squeeze SPEs out of the hidden basements of public companies in a single week if so provoked, and sometimes out of existence if appropriate, are the best judge of business practices we have. While markets may not be fooled, it is more difficult to make direct links between practice and market reaction when the practice is not tied to more popular benchmarks like EPS. Rather than crash all option compensation practices, I think it is much more likely that the market would provide its normal policing talents, ferreting out only the more abusive pieces, by most accurately (but of course not perfectly) measuring the costs they impose and the gains they provide. As a last point in this argument, I'd like to cite what to me was the most (only) substantive Washington hearing in the wake of the Enron and the Restless. Five (bipartisan) former SEC commissioners testified without fanfare about various accounting and market issues in a quiet session without mechanical bulls or syrup-drenched sanctimony. The only time I saw all five forcefully agree during the session was in their unanimous assent that option compensation ought to be expensed on the income statement. Arthur Levitt said that backing down on that issue was by far his biggest failing as Commissioner.

Second (don't worry, there aren't ten), I'd like to briefly respond to the argument that options don't cost anything to the company, as distinct from the shareholders, and thus should not be treated as a cost. This argument confounds, in my view, the juridical distinction between a corporation and its stakeholders and the purpose of the income statement. While it is true that most countries have created a fictionalized part-person for many legal purposes in the form of a corporation, none of those purposes include providing information on financial statements about inflows and outflows relative to stakeholders. That fact is plainly recognized in other instances, such as when companies pay suppliers with stock, offer below-strike options, or now even reprice options, and should likewise be recognized in the case of other contingent future cash flows being taken from existing equity holders to provide a period benefit such as at-the-money option compensation.

Options and even options repricing are at core like any other form of compensation, sometimes beneficial to equity holders and sometimes not. The capital market will not inappropriately punish the ones that are, so there's no reason to hide them from it.

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