A heated debate about whether tech firms should account for stock options as an expense is resulting in a classic Silicon Valley response: a willingness to think differently.
A handful of technology companies are heading in alternative directions when it comes to giving employees incentives to stay and perform well. Software giant Siebel Systems, for example, has replaced stock options with stock grants and cash. Chip firm Nvidia also has turned to actual stock. And online retail giant Amazon has agreed to expense stock-based grants beginning next year.
More and more tech firms may be thinking outside the options box soon. Critics argue that stock options are not the only or the best way to provide a carrot to employees, and political momentum for options accounting reform is growing. This month, for example, the U.S. accounting standards agency proposed quarterly and annual disclosure of the cost of stock options beginning as early as December. If companies are going to take a hit in their financial reports for stock options, incentive plans that have always involved an accounting expense may look more attractive. “Companies (that) are expensing options will use less of them,” says Dan Ryterband, managing director of executive compensation consulting firm Frederic W. Cook & Co. “The reason options were used with such abandon was that they were free. “
A stock option gives a person the ability to buy a share of stock at a set, or “strike,” price, typically the price of the stock on the day the option is granted. When given to employees, options usually “vest” become the property of the grantee gradually over a period of time spent at the company. Unlike actual stock grants or other equity giveaways, stock options do not have to be accounted for as expenses in a firm s profit and loss sheet. A company can instead tuck discussion of how options would have affected the balance sheet into a footnote in its annual report.
Because options are effectively “free,” they have been particularly attractive to cash-poor start-ups. They also tie into technology firms ethos of employee ownership. In addition, a variety of corporations have given large option grants to executives as a tool to “align” managers with shareholder interests.
Finance experts have argued back and forth for decades about whether to treat options as an expense on company balance sheets. But that relatively quiet debate has became a public firestorm over the past year in the wake of accounting scandals at firms such as Enron, WorldCom and Global Crossing. Critics have accused options of promoting deceitfulness and greed.
More broadly, the push for cleaner corporate books has included a call for expensing stock options. Wharton accounting professor David Larcker thinks such a requirement is long overdue. He was part of a task force in the 1990s looking into the issue for the Financial Accounting Standards Board, which sets guidelines for how companies report their financial results. His opinion on how to treat stock option grants didn t carry the day, but he hasn t budged. “It s clearly an asset transfer. It s clearly an expense,” he says. “You re giving away value from the company to the employee.”
Technology firms, though, beg to differ. They say accounting for options as an expense is itself misleading. For one thing, options generate cash for companies. That s because when employees exercise options, they pay the firm the strike price of the option. Another problem involves assessing the actual value of options. An option with a strike price of $5 would be worth $50 if the company s stock price rises to $55, but it would be worthless if the stock price slipped to $4. And regardless of the stock price change, an option is meaningless if the owner doesn t exercise it before its expiration date often 10 years from the time of the grant.
Firms already have a standard approach for calculating the worth of options. Called the Black-Scholes method, the model takes into account factors such as stock price, strike price, expiration date and the volatility of the stock s return. But the method is imperfect, suggests Wharton accounting professor John Core. “Figuring out how much these things cost is incredibly difficult,” he says.
The Black-Scholes model tends to inflate the value of options significantly, adds Intel spokesman Howard High. “You can t model these effectively.” Ryterband of Cook & Co. counters that corporations routinely make judgment calls in their accounting when handling the depreciation of buildings. To allow for more accurate valuations, he suggests creating options that expire in two or three years instead of 10.
As Ryterband sees it, tech firms and other corporations soon are going to have to change their option accounting practices whether they want to or not. “The snowball is moving very quickly downhill,” he says. “That momentum is in favor of expensing options.”
Earlier this year, Senators Carl Levin (D-Mich.) and John McCain (R-Ariz.) sponsored a bill to force companies to expense stock options. To McCain, not having to account for the expense of options was galling in light of the way corporations can use options as a tax deduction. Although the bill has been stymied, the movement to expense options has found additional support among institutional investors, accounting standards boards and some bellwether corporations. Pension and financial services provider TIAA-CREF has called for the expensing of options, as has the Council of Institutional Investors.
The U.S.-based Financial Accounting Standards Board calls expensing options the “preferable” method, and in early October proposed that all companies be required to disclose the cost of employee options on a quarterly and annual basis. The board declined to force companies to put this disclosure on the face of their income statements. But the proposal would require firms not expensing options in their profit and loss sheet to provide a table showing the effect on earnings if options were treated as a cost. The proposal also offers guidance for companies willing to expense options outright on their balance sheets.
The disclosure would be required in annual reports for fiscal years ending after Dec. 15, and in quarterly reports for quarters beginning after Dec. 15. A comment period regarding the proposal ends November 4, and the board intends to formalize a change in its accounting guidelines by the end of the year.
In addition, the International Accounting Standards Board, which is drawing up a set of global accounting standards, has proposed that option-based compensation be treated as an expense on the income statement.
Perhaps as important to the momentum for more disclosure is the fact that leading U.S. firms such as General Electric, General Motors and Coca-Cola have said they will account for options as an expense.
Tech firms, though, will take a bigger hit than other corporations if they expense options. A Merrill Lynch study on the effect of expensing options found that the technology sector would suffer a roughly 70% decrease in pro forma 2002 earnings, while the S&P 500 overall would record an earnings per share decline of just about 10%. Merrill Lynch concluded that tech giants Hewlett-Packard and Intel would see their forecast earnings in 2002 decline by 32% and 21%, respectively.
Tech firm officials warn that if forced to expense options, they won t be able to offer as many stock options to their workers. Intel, for example, grants stock options to all of its roughly 83,000 employees, with well over 90% of the grants going to rank and file workers. Intel has said it would likely reduce its option grant program with expensing. Company spokesman High said the effects of expensing include both the administrative costs of tracking the value of the options for so many employees and an impaired ability to raise capital, because the company s earnings per share would decline.
As an alternative to comprehensive options expensing, Intel CEO Craig Barrett has proposed that companies expense just the options given to the top five corporate officers. “That would in fact minimize abuse at the top but it would continue to allow companies to have a wide distribution of options to all of their employees without any expense,” Barrett has said.
Barrett s scheme makes little sense to Wharton s Larcker. He likens it to keeping track of the expense of pencils used by executives, but not the expense of pencils used by the rest of employees. Larcker also dismisses fears about declining earnings per share associated with expensing options. Company leaders should be focused less on earnings per share and more on improving the life-blood of any firm: cash flows. “If you cut back your stock option grants because of accounting, then obviously you ve got bigger problems,” he says.
Not all tech firms defend the current accounting of stock options. Amazon broke ranks in July when it announced that by the beginning of next year, all subsequent stock-based awards will be expensed. According to CNET News.com, Amazon CEO Jeff Bezos has said his company will continue to offer options, but also would consider other kinds of equity grants including restricted stock grants which are shares of stock subject to conditions, such as vesting over time and options with a stock price set at an average of Amazon s price over time rather than at a price on a given day.
Bezos framed the move to expense stock options in terms of flexibility. “This opens the door for other (compensation) options,” he told CNET.
Amazon may be the only major technology company to volunteer to expense options. But in recent months, other tech firms are showing a willingness to try new incentive approaches. Siebel Systems came up with a novel strategy to deal with so-called “underwater” options stock options whose strike price is above the current price of the stock. While some companies let employees get new options at a lower price, Siebel offered to swap its employees options priced at $40 or more for actual stock or, in some cases, cash.
With Siebel shares trading at less than $6, employees eagerly signed up for the deal. Roughly 88% of outstanding Siebel options were traded in by the Sept. 30 deadline. Siebel will cough up about $4,469,000 in cash, and give out 5.3 million shares of stock worth roughly $16,893,000. Although the new shares will be fully vested, Siebel placed restrictions on how quickly employees could sell half of them.
Graphics computer chip maker Nvidia has taken a similar step. In late September, it announced that employees with options with a strike price of $27 or more could swap them for fully vested shares of stock. For each option, Nvidia said it would give $3.20 worth of Nvida shares, which were trading for around $8.15 in early October.
Nvidia said it expects to take a charge of up to about $66 million in the October quarter related to the swap offer. The firm s CEO, CFO and board of directors are excluded from the deal.
The Nvidia and Siebel actions fit into a broader reassessment of options as a useful tool. A recent report in the New Yorker argued in favor of scrapping them altogether, and quoted former Federal Reserve chairman Paul Volcker as saying: “They are subject to abuse and temptation that s almost irrefutable.”
Even if options don t incite executives to commit fraud, they have drawbacks. Ryterband says CEOs with large option packages have an incentive to worry more about the firm s quarter-by-quarter performance with its impact on share price than on the longer-term strategy. What s more, he says, option grants can dilute shareholders wealth, don t reward employees for their performance relative to the overall market, and can spur turnover when underwater.
Ryterband suggests other incentive methods may provide more bang for the buck. One is a simple cash bonus tied to meeting operating performance goals, such as targets involving revenue, cash flow or market share. His other ideas include options that vest based on performance, actual shares based on performance and restricted shares that vest over time but whose vesting can be accelerated through employee performance.
Larcker mentions the prospect of premium priced options, where employees would get more options that come with a higher strike price and therefore have a strong incentive to push the stock to reach that price. He also notes the possibility of variably priced options. Also called indexed options, variably priced options would have a strike price that rises or falls depending on the broader market. Hence, employees would be rewarded for outperforming the market.
Wharton s Core says alternatives to traditional stock options aren t necessarily a panacea. He suggests that indexing options, for example, may provide a “perverse” incentive for managers to engage in overly risky behavior. Core sees no fundamental reason not to expense stock options. But he s wary of the drive to add another regulation to the U.S. economy, since it is bound to increase the cost of doing business especially for start-ups and tech firms. To him, smart investors have plenty of disclosure already about the impact of stock options and can solve option abuse problems on their own. “If you see somebody doing something bad, you either fix it or sell your stock and go elsewhere,” he says.
Larcker, on the other hand, hopes mandatory option expensing is coming down the pike. In any event, he adds, a silver lining to the options accounting debate is that more attention will be given to these matters, especially from corporate compensation committees. “You sort of sense that options were used too aggressively. (There will) at least be more scrutiny.”