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Author: ptbb Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 18386  
Subject: Today's report is full of errors Date: 2/17/2000 8:57 PM
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I'm quite disappointed to find that today's report, "Why Microsoft's Stock Options Scare Me", is full of factual errors and inflammatory and misleading statements. The Motley Fool is seen by many of us to be a reliable source for facts and very level-headed reason, and when I see an article as bogus as this one, I tend to wonder whether I've been mislead by "The Fool" in other areas where I have less intimate knowledge.

Though I'm not an accountant, I have been a Microsoft employee, and I'm compelled to at least begin to set the record straight.

Microsoft employees are compensated by the MSFT stock price in two ways. First, Microsoft issues company stock options to many employees. Additionally, Microsoft has an Employee Stock Purchase Program. Both programs are very simlar to programs at many other companies.

The Microsoft stock option program works just like any other company's stock option program. Microsoft periodically issues merit-based stock option grants to some employees. These grants have a standard multi-year vesting schedule. These options are issued at the current stock price, so exercising the options results in no value unless the stock price increases.

The Microsoft ESPP plan allows employees to automatically deposit up to 10% of their salary, taken after tax, into a special account. Every 6 months, the money in this account is used to but MSFT shares at a price equal to 85% of the lower of the stock price at the beginning of the 6 month period and the stock price at the end of the 6 month period. At best, this plan gives Microsoft employees an effective 6 month "advance" on 10% of their salaries, which they may use to buy stock at 85% of the market price. The maximum extra compensation obtained using this program is thus (100% - 85%) * 10% * SALARY, or approximately 1.5% of an employee's salary. Needless to say, while any "free money" is good, the Microsoft ESPP doesn't amount to much compensation.

Now I will respond to some of the specific inaccuracies in TMFOak's report:


A significant portion of the wages Microsoft pays to its employees comes in the form of stock options rather than in cash.


Since the price of MSFT has risen considerably over the last 14 years, for long-time employees, this is true enough.


These options give the employees the right to buy a certain number of shares of Microsoft stock at a tiny fraction of the current market price.


False. Microsoft employee options are issued at the market price. ESPP shares are purchased at 85% of the market price, but I'd hardly call this a "tiny fraction".

Employees can even take an automatic payroll deduction to make the token payment to exercise each stock option as it matures, and thus effectively get shares of Microsoft stock as part of their wages.


Not true for options. Microsoft ESPP contributions can be deducted automagically, but this has nothing to do with the option program.


Corporations pay taxes on their own income (generally 35%), but money they pay out in salaries to employees is deductible from the corporation's income. Since granting options to employees results in taxable income to those employees, Microsoft gets to deduct that taxable employee income from its own taxable corporate income, and that's where Microsoft got a tax-free $3.1 billion in cash in fiscal 1999: "Stock option income tax benefits."


"Granting options to employees" does not result in taxable income for employees and a tax deduction for Microsoft. Microsoft gets a tax deduction when an employee exercises an option because Microsoft must then PAY to the employee the difference between the MSFT stock price and the option strike price. This money comes out of the Microsoft coffers.


But if you stop and think about it, Microsoft didn't really have to spend actual money to provide the options.


This is simply wrong. Microsoft spends actual money to the employee, as described above. This money is then tax-deductable for Microsoft.


It even GOT a little money from its employees, in the form of the cash the employees paid (via payroll deductions) to exercise their options.


Wrong. Do some math and you'll find that $3.1 billion number is waaay too big to have come from the Microsoft ESPP plan (by a factor of 100), so we must be talking about the employee option program.

Microsoft does not get additional money from employees when the employees exercise options. The strike price of the options (the price an employee must "pay" to exercise the option) is included in the amount of the tax deduction that Microsoft claims. You can't add it in twice...

Also, no payroll deduction is made for the employee option program. Payroll deductions are only used for the ESPP plan, but that's not where this $3.1 billion number comes from.


All Microsoft had to do was issue new stock certificates, which more or less involves taking a vote in a board meeting and then firing up a laser printer.


All publicly traded companies "mint" new shares in this way. After all, shares which are publicly traded have to have come from somewhere. Companies may (and do) routinely issue new shares in primary and secondary offerings, to do acquisitions, for employee compensation... The annual report states that in 1999 Microsoft issued $1.35 billion worth of new shares. This means that last year Microsoft diluted shareholders by about 0.26%. I think that if you investigate other companies -- especially high-tech companies -- you'll find that this is a very low rate of dilution. Couple this with Microsoft's repurchase of $2.95 billion in stock and I'd argue that the net result on investors has been an increase in share value.


So Microsoft got $3.1 billion of tax money back from the government, which at a 35% tax rate would be in exchange for a $9 billion tax expense it never had to pay.


Again, this statement is inflammatory and incorrect. The employee gets the money from Microsoft. The only thing in this transaction which is different from one individual paying another is that Microsoft has the option to sell new shares to cover its costs. As I said before, neither issuing new shares nor the rate that Microsoft issues them is unusual.

It even got $1.3 billion of cash BACK from its employees in that payroll deduction to exercise the options (the "Common stock issued" line item, in the same Financing table as the "Stock option income tax benefits"). Together, that's almost $4.5 billion dollars Microsoft made directly from selling stock.


False. Microsoft made only $1.35 billion from the issuance of new stock, not $4.5 billion. The $1.35 billion was obtained on the open stock market, not "from its employees", and there is no "payroll deduction to exercise options".

Microsoft obtained a $3.1 billion tax savings from compensating employees -- an actual cost of $9 billion. There was no additional stock issued relating to this deduction.

There is no reason to believe that Microsoft's issuance of new stock has anything to do with Microsoft employees, the option program, or the ESPP plan.


This is on top of a huge cash savings from substituting shares of its stock for actual cash paid to employees in the first place. Remember, Microsoft only made a $7.8 billion net profit last year. To pay its employees an extra $9 billion in cash compensation expense, it would go $1.2 billion into the red.


Wrong. Microsoft _did_ pay employees enough to get a $3.1 billion deduction, approximately $9 billion by your math. This number was included in the $7.8 billion net profit. In other words, without the stock option plan, Microsoft would have had a $13.7 billion net profit (7.8 + 9 (for not paying employees) - 3.1 (for not getting the tax deduction).

But it doesn't have to, as the stock market provides the money to keep Microsoft going. Microsoft prints stock, pays its employees with the stock, and the stock market provides the cash for Microsoft's employees when they sell the stock or get margin loans against it. Microsoft can print as much stock as it likes in order to pay its employees, and as long as the market keeps wanting to buy shares from those employees, then Microsoft doesn't have to spend too much of its own cash to pay its people.


Again, this paranoia is unfounded. As the annual report states, Microsoft issued $1.3 billion, or 0.26% worth of new shares in 1999. Considering that something like $9 billion of options were exercised in that year and $2.95 billion of stock was repurchased, it doesn't sound to me like Microsoft is issuing new stock to pay its employees...


Of course printing more stock dilutes the value of Microsoft's existing shares
(... paranoid rant deleted...) And of course Microsoft can buy back some of its shares -- $3 billion in 1999 ("Common stock repurchased" in the same Financing table as before) -- but since it issued over $10 billion worth of shares ($9 billion taxable income over and above the $1.3 billion the employees paid for it), this buyback is a mitigating factor at best.

Factually incorrect. Microsoft issued $1.3 billion worth of shares. The $9 billion SPENT has nothing to do with issuing new shares.


So there you have it. $3.1 billion from a tax loophole, $1.3 billion from its employees, and $0.7 billion from put warrants combine to give Microsoft over $5 billion from its own stock in fiscal 1999. And it avoided paying $9 billion in wages.


Factually incorrect. $3.1 billion in tax savings from $9 billion in employee compensation SPENT. $1.3 billion from "minting" new shares. $0.7 billion from selling options on the open market. Nowhere does Microsoft "get $5 billion from its own stock" and nowhere does Microsoft "avoid paying $9 billion in wages".

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