Berkshire Hathaway
Amazing Cisco Hubris

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By AtlantaDon
December 7, 2004

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For those who didn't think Silicon Valley couldn't go any lower on the issue of stock option expensing, Cisco has just set a new standard. Apparently assuming that they will be forced to expense options in the near future, they decided to arbitrarily lower their assumption on how long Cisco employees will take to exercise options, from 5.6 years to 3.3 years. Shortening the estimated life of the options will of course reduce the cost of options using the Black-Scholes model. In Cisco's case, the reduction in expense from this change would be in excess of $300 million over 5 years for one year of option grants. The WSJ article doesn't say it but that would likely be $300 million per year or more by the time options have been expensed for 5 years.

What makes this assumption particularly amazing is that Cisco's employee options have 9-year lives and vest 20% each year for 5 years. So to get to an average life of 3.3 years, the options would have to be exercised on average just 15 weeks after they vest each year; i.e. the average of 1.3, 2.3 ,3.3 ,4.3 & 5.3 is 3.3. So that means the stock price would need to be well over the strike price each year as the options vest to cause employees to exercise so quickly.

One of the arguments in favor of options has always been to align employee interests with long-term shareholders. Options should be supposedly viewed completely differently than cash compensation, so they've told us. But with this assumption Cisco is basically telling us the employees will cash in the options immediately as they vest.

Cisco's controller claims this change is based on "an extensive analysis of actual exercise behavior of our employees, using independent valuation experts." The WSJ doesn't note whether or not he was snickering as he said it.

I expected there would be some tweaking of assumptions, particularly implied volatility, as option expensing became a requirement. But the audacity of this is breathtaking.

[Wall Street Journal Article, Subscription Required]

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