Berkshire Hathaway
Why are Stock Options so Popular?

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By MadCapitalist
May 24, 2004

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Stock options have been an enormously popular form of compensation. Proponents of stock options generally argue that they are a great form of compensation because they align the interests of employees and shareholders and they don't require cash. The aligning of interests is debatable (I think options have the opposite effect), but even if you assume that they do align interests, why not use restricted stock instead? Restricted stock clearly aligns employee and shareholder interests and doesn't require cash.

I think that stock options have been so popular because they have been incredibly effective -- at transferring wealth from shareholders to employees. What makes them so effective at wealth transfer?

1) They are treated as if they have no cost. Many investors have unfortunately bought into this concept. And of those that didn't, many have placed too much emphasis on *reported* earnings, which of course ignores the cost of stock options (for most companies), so even investors who understand that options have costs underestimate the cost. Because the cost is generally severely underestimated, board members have been willing to issue options in great numbers, and shareholders have been willing to go along with it. An expense that doesn't cost anything? Fantastic!

2) Stock options create *positive* cash flow instead of negative cash flow. First of all, they eliminate a cash expense and yet still offer a tax deduction (if the options are exercised). So they create positive operating cash flow. This has allowed companies that are heavy users of stock options to brag about their strong operating cash flow (they seem to forget to mention that it was made possible by offsetting operating outflows with equity financing). And of course there is a financing cash inflow because the company receives cash equal to the exercise price when the options are exercised. An expense that generates positive operating and financing cash flow and doesn't cost anything? Must be magic!

3) Stock options are much more leveraged than stock. By this I mean that employees will receive far more for each dollar rise in the stock price if they have stock options than if they have restricted stock. Lets take a look at an example. Buffett once suggested a rule of thumb for estimating the cost of an option issued at the money -- one-third of the exercise price.

.                                 Restricted Stock  Stock Options
Total value of compensation         $1,000,000     $1,000,000
Price per share/option               $100.00        $33.33
Shares/options issued                 10,000         30,000

The employee will receive three times as much money from an increase in the stock price if they have options compared to if they had restricted stock. In this example, if the stock price increases by $1, the employee will receive $10,000 from restricted stock and $30,000 if they have stock options. Lottery tickets anyone?

This last issue also helps explain why stock options might be a great incentive for accounting fraud. There is a massive payday waiting for executives who get the stock price up by any means possible, even if the price is only up long enough to exercise the options.

I find it alarming that so many boards of directors are clueless. I hope requiring employee stock options to be expensed will force companies (and their shareholders) to finally face up to their cost.

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