We would point out that this reasoning validates our earlier point that options are a substitute for cash. Financial statements reflect the economic perspective of the company, not the entities including employees with which it transacts. When a company sells a product to a customer, for example, it does not have to verify what the product is worth to that individual. It counts the expected cash payment in the transaction as its revenue. The company records the purchase price as the cash or cash equivalent it sacrificed to acquire the good or service. Suppose a clothing manufacturer were to build a fitness center for its employees.
The company would not do so to compete with fitness clubs.
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It would build the center to generate higher revenues from increased productivity and creativity of healthier, happier employees and to reduce costs arising from employee turnover and illness. The cost to the company is clearly the cost of building and maintaining the facility, not the value that the individual employees might place on it. The cost of the fitness center is recorded as a periodic expense, loosely matched to the expected revenue increase and reductions in employee-related costs.
While we agree with the basic logic of this argument, the impact of forfeiture and early exercise on theoretical values may be grossly exaggerated. Unlike cash salary, stock options cannot be transferred from the individual granted them to anyone else.
Nontransferability has two effects that combine to make employee options less valuable than conventional options traded in the market. First, employees forfeit their options if they leave the company before the options have vested. Second, employees tend to reduce their risk by exercising vested stock options much earlier than a well-diversified investor would, thereby reducing the potential for a much higher payoff had they held the options to maturity.
Employees with vested options that are in the money will also exercise them when they quit, since most companies require employees to use or lose their options upon departure.
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Recognizing the increasing probability that companies will be required to expense stock options, some opponents are fighting a rearguard action by trying to persuade standard setters to significantly reduce the reported cost of those options, discounting their value from that measured by financial models to reflect the strong likelihood of forfeiture and early exercise. Current proposals put forth by these people to FASB and IASB would allow companies to estimate the percentage of options forfeited during the vesting period and reduce the cost of option grants by this amount.
Also, rather than use the expiration date for the option life in an option-pricing model, the proposals seek to allow companies to use an expected life for the option to reflect the likelihood of early exercise. Using an expected life which companies may estimate at close to the vesting period, say, four years instead of the contractual period of, say, ten years, would significantly reduce the estimated cost of the option.
Some adjustment should be made for forfeiture and early exercise. But the proposed method significantly overstates the cost reduction since it neglects the circumstances under which options are most likely to be forfeited or exercised early. When these circumstances are taken into account, the reduction in employee option costs is likely to be much smaller. First, consider forfeiture. Using a flat percentage for forfeitures based on historical or prospective employee turnover is valid only if forfeiture is a random event, like a lottery, independent of the stock price.
In reality, however, the likelihood of forfeiture is negatively related to the value of the options forfeited and, hence, to the stock price itself. People are more likely to leave a company and forfeit options when the stock price has declined and the options are worth little. But if the firm has done well and the stock price has increased significantly since grant date, the options will have become much more valuable, and employees will be much less likely to leave. The argument for early exercise is similar.
It also depends on the future stock price. Senior executives, however, with the largest option holdings, are unlikely to exercise early and destroy option value when the stock price has risen substantially. Often they own unrestricted stock, which they can sell as a more efficient means to reduce their risk exposure. Or they have enough at stake to contract with an investment bank to hedge their option positions without exercising prematurely. As with the forfeiture feature, the calculation of an expected option life without regard to the magnitude of the holdings of employees who exercise early, or to their ability to hedge their risk through other means, would significantly underestimate the cost of options granted.
The adjustments, properly assessed, could turn out to be significantly smaller than the proposed calculations apparently endorsed by FASB and IASB would produce. Another argument in defense of the existing approach is that companies already disclose information about the cost of option grants in the footnotes to the financial statements. Investors and analysts who wish to adjust income statements for the cost of options, therefore, have the necessary data readily available.
We find that argument hard to swallow. Relegating an item of such major economic significance as employee option grants to the footnotes would systematically distort those reports. But even if we were to accept the principle that footnote disclosure is sufficient, in reality we would find it a poor substitute for recognizing the expense directly on the primary statements. An analyst following an individual company, or even a small group of companies, could make adjustments for information disclosed in footnotes. But that would be difficult and costly to do for a large group of companies that had put different sorts of data in various nonstandard formats into footnotes.
Clearly, it is much easier to compare companies on a level playing field, where all compensation expenses have been incorporated into the income numbers. For one thing, executives and auditors typically review supplementary footnotes last and devote less time to them than they do to the numbers in the primary statements. But surely recognizing the cost of options in the income statement does not preclude continuing to provide a footnote that explains the underlying distribution of grants and the methodology and parameter inputs used to calculate the cost of the stock options.
The result would be inaccurate and misleading earnings per share. We have several difficulties with this argument.
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First, option costs only enter into a GAAP-based diluted earnings-per-share calculation when the current market price exceeds the option exercise price. Thus, fully diluted EPS numbers still ignore all the costs of options that are nearly in the money or could become in the money if the stock price increased significantly in the near term. Second, relegating the determination of the economic impact of stock option grants solely to an EPS calculation greatly distorts the measurement of reported income, would not be adjusted to reflect the economic impact of option costs.
These measures are more significant summaries of the change in economic value of a company than the prorated distribution of this income to individual shareholders revealed in the EPS measure. This becomes eminently clear when taken to its logical absurdity: Suppose companies were to compensate all their suppliers—of materials, labor, energy, and purchased services—with stock options rather than with cash and avoid all expense recognition in their income statement.
Their income and their profitability measures would all be so grossly inflated as to be useless for analytic purposes; only the EPS number would pick up any economic effect from the option grants. Our biggest objection to this spurious claim, however, is that even a calculation of fully diluted EPS does not fully reflect the economic impact of stock option grants. The following hypothetical example illustrates the problems, though for purposes of simplicity we will use grants of shares instead of options.
The reasoning is exactly the same for both cases. But their net income and EPS numbers are very different. Of course, the two companies now have different cash balances and numbers of shares outstanding with a claim on them. Under current accounting rules, however, this transaction only exacerbates the gap between the EPS numbers. The people claiming that options expensing creates a double-counting problem are themselves creating a smoke screen to hide the income-distorting effects of stock option grants. Indeed, if we say that the fully diluted EPS figure is the right way to disclose the impact of share options, then we should immediately change the current accounting rules for situations when companies issue common stock, convertible preferred stock, or convertible bonds to pay for services or assets.
At present, when these transactions occur, the cost is measured by the fair market value of the consideration involved.
Why should options be treated differently? Opponents of expensing options also claim that doing so will be a hardship for entrepreneurial high-tech firms that do not have the cash to attract and retain the engineers and executives who translate entrepreneurial ideas into profitable, long-term growth. This argument is flawed on a number of levels.
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For a start, the people who claim that option expensing will harm entrepreneurial incentives are often the same people who claim that current disclosure is adequate for communicating the economics of stock option grants. The two positions are clearly contradictory.
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If current disclosure is sufficient, then moving the cost from a footnote to the balance sheet and income statement will have no market effect. More seriously, however, the claim simply ignores the fact that a lack of cash need not be a barrier to compensating executives. Rather than issuing options directly to employees, companies can always issue them to underwriters and then pay their employees out of the money received for those options.
Considering that the market systematically puts a higher value on options than employees do, companies are likely to end up with more cash from the sale of externally issued options which carry with them no deadweight costs than they would by granting options to employees in lieu of higher salaries. Even privately held companies that raise funds through angel and venture capital investors can take this approach. The same procedures used to place a value on a privately held company can be used to estimate the value of its options, enabling external investors to provide cash for options about as readily as they provide cash for stock.
But that does not preclude also raising cash by selling options externally to pay a large part of the cash compensation to employees. We certainly recognize the vitality and wealth that entrepreneurial ventures, particularly those in the high-tech sector, bring to the U. A strong case can be made for creating public policies that actively assist these companies in their early stages, or even in their more established stages.
The nation should definitely consider a regulation that makes entrepreneurial, job-creating companies healthier and more competitive by changing something as simple as an accounting journal entry. After all, some entrepreneurial, job-creating companies might benefit from picking other forms of incentive compensation that arguably do a better job of aligning executive and shareholder interests than conventional stock options do. Indexed or performance options, for example, ensure that management is not rewarded just for being in the right place at the right time or penalized just for being in the wrong place at the wrong time.
A strong case can also be made for the superiority of properly designed restricted stock grants and deferred cash payments.