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Stock Strategist

Stock Options Should Be Expensed

It's only logical to put options on the income statement.

I find few things funnier than the way certain issues can transform ordinarily rational individuals into the equivalent of a zombie in “Night of the Living Dead,” stripping them of all reason and logic. Ask a roomful of people whether deficits affect interest rates, whether charts can be used to predict future stock prices, or whether the Cubs will ever win the World Series, and at least one person will surely start foaming at the mouth and acting like a street preacher.

Stock options have the same effect. Ask a roomful of technology executives--or politicians from a certain large West Coast state--why options should not be expensed, and you’ll get some pretty vehement responses, most of which have pretty shaky logical foundations. Since the Financial Accounting Standards Board issued its recommendation to expense options a couple of weeks ago, the papers have been filled with technology wonks hyperbolizing about the damage that such a proposal will do to the country--so I think it’s a good time to review the flaws in anti-expensing arguments.

Options are not a cash expense.
This is the "no money has changed hands" argument. As the American Electronics Association (a huge lobbying group for tech companies) puts it, "When a company grants an option to an employee, no money has changed hands…. There is not a definite value of the option at the grant, and therefore it is very hard to report that value on a company's earnings statement at the time of grant."

Phooey. For one thing, there are lots of non-cash expenses currently deducted from earnings, and no one makes a fuss about them. Should we stop charging depreciation against earnings just because companies don't have to write a check to cover the annual costs of the wear-and-tear on their machinery? The point is that an item of economic value has been transferred from the company to the employee, and that value should be reflected on the income statement. Granted, calculating just how big (or small) that value is can be a little tricky--but we'll come back to that in a moment.

Moreover, the vast majority of firms that grant options spend very large sums of money--billions, in the case of large tech firms--repurchasing shares to offset the dilutive impact of giving out options willy-nilly. This is cold, hard cash that could have been spent in a more useful fashion, rather than being frittered away by selling stock cheaply to employees and buying it back at a higher price.

Options are necessary for startups to attract talented employees.
Also known as the "Don't kill innovation!" argument. According to this line of thinking, expensing options would make it prohibitively expensive for companies to issue them, so many option programs would be phased out, thus severing an important link between the interests of employees and those of shareholders. The AEA makes this argument rather plaintively in a form letter that it kindly provides to its constituents: "If this legislation becomes law, it’s possible that my company will have to end the practice of giving stock options to its employees. Please don’t let that happen."

Hang on a minute. The value of a stock option is precisely the same whether it's deducted from earnings or not--the only thing that changes is the manner in which that value is recorded. Expensing options would not make stock-option programs "prohibitively expensive" in the sense that companies would have to incur a new and burdensome cost--all that would happen is that the cost would be deducted from reported earnings rather than buried in a footnote.

Yes, this would lower reported earnings. But isn't that what costs do? I mean, one could argue that recording rent as an expense lowers earnings, so companies shouldn’t have to record the checks they send to their landlords every month as an expense. That sounds rather silly, though, doesn’t it?

Another version of this argument--favored by the venture capitalist folks--asserts that startups will be irreparably harmed: “Most importantly, the proposal will seriously harm private, emerging growth companies that are highly dependent on employee stock options to recruit and retain employees as the mandatory expensing of employee stock options carries a cost that is too large for the majority of small businesses to bear…. By requiring the expensing of options, FASB is asking small companies to choose between attracting talent or showing positive net income--both of which are key drivers in the ultimate success of the organization.”

I think that “positive net income” is about the last thing that investors in startups are looking for. If I were investing in a young company, I think I'd be a lot more interested in a) how fast it was burning through its cash, b) how its product development is coming along, and c) what kinds of customer wins it's getting.

Moreover, if my choices as an entrepreneur are either to attract great employees by issuing options that will then be expensed, or to attract a bunch of losers who'll work for peanuts, which do you think I'd do if I were interested in maximizing the long-term value of the business? The bottom line is the same: Options do not consume the scarce cash of a startup, but they do have value, and that value should be reflected in the calculation of earnings. End of story.

Options are the only way to link the interests of employees and shareholders.
Again, I say phooey. Restricted stock aligns the economic incentives of employees with those of shareholders in a much more beneficial way, and restricted stock has to be expensed. The payoff profile of an option is asymmetric--it’s either worth nothing, or it’s worth a lot. (Think of a lottery ticket.) This can encourage short-term thinking by managers, especially if the options have a short vesting period. On the other hand, shares have value when they’re granted, and that value decreases or increases one-for-one with the value of the stock held by shareholders. Combine restricted stock with a long vesting period, and you have a well-structured incentive that promotes long-term thinking.

Options are tough to value.
Aha! Unlike the previous three arguments, this one actually holds a bit of water. Options are indeed tricky to value, and employee stock options are even trickier because they can't be sold and they’re much more long-lived than exchange-traded options. Moreover, some options may never be exercised, and it's difficult to estimate what proportion of the total granted will expire worthless.

However, there are adjustments that one can make to the standard Black-Scholes option-pricing model that can account for the lack of liquidity and long duration of employee stock options. It's ugly, but it can be done--though the critics are correct that the result is an estimate rather than a precise value. That's not as much of a problem as the anti-expensers might have you think, though, because accounting is full of uncertain estimates (such as the useful life of a piece of machinery, to cite just one example). What's important is that these estimates should be applied the same way to all companies, to ensure the accounting principle of "comparability."

At the end of the day, just because something is difficult doesn't mean it's impossible--and as economist John Maynard Keynes famously said, “It is better to be approximately right than precisely wrong.” It’s clear to me that opponents of expensing options are precisely wrong, because options are a cost, and costs go on the income statement--even if only in an approximately right fashion.

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