SOCIAL TOPICS (Archive): INVESTMENT & ECONOMIC ANALYSIS

Published, March 2003

By Bill Apfel

The debate over  the use and reporting of incentive stock options has gotten so heated, and the arguments made on both sides portrayed as so self-evident, that it makes sense to take a step back and consider the whole subject of stock options as a means of compensation. The controversy frequently pits well-intentioned shareholder advocates against self-interested options advocates¾high tech CEOs, discredited get-rich-at-any-price IPO entrepreneurs, and the usual suspects in the “business is always right” crowd. For once, the opponents of the standard pro-business position seem to have gotten the better of the public debate.

But casting this debate as a conflict between shareholder rights and executive greed is simplistic and misleading and might damage the goal of improving the health and fairness of the market system. For the outcome to be constructive, it is critical that participants distinguish carefully between an appropriate desire to devise a meaningful financial reporting system for options and the unintended result of curtailing option use. It’s worth recalling why many social investors have been long-time advocates of options-based compensation. The reason is simple and the mechanism elegant. Incentive stock options are a way for current stockholders to transfer a portion of the ownership of their company to its employees when and if those employees enhance the value of the company, as reflected in the company’s stock market value over a specified period of years. In theory, the result should be to align better the interest of shareholders and employees, to diffuse corporate ownership, and to produce a more effective and fair corporate culture.

Of course, we know what went wrong. An extraordinary market bubble opened the door for avaricious managers to turn this fundamentally positive trend in compensation practices into a vehicle for extracting quick riches from speculative stock prices. Worse, it encouraged the most unscrupulous managers to manipulate stock prices without regard to the long-term health of their companies. And finally, options were too often distributed disproportionately to a narrow group of executives who benefited at the expense of both employees and shareholders. No doubt, the current practice of simply ignoring the cost of options in financial reports encouraged these abuses. But certainly, shareholder advocates and social investors should take care to keep the baby as we drain the bath water.

It is striking how frequently newspapers carry pieces by supposed experts who demand the “expensing” of stock options without ever proposing how this should be done, or as though an option’s precise value was readily identifiable. Undertaken without an appreciation for the complexities and benefits of options, the unintended result could be reluctance by progressive managements to use this tool at all. This would be a shame for shareholders and employees alike. A sensible reporting system, however, would avoid misleading investors about a program’s true costs, while making plain how managers were allocating shareholder resources to achieve corporate goals.

Why do many proposals to “expense” options fail this test? Options are really “contingent liabilities.” That is, they are a commitment by a company and its current shareholders to issue shares to employees at a specified price for a finite number of years. An expense will only be incurred if the stock price rises. If it rises a great deal, the cost of that commitment will be very large. If it falls, the option will have no value and there will be no cost to current shareholders. It would be simple to quantify exactly how big or small the commitment would be if we knew where the stock’s price would be at the expiration of the option grant period. But we don’t know, so “expensing” some guess of their future value is almost certain to get wrong the true cost to shareholders. Perversely, an accounting system that expenses all options based on a fixed, mathematical guess of their true cost (the essence of most proposals), fails to capture the financial appeal of options issuance from the point of view of current holders: They will only be required to make good on their commitment to transfer part of the ownership of their company if the value of the company’s stock rises.

An accounting system that reflects the fundamental uncertainty of options-based compensation would be simple enough to devise.* Each year companies would be required to record an initial estimate of the ultimate cost of newly granted options and this would commensurately reduce earnings. In subsequent reports this estimate would be adjusted to reflect changes in the estimated value of all outstanding options, and this change would also be reflected in earnings. The ultimate cost of option grants would be recorded upon exercise, reducing the incentive for companies to manipulate their estimates along the way. For companies that fared well, the estimated cost of all outstanding option grants from prior years would increase, reducing reported earnings. For those companies that fared poorly, the costs would decline, yielding the opposite effect.

Is this system just too complicated for the investing public? We don’t believe so. Accounting principles are normally complex, indeed arcane, because they seek to describe the complex nature of profit and loss. The worst accounting treatments are those that allow for simplistic reports that misrepresent reality and thus run the risk of encouraging behaviors designed to mislead their users, or simply discourage behavior that would be in the best interest of investors and other stakeholders. Let’s make sure this is not the outcome of the options debate. –B. Apfel

*Mark Rubinstein has devised such a reporting framework. It was described in The Economist of November 9, 2002.