One of my favorite pastimes as the final ruling on expensing stock options came upon us has been to read the increasingly hysterical opinion pages of the San Jose Mercury News, the newspaper of record for Silicon Valley.
I will give the folks at the Mercury News credit: They know their audience. Workers in the Valley have been among the biggest beneficiaries of employee stock options programs, and are naturally concerned about what the change in accounting policy will bring. Naturally, though, being worried about a certain outcome, they've gone to great lengths to paint the discussion in the terms of that outcome. Over and over we've seen some form of this argument: "Options expensing will reduce the amount and breadth of options granted to rank-and-file employees, destroying an incentive that has driven the U.S. economy."
In fact, let's look at today's editorial. Ah, yes, there it is, almost word for word: "... destroying an incentive that has motivated millions of workers and helped scores of innovative start-ups...."
What utter poppycock. Can you just see it now? Somewhere in a garage, three young entrepreneurs have come up with a great idea that will render the hair dryer as we know it completely obsolete. "Aw, forget it," one says with a resigned shrug," there's no point in even trying now that we have to expense stock options." If these three bring in a fourth employee and grant her options, they know full well that they have ceded her a right, something of value. FAS 123R, which the Financial Accounting Standards Board released yesterday, is a recognition of this fact. An option has value the day it's granted. What's the value? Expense that amount.
"Ah," says the editorial, finger-wagging and arms akimbo, "but that amount will be flawed, because the assumptions are open to manipulation." Look, for example, at what Cisco (NASDAQ:CSCO) did recently -- it decreased its average employee holding period, but decreased volatility assumptions (something which should not happen, all else being equal). Yep, better to value employee stock options at zero. After all, as Craig Barrett at Intel (NASDAQ:INTC) noted, that's how they do it in Red China.
This arm waving simply begs the question of whether zero is a better estimate than one based on estimates. But fine, let's say estimates are evil. Under this standard, the cost of goods sold element of the income statement should also be zero, since first-in, first-out and last-in, first-out inventory valuation is also manipulable and based on estimates.
The overarching theme is that anything that decreases reported earnings is a negative, ditto anything that creates an impediment to employee ownership. That's what the warnings about "threats to economic growth" and "impact on America's technological leadership" are all about. But accounting treatments do nothing to change the economic condition of a company, while improved accounting does help investors and creditors make better economic decisions. How less likely would investors have been to plow money into options-abusing companies like Brocade (NASDAQ:BRCD) and even IBM (NYSE:IBM), the latter of which bought back $9 billion worth of stock during the Lou Gerstner era while issuing more than $20 billion in new debt so that it could mask the dilution from options grants.
That's $9 billion in shareholder equity, spent to buy back newly dilutive shares. This does nothing to say whether an IBM or a Brocade got value from employees consequent to this level of compensation. Some $40 billion of market value at Brocade has evaporated since the market bubble popped. How many investors thought that the company was capable of producing substantially higher economic profit for shareholders because they missed the fact that management was issuing options equivalent to nearly 20% of total outstanding shares in a single year?
That companies are paring back their options programs or replacing them with other forms of compensation only highlights the fact that their accounting treatment was inappropriate. FASB isn't requiring companies to hand over bags of money, restrict assets, or anything of the sort. Companies' economic condition will be in every way identical on the day employee options expensing is required as they were the day before. The only difference will be that this form of non-cash compensation will be represented on the income statement from that day forward. It's an adjustment that most sophisticated security analysts already make when determining the intrinsic value of public company shares, and one that will help all investors understand the economic transactions necessary for the company to operate.
Don't expect the hysteria to subside just yet, but after thousands of hours of consultation, FASB has finally come down on the side of "zero" not being good enough.
See also:
- Whitney Tilson's Stock Options Hurt U.S. Competitiveness
- Bill Mann's The Best Stock Options Model
- Warren Gump's 1999 classic three-part series Optionmania, Part II, and Part III
Bill Mann is a member of the Financial Accounting Standards Board's User Advisory Council. He owns none of the companies mentioned in this story.
