In theory, you've got to love stock options. Employees are given equity stakes as a loyalty incentive, and those stakes are valuable only if the underlying shares appreciate. Happy days. Cue the sunset.
It's bogus, though. It hurts me to point out that something so seemingly wholesome has been butchered in the real world, but it has. Stock price tanks? Reprice the options! Market price too high? Backdate the options to a 52-week low! Sarbanes-Oxley is forcing stock-based compensation to be recorded as rightful expenses? Let's blur reality by posting two sets of earnings, as analysts egg us on!
I won't lie to you. I own a tiny piece of The Motley Fool, and I never had to pay a penny for it. I've been here since the mid-1990s, and my options were part of a 1997 incentive plan. I certainly didn't need that to light a fire under my feet, but I'm not going to throw those shares into the bonfire, either. I just don't think options are a very effective motivator.
Billionaires Bill Gates, Paul Allen, and Steve Ballmer gained their wealth by toiling away for Microsoft (NASDAQ:MSFT) in its early days. Do you really think they would have slacked off if stock-based compensation wasn't in the mix? I doubt it.
These days, even poor performance is rewarded with lavish options. Just last week, Oracle (NASDAQ:ORCL) chieftain Larry Ellison was awarded 7 million stock options, following a 2.5-million-option grant last year and a 900,000-option reward the year before that. Meanwhile, Oracle has seen its share price more than halved over the past six years. I'm a fan of Ellison's abrasive style, but I don't see why someone valued at $16 billion -- most of that tied to Oracle stock -- really needs even more as a tipping point to do something amazing to reward shareholders overnight. It's a ludicrous notion.
The dark side of options as compensation
I'll never forget the day I turned against Rainforest Cafe. I had attended an analyst meeting to go over the opening of the themed eatery's new restaurant at the entrance of Disney's Animal Kingdom theme park. The company had hit a rough patch a few months earlier, replacing outstanding employee stock options with new ones at lower strike prices to reflect the reduced market price.
It's a perfectly legal practice, but I was still incensed. As a shareholder, I certainly didn't have the right to call up my broker and have her knock down the cost basis on my shares. Why should company executives have that kind of luxury? If you were given stock options under the inane notion of motivation -- and they failed miserably as an incentive -- why cave in further at the expense of diluting everyone else?
When it came time for the Q&A, I asked the company about it. I wondered what kind of assurances Rainforest Cafe could give its investors that such repricing would not be a recurring practice if the stock tanked further.
The analysts in the room looked at me like I was from another planet. The practice seemed perfectly acceptable to them. It may even seem perfectly acceptable to you. It's legal, but is it ethical?
Things have gotten even worse lately. Over the past few months, dozens of companies have come under SEC inquiries, government subpoenas, and class action lawsuits for the suspected practice of backdating options. We aren't talking about just tiny tech stocks here, either. Bellwethers like Intuit (NASDAQ:INTU) and Apple Computer (NASDAQ:AAPL) have gotten caught up in the controversy. Even a pair of Rule Breakers newsletter picks -- CNET Networks (NASDAQ:CNET) and Openwave (NASDAQ:OPWV) -- have fallen prey to the malaise.
The backdating bug is symptomatic of currency so flawed as compensation that some of the biggest names in tech apparently feel they can abuse the privilege. That's rubbish. Stock-based compensation isn't necessary.
Another billionaire you may know, Berkshire Hathaway's (NYSE:BRKa) Warren Buffett, is no friend of stock options. He helped champion legislation that now forces companies to expense stock options as if they were compensation.
Unfortunately, analysts are still publishing estimates that ignore the impact of stock-based compensation in order to inflate bottom lines. Publicly traded companies are eating this up, peppering reported figures with the illusion of how much higher they would be without stock-based overhead.
That's the flaw, of course. Now we're seeing how deeply earnings are being slashed by companies with carefree compensation practices. It won't be long before analysts have no choice but to come clean and factor executive stock options into their models.
Companies will have to scale back on exercising new grants or knock down their paychecks. Stock options, that wonderful concept on paper, has been abused badly by compensation committees that Buffett once called more "Chihuahua" than "Doberman" in their composition.
Who let the dogs out?
Think you're done with the Duel? You're not! Go back and read the other three arguments, and then vote for a winner.
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Longtime Fool contributor Rick Munarriz works for food, not stock options. He does not own shares in any of the companies in this story. T he Fool has a disclosure policy. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early.
