After a few days away from the office, I'm finding that my portfolio didn't change much -- as I expected -- but there were a number of interesting events that unfolded while I was away. At the top of the list is the SEC's response to a proposal from Cisco (NASDAQ:CSCO) to sell a derivative (another option) to investors that would reflect the value of an option issued to an employee -- the idea being that this method could be used in place of models such as Black-Scholes.
Having moved past the argument of whether stock options would be expensed, Cisco was now suggesting another method for how the expense should be measured or calculated. The initial response from the SEC is no, but the memo from the Office of Economic Analysis (OEA) does support the idea that a market-based system could work if the option transferred the full economic burden of the company or benefit to the employee to the option holder.
What Cisco had proposed was an option that could be purchased and would reflect similar terms to what an employee receives -- meaning the options take time to vest, are not transferable, and expire after a period of time. The OEA findings rightfully point out that the relationship between an employee and employer is quite different from that of an employer and an investor, which means the employee and the investor are likely to value the options differently.
As an employee with options, you might be willing to hold onto the options for years regardless of how the company performs, because they cost you nothing and there's nothing to lose. For an investor to purchase options like those an employee would receive is a different ball of wax. There is a cost for the investor, and there is less attachment to the company and the option than an employee would have, because there's nothing an investor can do to improve the performance of a company or, in turn, increase the value of the option.
Given the above scenario, options don't appear to be worth much at all, which is the point that Cisco was hoping to get across. Such a system would have greatly benefited heavy option issuers such as webMethods (NASDAQ:WEBM) and ATI Technologies (NASDAQ:ATYT) and is one of many attempts by Cisco and others at trying to arrive at a method that states a lower cost or no cost. Unfortunately, this theory doesn't hold up when examined just a bit more closely. Eventually all costs are born by the owners of a company whether they are explicit (actual expenses paid for or revenues received in the form of cash) or implicit (an example being investing equity into a company versus making a different investment).
While accounting rules ignore the cost of equity, I can assure you that companies do not. At the company I worked at prior to coming to Fool HQ, large projects were required to show a return that exceeded the cost of debt and equity capital -- and for the record, this company expenses options already. Most companies evaluate projects this way, because they don't want to fund projects that earn poor returns. What this also means is that companies are fully aware of the potential value that is being given away when an employee is granted an option -- they just don't want to recognize it when it's inconvenient.
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Nathan Parmelee has no financial interest in any of the companies mentioned. The Motley Fool has an ironclad disclosure policy.
