Gideon's Blog

In direct contravention of my wife's explicit instructions, herewith I inaugurate my first blog. Long may it prosper.

For some reason, I think I have something to say to you. You think you have something to say to me? Email me at: gideonsblogger -at- yahoo -dot- com

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Friday, July 19, 2002
Okay, back to the market. There's been a bunch of bloviating about stock options and whether they can be expensed. I'd like to offer the insights of someone who actually structured hedges for these programs, and elaborate on why I think it is important that they indeed be expensed.

We all understand why companies issue stock options to their employees. It boils down to two rationales: (1) it's a cheap way to give potentially outsized compensation because it costs the company nothing in up-front cash, and therefore helps risky ventures with high upside potential lure top managerial talent; (2) it's a way to align management interests with those of shareholders generally, in that it rewards management for a rising stock price, which is what investors want.

The former is unproblematic. Were it not for stock options, startups would have a very hard time luring experienced managers who usually have many offers for their services to choose from (including the option of starting their own firm). In spite of everything that has happened since the bubble burst, I think we can all agree that entrepreneurial activity is a good thing, that technology startups in particular have done a great deal to add value to the American economy, and will continue to do so in the future. We don't want to jeopardize this activity, and if expensing stock-options would do so, then this would be an argument against such expensing.

Fortunately, an accounting change will have no impact on these young, fast-growing companies. These companies are not measured on a quarter-by-quarter earnings yardstick but according to metrics more appropriate for their youth. Their investors tend to be extremely knowledgeable and will not be put off by a change in accounting. And they are frequently expected to post losses for some time before achieving profitability. A change in accounting for stock options will have no impact on this sector.

The second reason why companies issue stock options is far more problematic. First of all, options are not the same as stock in terms of the incentives they put on management. Stock has both upside and downside; the asset can gain or lose value. A stockholder, therefore, has an incentive not only to take risks to increase value but to weigh risks carefully because, if they don't work out, they can cause a loss in value. Moreover, a stockholder has theoretically an infinite amount of time to achieve her goals; while future earnings must be appropriately discounted, all the earnings, into infinity, go into the value of the stock. By contrast, an option holder has unlimited potential upside but limited downside. An option is worth only a fraction of the value of a share, but the potential gains on an option are equal to the potential gains on a share. Moreover, all options have expiration dates, so that improvements in share value need to be recognized by the market within that time limit for the option to pay off for the holder. Both of these factors - limited downside and time-constraints on returns - encourage an option holder to seek risk. An increase in riskiness of the underlying shares, even if it subtracts value from shareholders, increases the value for option holders, because it increases the odds of a spectacular payout.

This problem - that options encourage excessive risk-taking - is not acute for startups because startups are already extraordinarily risky. But at mature corporations, large option grants encourage management to behave as if they were running a start-up - as if time were acutely short and both upside and downside potential were enormous. They encourage management to increase leverage and to take actions that erode shareholder value in the interests of increasing volatility, and thereby potential upside. This is, contrary to bubble-era logic that treated risk is meaningless and focused only on potential reward, extremely bad management.

It would be far more sensible for large corporations to align their managers' interests with those of shareholders by compensating them in part in restricted stock. But such stock grants, unlike options grants, have an immediate and negative impact on the company's bottom-line through dilution. Moreover, a company will have to pay a manager more in stock than in cash because stock is riskier than cash. Options, however - because of their current accounting - are free. They are valuable securities - long-dated options on typical stocks can cost over 25% of the value of the stock, even with strike prices significantly above the current market price - and this value is directly transferred from investors to managers. But this value transfer is never recorded on the balance sheet of the company.

If you doubt that companies are over-generous with stock options because of the accounting, just look at how hostile they are to the idea of changing that accounting. It never ceases to amaze me that commentators can say on the one hand that the accounting for options doesn't matter because investors "see through" the accounting to the underlying value, and on the other hand that changing that accounting would have a real and negative impact on business. You can't have it both ways. If accounting doesn't matter to shareholders, then let's make the change and not worry about it. If it does matter, then let's have a substantive debate about the various ways to account for options and decide what is best.

Options, as I have said, do give management a strong incentive to increase the company's stock price, but they also give management a perverse incentive to seek risk even where it marginally erodes shareholder value. Accounting for options as if they were free gives corporate boards a perverse incentive to over-issue options, since they are perceived to be the cheapest way to attract talent. This over-issuance, then, distorts the entire compensation market, encouraging executives to chase the hottest option-grant opportunities - to go work for the company with the greatest perceived likelihood for a rapidly rising stock price - rather than try to add the most value at a firm where they have established expertise and strong working relationships. The stock-options game, by giving such outsized compensation to some executives during the bubble market, put all corporations in the position of an arms race: in order to retain executives, older, stabler corporations had to vastly increase their options grants; companies with declining stock prices had to re-price options - a truly perverse action, given that the point of options compensation is that the executives are supposed to be paid less when the stock goes down; etc.

Accounting for stock options as an expense is the simplest way to dramatically reduce these perverse incentives in the future. There are several arguments against such a change, however, and I'd like to address them all here.

OBJECTION: You can't actually value stock options because you don't know what they are ultimately going to be worth.

RESPONSE: This is silly. I work in a derivatives business. We value stock options all day long. There is a huge market in options of all kinds, not just the standard listed options but all kinds of exotic over-the-counter structures. If a company can't do the valuation itself, it can hire an auditor or an investment bank to do the valuation. In fact, the simplest way to get a valuation would be to purchase hedges. Most companies do not do this, leaving themselves exposed to what are effectively large losses (though they are never accounted for that way) if the stock price rises. Why don't they buy hedges? Because that would cause them to book an expense up-front, while if they don't hedge, the options they have granted are costless.

OBJECTION: But that isn't really fair. If the company doesn't hedge, it won't face any kind of a loss unless the stock goes up and the options are exercised. Why penalize the company if it never faces this cost?

RESPONSE: Okay, then, we'll give companies a choice. They can either book the cost of the options as an expense up-front, when the options are granted. Then, when the options are exercised, they won't have to book any additional expense. Otherwise, they can book no expense up-front, but when the options are exercised they will have to book an expense equal to the difference between the market price and the exercise price of the options. The latter is what is done today for tax purposes. I suspect that most early-stage companies will similarly use the latter method because their earnings are already highly volatile, and therefore they will prefer to dampen that volatility by taking losses in good years when the stock is up rather than face a drag on earnings every year from option grants; moreover, they will be unlikely to buy hedges because this would involve a cash outlay. By contrast, I would expect mature companies to expense the options up-front, because such companies place a premium on earnings predictability, and up-front expensing would provide this; moreover, once they expensed the options, they would have an incentive to purchase hedges so that their cashflow tracked their earnings more closely and was similarly predictable. Does that sound fair?

OBJECTION: It sounds fair, but it is really punitive, because currently the cost of stock options is accounted for upon exercise through dilution. The market knows more shares have been issued, and discounts them appropriately.

RESPONSE: It may look punitive in comparison with the current system, but that is because the current system is biased in favor of options grants. You're right that the market responds to the dilution. But you can't tell by looking at an accounting statement how much value was transferred from shareholders to managers via options grants. That is important information, and it is very hard to determine because of current accounting. If you accounted for stock options as an expense on the back end, upon exercise, you would show the same cash flow as is currently the case, but you'd have a bigger number representing the value of the stock issued (based on the current value of the stock) and then a big negative number representing the difference between that number and the actual proceeds, reflecting the fact that the stock option caused the company to sell stock below market. Because the issuance of securities is not income, while the cost of the options exercise would be expense, it would affect the company's reported earnings. And that's appropriate: the options grant was a transfer of value, and is part of the cost of doing business, and this should be recorded somewhere. Now it isn't, and that's wrong. Dilution is correctly accounted for today, and tells you the denominator for EPS. Cashflow is accounted for properly as well. But the numerator of EPS is incorrect because part of the cost of doing business is the cost of stock options, and that cost is nowhere on the accounting statements.

OBJECTION: Well, we can agree to disagree on what is the most correct accounting, but surely you must agree that a sudden change in accounting standards will be very confusing to shareholders. More important, businesses whose plans depend on the regular issuance of options will suddenly be thrown into disarray, as they will be unable to economically offer the same kind of package and retain their top employees.

RESPONSE: I think this objections answers itself. We cannot agree to disagree on what counts as proper accounting and then agree that changing accounting would be a bad idea. If businesses depend on a certain accounting, then it matters a great deal whether that accounting is correct; we can't agree to disagree about it. If changing accounting standards are confusing, then presumably incorrect accounting standards are more confusing. If businesses' plans depend on wrong accounting, there is something wrong with those plans. If entire industries depend on overcompensation of executives abetted by bad accounting, then perhaps too much capital is being devoted to those industries; indeed, such a mis-allocation of capital could be a contributing cause of a stock-market bubble.

It comes down to this: it is possible to hedge the risks associated with issuing stock options. Virtually no major companies lay out this expense because, under current accounting, the issuance of stock options is free. A change in accounting would encourage these companies to hedge or, alternatively, to accept that their earnings will be dampened in years when their stock does well, in either case revealing the true cost of stock-options issuance. If banks were apparently making money, and compensating their employees on that basis, because they did not have to fully acknowledge the interest-rate risks or credit risks they were taking, everyone would agree that an accounting change was in order. The only difference here is that, because of continued prestige of the high-tech industry, and because of that industry's ecumenical policy with respect to campaign contributions, their objections - and they have objected vociferously to any change in the accounting for options - carry a weight in excess of the merits of their arguments.

Final point: I do not think that stock-options accounting was in any way directly to blame for the fraud that occurred at Enron, Worldcom, etc. However, I do think it was indirectly to blame in two ways: it helped fuel the bubble that made everyone lose their bearings, ethically and otherwise, and it created perverse incentives to pump-up stock prices that may have tipped some companies over the edge from aggressive accounting into outright fraud in an effort to avoid a stock collapse. The existence of perverse incentives in no way mitigates the criminality of those who committed accounting fraud. But we should nonetheless pay at least as much attention to those incentives as we do to criminal penalties as a solution to our current crisis of credibility.