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The below estimates were made using Cisco annual reports to get information on issued options. The "Statement of Shareholders' Equity" was used to determine the number of new shares issued, which are presumed to be due to options being exercised. The Paid-in Capital entry next to each of those is assumed to reflect the strike price being paid to cisco for those options.

The value of the options issued is estimated by taking the Cisco stock price in the midyear, in particular at February of each year as the estimate of the price of the stock when the shares are issued.

Then from this analysis we find:

Between July 1997 and July 2003, Cisco employees exercised options on about a Billion shares of Cisco. This is one billion shares of Cisco stock put into the market that did not exist before July 1997.

In return for issuing these Billion shares, Cisco the company collected $5.6 Billion in strike prices.

The market value of these options as they were issued was about $30 Billion. So the options grantees of Cisco netted $24 Billion from exercising options.

At July 2003 (most recent annual report,) Cisco claims a total net worth of $28 billion, of which $21 billion is due to paid-in capital and $6.6 billion is due to earnings retained over the life of the company.

In Summary we have:

Earnings retained by Cisco over its lifetime:
$6.6 Billion
Paid-in Capital acquired by Cisco for all issued stock:
$21.0 Billion
Net Value transferred to Cisco employees by options exercises:
$24 Billion
"Expense" booked by Cisco for paying its employees with options:
$0 Billion

Cisco employees netted more from Cisco issuing stock to honor options grants than Cisco itself has cumulatively collected for issuing all the Cisco Stock it has ever issued.

Cisco employees have received from Cisco 4 X as much as has been retained for stockholders in Retained Earnings over the lifetime of Cisco. This is not even including the employees salaries and cash bonuses, it just considers the value they netted from exercising stock options.

The expenses Cisco has booked associated with this $24 Billion in payments to its employees has been $0.

R:
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No. of Recommendations: 4
The expenses Cisco has booked associated with this $24 Billion in payments to its employees has been $0.


that is because, quite literally, it didn't cost Cisco a penny.

Sorry, I've looked and looked at the claim that this kind of compensation should be expensed and I simply don't see it.

Imagine you are standing on the street and you ask someone to work for you for a dollar a year, plus give them the option to buy a share of stock from you a year later for a price y'all agree to now, another dollar. A year later he decides to buy the stock for the dollar from you. That dollar goes into your pocket, then back to him for his yearly pay. He takes that share of stock and turns around and shouts on the street: "Hey, how much you wanna give me for this share of this stock?" And, some bozo walks up and says, "I'll give you 10 bucks for it." And, that transaction occurs. The employee is $10 richer for the year, and you are not a penny poorer.

That is, with different numbers, exactly what is going on with stock options. Where is the cost to the company... in the management of the system, yeah, but that *is* accounted for in the expense column...

It seriously doesn't matter what the company *could* have gotten for that share of stock. And, it ain't like the company didn't get anything. The company got a loyal employee who, presumably, put more of his creativity into his job than simple requirements because of this outstanding deal that was coming up. The company, therefore, gained in value, added to marketshare, and otherwise improved due to this employee's dedicated work. Heck, the company arguably was able to get better employees than the usual worker drone because it offered this kind of package.

And, the dilution arguments don't impress me either. It isn't like the shares are being issued without money coming into the company. The book value is increasing due to the issuance of the shares. No, not as much as if the shares had been issued on the open market. But, it is increasing. And, it ain't like the investors (folks like me) are unaware that the company does this options gig. If we aren't paying attention to what it means in terms of total value of the company being spread over more shares (therefore suppressing potential share price) then we are the fools.

Paul
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Imagine you are standing on the street and you ask someone to work for you for a dollar a year, plus give them the option to buy a share of stock from you a year later for a price y'all agree to now, another dollar. A year later he decides to buy the stock for the dollar from you. That dollar goes into your pocket, then back to him for his yearly pay. He takes that share of stock and turns around and shouts on the street: "Hey, how much you wanna give me for this share of this stock?" And, some bozo walks up and says, "I'll give you 10 bucks for it." And, that transaction occurs. The employee is $10 richer for the year, and you are not a penny poorer.

In order for you to sell the stock for $1 to your employee, don't you first have to buy it from someone on the street, for say 10$? In that case, you spend $10 to get the stock and get $1 back from your employee resulting in a loss of $9. And the employee is then free to sell it back on the street for a personal profit of $9.
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In order for you to sell the stock for $1 to your employee, don't you first have to buy it from someone on the street, for say 10$? In that case, you spend $10 to get the stock and get $1 back from your employee resulting in a loss of $9. And the employee is then free to sell it back on the street for a personal profit of $9.

Nope, the company issues stock just like the Fed prints money. Literally, they declare the shares to exist and to be available for sale. The stock is not bought off the open market but is bought directly from the company from a 'pile of certificates' that are 'sitting on a table,' reserved exclusively for employees to buy on option. Indeed, you see scattered through company reports and sometimes voted on by the stockholders that the company wants to issue a certain number of shares for the purposes of employee compensation.

Seriously, the company does *not* have to buy the stock on the open market unless they plan poorly and don't have enough certificates legally available (very very unlikely).

Paul
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Nope, the company issues stock just like the Fed prints money. Literally, they declare the shares to exist and to be available for sale. The stock is not bought off the open market but is bought directly from the company from a 'pile of certificates' that are 'sitting on a table,' reserved exclusively for employees to buy on option.

Seriously, the company does *not* have to buy the stock on the open market unless they plan poorly and don't have enough certificates legally available (very very unlikely).



I disagree.

From CSCO's latest 10k (filed September 2003):
During fiscal 2003, we repurchased and retired 424 million shares of our common stock for an aggregate purchase price of $6.0 billion.

In the same 10k, Cisco reported that shares outstanding decreased from 7,301 million to 7,124 million in 2003, a decrease of 177 million shares. Ergo, excluding the repurchase, the number of shares outstanding would have increased by 247 million. Cisco repurchased those shares off the open market at a cost of $3.50 billion to compensate for dilution due to options.

Per remaining share outstanding this is a cost to shareholders of 49 cents. How is this not a compensation expense?

Calpinist
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In the same 10k, Cisco reported that shares outstanding decreased from 7,301 million to 7,124 million in 2003, a decrease of 177 million shares. Ergo, excluding the repurchase, the number of shares outstanding would have increased by 247 million. Cisco repurchased those shares off the open market at a cost of $3.50 billion to compensate for dilution due to options.

Per remaining share outstanding this is a cost to shareholders of 49 cents. How is this not a compensation expense?


The costs are being accounted for in their proper place, in the repurchase of shares. That is an independent act of a company that may be done regardless of options status. Companies repurchase stock shares all the time, even those that have no options programs. Shouldn't the cost of repurchase of shares be accounted for in the same place across companies? The stock is not literally being offered for an options price later on. They are separate transactions and accounted for separately.

Paul
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No. of Recommendations: 4
The expenses Cisco has booked associated with this $24 Billion in payments to its employees has been $0.


that is because, quite literally, it didn't cost Cisco a penny.


If Cisco had given bonuses of stock sold to employees at 75% discount to current market prices, would you consider that not costing Cisco a penny? After all the stock costs Cisco as much to "create" as does the option on the Cisco stocks that they DID give away.

If your answer is yes, giving away stock at below market prices DOES NOT cost Cisco anything, then you are at odds with basic accounting principles that even the high tech wizards of Silicon Valley obey.

If your answer is no, giving away stock below market price does somehow cost cisco something, then three observations:
1) The options were given away at below market prices. 2.5 year options typically cost 15-25% of face value of stock when traded on markets. These were 10 year options, probably worth 25%-75% of face value of stock optioned if cisco tried to buy them or sell them.
2) These options which "cost Cisco nothing" wound up OBLIGATING Cisco to sell stock at an average 75% discount. If Cisco had sold the same stock at the same time on the markets instead of to its employees, Cisco would have been $24 billion richer
3) Those options which "cost Cisco nothing" have motivated Cisco to spend ~$8 BILLION to soak up HALF the dilution in stock those options caused.

Looking at items 2 and 3, it is difficult to come up with a cost lower than $10 billion (or higher than $24 billion) to describe what those options ACTUALLY cost Cisco. The $10 billion is prorated from net $s actually out the door in buybacks, but credited with the strike-prices Cisco did collect when options were exercised. The $24 billion is by far the more reasonable number based on "opportunity cost," the exact same time-series of stock issues, sold by CISCO to the market, would have left Cisco $24 billion richer today than it is.

*****

For something which "didn't cost Cisco a penny," there are an awful lot of BILLIONS of $s (amusingly, nearly a TRILLION pennies so far) spent on buybacks to undo dilution from these free options.

R:
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Imagine you are standing on the street and you ask someone to work for you for a dollar a year, plus give them the option to buy a share of stock from you a year later for a price y'all agree to now, another dollar. A year later he decides to buy the stock for the dollar from you. That dollar goes into your pocket, then back to him for his yearly pay. He takes that share of stock and turns around and shouts on the street: "Hey, how much you wanna give me for this share of this stock?" And, some bozo walks up and says, "I'll give you 10 bucks for it." And, that transaction occurs. The employee is $10 richer for the year, and you are not a penny poorer.

You are not a penny poorer compared to what? Compared to if you had sold the stock yourself and given the $10 cash directly to the employee.

Now if you sell stock to raise cash to run a business and then use the cash to pay the employee, how much did you pay the employee? $10.

But if you instead give the stock to the employee, and HE sells it for $10, you have paid the employee nothing? He worked for you for free? And yet he winds up with $10 in his pocket he wouldn't have if he hadn't worked for you?

This is PRECISELY the kind of logic behind most stock scams: take money from later investors buying the stock and book it as "earnings" instead of paid-in capital. Makes the company look profitable, encouraging new investors to pay more for the stock so you can take THEIR money, book it as earnings instead of paid-in capital, and attract still MORE investors....

And so on and so on until the bubble bursts. Which is what happened.

R:
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In order for you to sell the stock for $1 to your employee, don't you first have to buy it from someone on the street, for say 10$? In that case, you spend $10 to get the stock and get $1 back from your employee resulting in a loss of $9. And the employee is then free to sell it back on the street for a personal profit of $9.

You either buy it on the street for $10, or you "buy" it from the existing shareholders by having them authorize you to give perfectly good $10 shares away at a deep discount while giving them nothing.

"Fair Value" accounting means you have to book what someone on the street would sell you the thing for before you give it to your employee. This is PRECISELY what FASB is asking for, and what Cisco and other high tech companies are asking their congress critters to pass a law AGAINST.

R:
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Per remaining share outstanding this is a cost to shareholders of 49 cents. How is this not a compensation expense?

Calpinist


Per act of congress if Cisco and other high techs get their way. Warren Buffett equates it to legislatively declaring Pi=3.2 to simplify calculations. See
http://www.washingtonpost.com/wp-dyn/articles/A29807-2004Jul5.html which requires a free registration to see in its entirety. Excerpt:
Until now the record for mathematical lunacy by a legislative body has been held by the Indiana House of Representatives, which in 1897 decreed by a vote of 67 to 0 that pi -- the ratio of the circumference of a circle to its diameter -- would no longer be 3.14159 but instead be 3.2. Indiana schoolchildren momentarily rejoiced over this simplification of their lives. But the Indiana Senate, composed of cooler heads, referred the bill to the Committee for Temperance, and it eventually died.

R:
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Thanks Ralph, I enjoyed reading the washingtonpost article by Warren Buffett. I was not aware that this bill was being considered by the house of representatives:

"What brings this episode to mind is that the U.S. House of Representatives is about to consider a bill that, if passed, could cause the mathematical lunacy record to move east from Indiana. First, the bill decrees that a coveted form of corporate pay -- stock options -- be counted as an expense when these go to the chief executive and the other four highest-paid officers in a company, but be disregarded as an expense when they are issued to other employees in the company. Second, the bill says that when a company is calculating the expense of the options issued to the mighty five, it shall assume that stock prices never fluctuate."

LOL. Only count the options given to the top 5 executives of a corporation and then decide that volatility is equal to zero. If vloatility is equal to zero then the value of the option would also be equal to zero, or close to zero... I figured that imaginative minds would find a way to "account" or "expense" options in a way beneficial to corporate america, but this solution is amazing!!!!

Three Cheers for Congress!

JTT
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"In order for you to sell the stock for $1 to your employee, don't you first have to buy it from someone on the street, for say 10$? In that case, you spend $10 to get the stock and get $1 back from your employee resulting in a loss of $9. And the employee is then free to sell it back on the street for a personal profit of $9. tennjed33"

NO! You use "authorized but unissued" shares-----"treasury" held shares. If a Corp. "runs-out" of these shares-----they just ask the shareholders to "authorize more shares"!!!! Happens all the time. crpurdum
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JTT,

LOL. Only count the options given to the top 5 executives of a corporation and then decide that volatility is equal to zero. If vloatility is equal to zero then the value of the option would also be equal to zero, or close to zero... I figured that imaginative minds would find a way to "account" or "expense" options in a way beneficial to corporate america, but this solution is amazing!!!!

I agree that the stated provision does not pass the snicker test, but it's likely to get amended when it goes to committee.

Actually, there is one situation in which stock options should constitute an expense. If the price to exercise the option is less than the fair market value of the shares as of the date of grant, the company should report an expense equal to the difference. By way of illustration, a company that grants an executive options to buy 500 shares of stock at $10.00 per share when the value of the stock is $15.00 per share should report an expense of 500x($15.00-$10.00)=$2500 on the grant of those options and the employee realizes paper income in the same amount.

There are at least four significant reasons why reporting expenses for employee stock options based upon a value obtained by the Black-Scholes Formula or some other method of prediction are not a good idea.

>> 1. Any attempt to assign a value to stock options based upon prediction of future value is necessarily speculative and thus an opportunity for (1) actual manipulation of the company's books by corrupt executives and (2) expensive lawsuits over allegations of such manipulation of the company's books -- both of which would cause real harm to investors.

>> 2. The Black-Sholes Formula, developed to estimate the value of derivative options, depends upon a critical assumptions that the stock options (1) are immediately exercisable, (2) have a short term (expiration typically within two years), (3) are marketable entities, and (4) carry no risk of forfeiture. Employee stock options rarely meet either of these assumptions because they typically have vesting periods, much longer lifetimes (often expiring as long as ten years after the dae of grant), absolute restrictions on transfer other than by inheritance upon the event of the death of the holder, and provisions for forfeiture upon termination of employment for any reason other than the death of the employee. This violation of assumptions invalidates the Black-Scholes Formula for valuation of employee stock options.

>> 3. The most common way of predicting a company's future growth is to extrapolate from recent history on the assumption that what the company is doing will continue to produce the same result. Such extrapolation obviously predicts very high gains, generating a relatively large "expense" for stock options, during periods of high growth and small gains, generating a relatively small "expense" for stock options during periods of slow growth. The consequent fluctuation in the "expense" reported for stock options would mask the real trends in profitability of the company. The alternative method to predict growth would compare present orders backlog for future deliveries with present sales, but very few companies have an order cycle that's long enough for future orders to be a meaningful indicator over the life of employee stock options.

>> 4. The reporting of an "expense" for employee stock options also would create other complications in the company's financial reports. By way of example, the company would have to realize "income" for stock options forfeited as a result of either expiration or termination of employment of the holder. Additionally, the company would have to make offsetting entries in its statement of cash flows to offset the "expense" and the "income" from stock options in order to balance its cash accounts since no cash actually changes hands in these events.

The present method of reporting both actual and "fully diluted" earnings per share is a much more reliable indicator of the real impact of stock options on the company's finances. Here, the "fully diluted" figure assumes exercise of all outstanding stock options and thus shows the maximum dilution of earnings that can occur due to the stock plan.

Norm.
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Norm,

Thanks for a thoughtful and meaty response on this issue. May I challenge it on every single point?

There are at least four significant reasons why reporting expenses for employee stock options based upon a value obtained by the Black-Scholes Formula or some other method of prediction are not a good idea.

The Black-Scholes Formula is only ONE option available to management to determine "fair-value." A very good alternative to determine "fair-value" is... go to your investment bankers and see who will sell you options for granting at the best terms. Create a market in the options being granted to employees. "Securitize" the asset being marketed.

It is currently the case that RESIDENTIAL MORTGAGES are securitized. These mortgages have the problems of 1) all are "callable" at the mortgagee's option. Mortgages CAN be paid off early. What a tremdous monkey wrench that throws into the machinery of valuing these mortgages. Yet Freddie Mac manages to securitize mortgages many billions of $ a year.

Someone might try to claim that noone would create a market to securitize the value of restricted 10 year options. I don't find that plausible at all. People trade derivatives, derivatives on derivatives, and no doubt derivatives on derivatives of derivatives. You can buy and sell options or puts on interest rate futures (I think).

So what do you think it would cost someone to take the risk of holding a 10 year option at the money? I think it would cost a very significant fraction of the price of the stock. The most straightforward way to hedge the risk on that option would be to buy the stock up front to cover your payout on the options. Then your scenarios are: 1) The stock goes up in price, all options get exercised, you break about even, 2) The stock goes down in price all options expire worthless, you lose money on the original stock investment, 3) the stock goes up in price, you make a little money on the unvested options that are in the money when employees change jobs.

Meanwhile, not only do you have to put the money out to buy the stock to hedge this 10 year option you are selling, but you are going to need to charge your 10 year cost of cash. 5% interest anyone? 5% for 10 years is 63% compounded interest. A rational seller of the option when 10 year money costs 5%/yr will need to charge 63% of face value of option just to cover his hedge. Increase that for the risk the stock goes down over 10 years. Reduce it for the dribs and drabs o in-the-money unvested options that die on the table as people leave employment.

Think about it that way. What would YOU charge to carry that risk?

The reason that large companies don't go to their investment bankers to find out how much their options cost is going to be because Black-Scholes gives them an answer they like better, a LOWER answer than the investment bankers would give them.

SUMMARY OF THIS POINT: If companies don't like Black-Scholes valuations, they can ask their investment banker to buy the risk from them. Get four investment bankers bidding against each other and you will wind up with a TRULY "Fair Market Value." Black-Scholes is offered as an OUT for companies that are AFRAID that the options are worth more than Black-Scholes predicts.

1. Any attempt to assign a value to stock options based upon prediction of future value is necessarily speculative and thus an opportunity for (1) actual manipulation of the company's books by corrupt executives and (2) expensive lawsuits over allegations of such manipulation of the company's books -- both of which would cause real harm to investors.

Which is more accurate, assuming that 10 year options are worth $0, when 2 year options trade for from 15% to 50% of current stock values (check yourself! All published daily), or to assume that if the companies thought the Market would give them an answer they liked better than Black-Scholes that they would be there in a Wall Street minute?

If you want real harm to investors, how about fobbing off as Earnings from a Business what are actually "Earnings" from pretending the "dollar bills" you pay your employees with are really worth $0? Suppose the earnings thus reported made even more investors think "Ka-zart, LOOK at that earnings growth, I've GOT to get in on this stock," which of course raises the COST of the granted options, which of course makes them look great to pay employees with, which, and we are circling back now, do not get booked as costs? Google Ponzi for more on this topic.

SUMMARY OF THIS POINT: When you are allowed to pay your employees without expensing that pay, you wind up booking as "Earnings" what should really be booked as "Paid-In Capital." Since the purpose of buying stock is to buy future earnings of the BUSINESS, the stock price is bid up, which creates a vicious circle as increasing stock prices increase the COST and VALUE of the options you pay your employees with, which causes your overstatement of "Earnings" to be even more extreme. You could wind up with a stock price bubble from this practice, which, remarkably, is PRECISELY what happened.

>> 2. The Black-Sholes Formula, developed to estimate the value of derivative options, depends upon a critical assumptions that the stock options (1) are immediately exercisable, (2) have a short term (expiration typically within two years), (3) are marketable entities, and (4) carry no risk of forfeiture. Employee stock options rarely meet either of these assumptions because they typically have vesting periods, much longer lifetimes (often expiring as long as ten years after the dae of grant), absolute restrictions on transfer other than by inheritance upon the event of the death of the holder, and provisions for forfeiture upon termination of employment for any reason other than the death of the employee. This violation of assumptions invalidates the Black-Scholes Formula for valuation of employee stock options.

I'll dispose of (3) first. If corporations chose to, they could securitize their options exposure and the securities could trade. These ARE marketable entities which the corporations CHOOSE not to market. Black-Scholes allows them an out from ACTUALLY marketing them to establish "fair value." Marketing them is always an, uhm, "option."

Let me whack at (1) and (4) collectively. Restrictions on options should LOWER their cost since windows for exercising them are NOT as open as Black-Scholes assumes, no? If this were signficant, the company could create a securitized instrument to cover their options exposure and PROVE the market provided a discount from Black-Scholes. HOWEVER, mostly restrictions are asymmetric, reducing the value of the option to the option holder, but not reducing the cost of the option to the grantor by that much. I'm just claiming that without justifying it, but the main point is whenEVER the company thinks it can do better than Black-Scholes, it has that option.

Whacking at (1), for a rising stock, and no one values options much on stocks that are falling, the value of the later exercise is the vast bulk of the value in the option. There is no GOOD reason to exercise an option unless you are going to sell the underlying security, or unless it is expiring. You just increase your costs by putting your money in the investment, without increasing your benefit. So (1) is not likely going to have much impact on Black-Scholes.

For (4), this is largely spurious given the way options are expensed. The VALUE of the options is determined at grant. The expense is booked as the option VESTS. As such, UNVESTED options are NOT expensed under "Fair Value."

SUMMARY: Black-Scholes is available for the company who does not believe it can get a better "Fair Market" value by actually going to the market. As such, it is an invalid complaint that it overstates the value of options. If this were ACTUALLY true, the company could fix the problem immediately with a few phone calls to their investment bankers to create the market.

>> 3. The most common way of predicting a company's future growth is to extrapolate from recent history on the assumption that what the company is doing will continue to produce the same result. Such extrapolation obviously predicts very high gains, generating a relatively large "expense" for stock options, during periods of high growth and small gains, generating a relatively small "expense" for stock options during periods of slow growth. The consequent fluctuation in the "expense" reported for stock options would mask the real trends in profitability of the company. The alternative method to predict growth would compare present orders backlog for future deliveries with present sales, but very few companies have an order cycle that's long enough for future orders to be a meaningful indicator over the life of employee stock options.

Again, if you were right, the market would value options at recently-raised stock prices at a LOWER premium than when stock prices are lower. An examination of actualy options markets will show this is NOT what the market does. When stock prices rise, options prices rise, too. But anyway, be that true or be that fiction, the option to securitize options grants is always there. The company could test any of these hypotheses about "true" value of options any time it wished.

>> 4. The reporting of an "expense" for employee stock options also would create other complications in the company's financial reports. By way of example, the company would have to realize "income" for stock options forfeited as a result of either expiration or termination of employment of the holder.

Actually, the company VALUES the option at issue, but it doesn't EXPENSE the option until it vests. Since vested options can be exercised if they are in the money by a leaving employee, the expense does not need to be reversed.

Further, expiration of an option does not bring any money back to the company. If I said you can use my house any time you want over the next 5 years, I spent money to make arrangements as to what I would do with my family if you showed up. If you never showed up after 5 years, whos fault is that? You are not getting the money back for my leaving my house open to you. When you buy an option in the market, you KNOW you are not getting any money back if you don't take the option. The same MUST apply to expensing an option.

Additionally, the company would have to make offsetting entries in its statement of cash flows to offset the "expense" and the "income" from stock options in order to balance its cash accounts since no cash actually changes hands in these events.

The proper place to book the offset to the expense is "paid-in capital." When a company pays you with stock, they book the value of the stock to "paid-in capital" and that offsets the expense they must take for giving you the stock.

As the last few years should prove, when a company issues options, it is effectively issuing stock. Of course there is a "betting" component to issuing the option rather than the stock directly. But, effectively, the money you get for selling your stock immediately gets booked as paid-in capital, the money you SAVE by handing out new-issue stock to employees or suppliers or whomever is ALSO then paid-in capital, then the money you get for promising to sell stock in the future should also go to "paid-in capital."

Issuing new stock is an awful lot like issuing a promise to issue new stock. THAT is the main lesson of all of this.

The present method of reporting both actual and "fully diluted" earnings per share is a much more reliable indicator of the real impact of stock options on the company's finances. Here, the "fully diluted" figure assumes exercise of all outstanding stock options and thus shows the maximum dilution of earnings that can occur due to the stock plan.

Au contraire. If I paid you half in stock and half in cash, and I booked only the half in cash as expense, I would cut my payroll in half. This could easily turn a business showing a loss into a business showing a profit. What would dilution do: It would take this make believe profit I had generated by hiding half my expenses and cut it in half. So I have a money losing business. I report only half my payroll expenses by paying you half in stock and half in cash. This makes me look profitable "on paper."

Does dilution fix this? No. Dilution takes my science-fiction profit and turns it into a smaller science-fiction profit. Dilution can never turn ignored costs into unignored costs.

The main take home lesson is: options are ALMOST stock. They are actually BETTER than stock, in that if the stock goes down and you own it, you lose money, if the stock goes down and you own only options, you lose nothing.

R:
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The present method of reporting both actual and "fully diluted" earnings per share is a much more reliable indicator of the real impact of stock options on the company's finances. Here, the "fully diluted" figure assumes exercise of all outstanding stock options and thus shows the maximum dilution of earnings that can occur due to the stock plan.

I would support some sort of system that would look at how many options were actually exercised each year and the difference between the exercise price and the actual value of the stock acquired by the employee. This way no "estimates" of the options future value would be necessary. Of course in years where the stock price rises a lot more options might be exercised, and in years when the share price falls less of an options expense would probably be recognized. The biggest failing of this plan is that options issued 5 or 7 or 9 years ago might show up as an expense this year, but that is what is actually happening...

Retroactive information could be provided for the last 5 years so that the investing public would be able to make a judgement about how much "dilution" or "expense" is actually being created by options being exercised. Of course this sort of accounting would be best shown as a footnote to the financial statements, with the aim of not changing reported earnings but as an aid so that investors would be better informed about dilution from options exercises.

A lot of the arguements against "expensing" options using estimates of future performance might be eliminated by using historical data instead. Also I think this data would best be presented on a yearly basis to minimize quarterly fluctations...

JTT
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Ralph,

May I challenge it on every single point?

Only if I get to respond to every single point of challenge in a way that exposes the fact that you're shooting from the hip....

The Black-Scholes Formula is only ONE option available to management to determine "fair-value."

True -- as reflected in my original wording, "... the Black-Scholes Formula or some other method of prediction..." (boldface added).

A very good alternative to determine "fair-value" is... go to your investment bankers and see who will sell you options for granting at the best terms. Create a market in the options being granted to employees. "Securitize" the asset being marketed.

Great theory -- but it is a situation that confronts us. The options that you offer for sale must replicate (1) provisions such as non-transferability and forfeiture upon termination of employment that are part of most employee stock option plans and (2) the benefits to the company of loyalty and dedication that employee stock options tend to foster, with the conseqeuence of superior motivation, efficiency, and productivity on the part of the company's employees. Simply stated, an employee who will share in the growth and profitability of the company through ownership promoted by stock options has a lot of incentive to go the extra mile to make the company as profitable as possible. If you can't replicate those phenomena accurately, you won't have a comparable security.

BTW, don't forget that the risk of forfeiture of stock options due to termination of employment may well vary considerably from one group of employees to another, depending upon the nature of the company.

There are two additional major problems in your proposal. The first is that any actual sale of options would cause an increase in dilution beyond that caused by granting options to employees, with no offsetting benefit of better productivity and efficiency due to improved loyalty and dedication of the company's employees. The second is that the law of supply and demand predicts that the price on the open market will be at the point where the supply matches the demand. Thus, the company's executives could affect the fair market value by offering more or fewer options for sale.

It is currently the case that RESIDENTIAL MORTGAGES are securitized. These mortgages have the problems of 1) all are "callable" at the mortgagee's option. Mortgages CAN be paid off early. What a tremdous monkey wrench that throws into the machinery of valuing these mortgages. Yet Freddie Mac manages to securitize mortgages many billions of $ a year.

Actually, the investor loses nothing if the borrower pays off a morgage early because the investor still gets the whole principle back. This would represent a paper loss only if the investor could not reinvest that money to achieve a rate of return equal to the interest rate on the mortgage. A drop in interest rates is the primary motivation to refinance a mortgage, of course, but a lot of mortgages get paid early for other reasons such as a windfall (from an inheritance or a large lottery prize, for example) or a promotion that provides a significant increase in resources with which to make larger payments.

Someone might try to claim that noone would create a market to securitize the value of restricted 10 year options. I don't find that plausible at all. People trade derivatives, derivatives on derivatives, and no doubt derivatives on derivatives of derivatives. You can buy and sell options or puts on interest rate futures (I think).

Again, the problem here is not one of creating a market. Rather, the problem here is one of making the instrument really equivalent in all respects to an employee stock option in a way that does not alter the value of either the option or the stock.

Meanwhile, not only do you have to put the money out to buy the stock to hedge this 10 year option you are selling, but you are going to need to charge your 10 year cost of cash. 5% interest anyone? 5% for 10 years is 63% compounded interest. A rational seller of the option when 10 year money costs 5%/yr will need to charge 63% of face value of option just to cover his hedge. Increase that for the risk the stock goes down over 10 years. Reduce it for the dribs and drabs o in-the-money unvested options that die on the table as people leave employment.

Think about it that way. What would YOU charge to carry that risk?

The reason that large companies don't go to their investment bankers to find out how much their options cost is going to be because Black-Scholes gives them an answer they like better, a LOWER answer than the investment bankers would give them.

The reason that large companies don't go to their investment bankers to find out how much their options cost is going to be because Black-Scholes gives them an answer they like better, a LOWER answer than the investment bankers would give them.


I'm not persuaded. Again, Black-Sholes does not take into account many factors that are inherent in employee stock options that actually represent additional liability to the holder, including the risk of forfeiture of the options in the event of termination for any reason whatsoever including layoff, dismissal, voluntary resignation, etc. You are thus attempting to compare apples to oranges.

Which is more accurate, assuming that 10 year options are worth $0, when 2 year options trade for from 15% to 50% of current stock values (check yourself! All published daily), or to assume that if the companies thought the Market would give them an answer they liked better than Black-Scholes that they would be there in a Wall Street minute?

You still are not comparing like entities.

>> 1. The derivatives known as "call options" are transferable, so the holder can sell thm at will, whereas employee stock options typically are transferable only by inheritance upon death of an active employee.

>> 2. The derivatives known as "call options" are exercisable immediately because they have no vesting period, whereas most employee stock options vest over a period of several years and are not exercisable until they vest.\

>> 3. The derivatives known as "call options" have no forfeiture before their dates of expiration, whereas employee stock options are forfeited upon termination of employment, regardless of the reason for the termination. When combined with the vesting schedule, there's a significant risk of forfeture of employee stock options before they become exercisable.

>> 4. The derivatives known as "call options" have no involvement whatsoever of the company because their exercise causes only a transfer of shares that are already outstanding from the stockholder who writes the options to the holder of the option contract, whereas the exercise of an employee stock option causes either transfer of treasury shares held by the company or issuance of new shares to the employee in exchange for a sum of cash that the employee pays to the company (reported as an addition to paid-in capital on the company's financial statement).

>> 5. The derivatives known as "call options" usually have relatively short lives, such that there's good visibility to the likely performance of the company over the life of the option, whereas employee stock options usually have sufficiently long lives that there's no visibility as to the likely perfomance of the company over the life of the option. Further, many employee stock options have sufficiently long vesting periods that there is not even good visibility to the likely performance of the company over the vesting period! Note that the Black-Sholes Formula and other methods of valuing stock options depend upon good visibility to the performance of the company over the life of the option.

>> 6. The derivatives known as "call options" carry no restrictions whatsoever on the subsequent sale of shares obtained by their exercise, whereas many employee stock options do carry such restrictions -- often enforced by issuing a separate class shares (often called "restricted convertible shares" or something similar) that are not transferrable but that convert to tradeable common shares after a holding period. The employee often may sell such shares only after the automatic conversion, and thus carries the additional risk of a drop in the stock price during the compulsary holding period.

There are other differences between so-called "call options" and employee stock options that are much more subtle, but this list should be sufficient to make the point that they are not comparable or even equivalent.

If you want real harm to investors, how about fobbing off as Earnings from a Business what are actually "Earnings" from pretending the "dollar bills" you pay your employees with are really worth $0? Suppose the earnings thus reported made even more investors think "Ka-zart, LOOK at that earnings growth, I've GOT to get in on this stock," which of course raises the COST of the granted options, which of course makes them look great to pay employees with, which, and we are circling back now, do not get booked as costs? Google Ponzi for more on this topic.

SUMMARY OF THIS POINT: When you are allowed to pay your employees without expensing that pay, you wind up booking as "Earnings" what should really be booked as "Paid-In Capital." Since the purpose of buying stock is to buy future earnings of the BUSINESS, the stock price is bid up, which creates a vicious circle as increasing stock prices increase the COST and VALUE of the options you pay your employees with, which causes your overstatement of "Earnings" to be even more extreme. You could wind up with a stock price bubble from this practice, which, remarkably, is PRECISELY what happened.


In this whole rant, you're missing the point that most employee stock option plans require that the cost to exercise the options be equal to the price of the stock on the date of grant. If there's a bubble in the stock price, that bubble affects the cost to exercise of all new employee stock options granted during the bubble. When an employee elects to exercise a stock option, the employee writes a check to the company for that amount and the company reports the receipt as new paid-in capital. Thus, an employee stock option plan does bring new capital on the books -- but it happens at the time of exercise (when the employee also acquires the right to vote the shares and to receive dividends on the shaes) rather than the time of grant.

Also, you still have not made any attempt to account for the value that the company receives from its employees holding an interest in the company that I described above. It's not like the company does not receive a clear benefit for granting stock options.

I'll dispose of (3) first. If corporations chose to, they could securitize their options exposure and the securities could trade. These ARE marketable entities which the corporations CHOOSE not to market. Black-Scholes allows them an out from ACTUALLY marketing them to establish "fair value." Marketing them is always an, uhm, "option."

Okay, here's the set-up. Employee Joe Schmuck is frustrated with the company and has decided to quit, but he holds a bunch of options that won't vest for anywhere from several months to three or four years. Thus, he sells his unvested options on the market on Tuesday and quits on Friday -- causing expiration of the options that he sold on Tuesday. The buyers of the options are stuck.

Now, how much are you willing to pay for unvested options, given knowledge that terminating employees will sell their unvested options before they terminate?

And what do you suppose would be the cost of keeping track of which options on the market had been granted to which employees, and thus which options actually expire upon an employee's termination of employment?

This strikes me as a recipe for disaster.

Let me whack at (1) and (4) collectively. Restrictions on options should LOWER their cost since windows for exercising them are NOT as open as Black-Scholes assumes, no? If this were signficant, the company could create a securitized instrument to cover their options exposure and PROVE the market provided a discount from Black-Scholes. HOWEVER, mostly restrictions are asymmetric, reducing the value of the option to the option holder, but not reducing the cost of the option to the grantor by that much. I'm just claiming that without justifying it, but the main point is whenEVER the company thinks it can do better than Black-Scholes, it has that option.

The real value of a stock option to the option holder is the discount from fair value at which the option allows its holder to buy the stock. This value obviously fluctuaes with changes in the stock price. If there's no discount (that is, the cost to exercise is equal to the fair market value, as on the date of grant), the option has no real value.

The argument that there's some asymmetry is also wanting. The company incurs no tangible cost whatsoever to grant stock options to its employees. In fact, a quirk in the Internal Revenue Code actually converts some income to paid-in capital when employees exercise most stock options, resulting in a reduction in the company's corporate income tax. You'll see this reported as a "stock tax benefit" in the company's annual report.

For (4), this is largely spurious given the way options are expensed. The VALUE of the options is determined at grant. The expense is booked as the option VESTS. As such, UNVESTED options are NOT expensed under "Fair Value."

Even the IRS does not buy into this game. The Internal Revenue Code treats the exercise of most employee stock options as though the employee had paid fair value on the date of exercise for the shares and the company had granted the employee a bonus equal to the difference between the fair market value and the cost to exercise. The phantom bonus becomes taxable income to the employee and both a phantom expense and additional paid-in capial to the company, but only for tax purposes. The phantom expense is what reduces the company's taxes, yielding the "stock tax benefit" described above.

Again, if you were right, the market would value options at recently-raised stock prices at a LOWER premium than when stock prices are lower. An examination of actualy options markets will show this is NOT what the market does. When stock prices rise, options prices rise, too. But anyway, be that true or be that fiction, the option to securitize options grants is always there. The company could test any of these hypotheses about "true" value of options any time it wished.

In most cases, derivatives seem to track the difference between fair market value and cost to exercise pretty closely, albeit with some speculative flucuations. Of course, highly volatile stocks may draw more speculators into their derivative markets and thus exceed the basic valuation.

Actually, the company VALUES the option at issue, but it doesn't EXPENSE the option until it vests. Since vested options can be exercised if they are in the money by a leaving employee, the expense does not need to be reversed.

You need to get your facts straight on this. The actual proposal put forth by Warren Buffet and other advocates of expensing stock options actually generates a phantom expense at the time of grant rather than at the time of vesting. That's also the provision of the option to expense stock options provided by current U. S. Generally Accepted Accounting Principles (GAAP) issued by the Federal Accounting Standard Board (FASB).

Further, expiration of an option does not bring any money back to the company. If I said you can use my house any time you want over the next 5 years, I spent money to make arrangements as to what I would do with my family if you showed up. If you never showed up after 5 years, whos fault is that? You are not getting the money back for my leaving my house open to you. When you buy an option in the market, you KNOW you are not getting any money back if you don't take the option. The same MUST apply to expensing an option.

Your analogy does not fit for the reasons discussed above. If you realize a phantom expense and phantom receipt of paid-in capital upon issuance of a stock option, you must reverse that if the stock option expires without exercise.

The proper place to book the offset to the expense is "paid-in capital." When a company pays you with stock, they book the value of the stock to "paid-in capital" and that offsets the expense they must take for giving you the stock.

Yes, but we are not talking about a situation in which a company pays an employee with stock. Rather, we are talking about a situation in which the company grants an option to buy stock at the current price at some time in the future -- with no guarantee tht the underlying shares won't be "under water" (that is, worth less than the cost to exercise the options).

As the last few years should prove, when a company issues options, it is effectively issuing stock.

No. That's a major error in your thinking. Rather, when a company issues stock options to employees, it is issuing the right to buy newly issued shares of stock at the present stock price at some time in the future, subject to certain conditions and restrictions and with no guarantee that the fair value of the stock will exceed the price in the option at any time during the period when the option is exercisable.

Of course there is a "betting" component to issuing the option rather than the stock directly. But, effectively, the money you get for selling your stock immediately gets booked as paid-in capital, the money you SAVE by handing out new-issue stock to employees or suppliers or whomever is ALSO then paid-in capital, then the money you get for promising to sell stock in the future should also go to "paid-in capital."

Of course -- which is precisely why, under current GAAP, the money that the company get "for promising to sell your stock in the future" DOES go to paid-in capital -- but not until the employee exercises the stock option to buy the shares and the company actually gets the money.

Issuing new stock is an awful lot like issuing a promise to issue new stock.

This is true only in that the promise obligates the company to issue new shares at some time in the future if the employee chooses to exercise the option.

Au contraire. If I paid you half in stock and half in cash, and I booked only the half in cash as expense, I would cut my payroll in half. This could easily turn a business showing a loss into a business showing a profit. What would dilution do: It would take this make believe profit I had generated by hiding half my expenses and cut it in half. So I have a money losing business. I report only half my payroll expenses by paying you half in stock and half in cash. This makes me look profitable "on paper."

The key difference is that the share of stock has a tangible cash value, whereas an option to buy a share of stock at the current stock price has no value at all.

The better analogy would be if an employer were to pay an employee his or her full salary, then grant an option to the employee to buy a certain number of shares of stock at the current stock price that expires at midnight tonight. If you elect to exercise the option, you pay in cash and receive the shaes. The company books an expense for your salary and paid-in capital equal to the cost to exercise the option.

The only difference between this example and most employee stock option programs is that the option is not exercisable until some time in the future, and then only if if the employee remains with the company. The of the exercise may allow the employee to benefit from a gain in the value of the option, but not without risk that there won't be any value on which to capitalize and not without risk of forfeiture of the options.

Does dilution fix this? No. Dilution takes my science-fiction profit and turns it into a smaller science-fiction profit. Dilution can never turn ignored costs into unignored costs.

The main take home lesson is: options are ALMOST stock. They are actually BETTER than stock, in that if the stock goes down and you own it, you lose money, if the stock goes down and you own only options, you lose nothing.


But there are NO ignored costs associaed with stock options. If the cost to exercise a stock option on the day of grant is equal to the price of the shares on the day of grant, the value of the option is zero on the day of grant -- which is the day when the employee receives it. Thus, the expense is zero. The fact that something appreciates in value after it belongs to the employee does not make it have more value when the employee receives it.

If the cost to exercise an option were less than the fair market value of the stock on the date of grant, the option would have tangible value but it would be necessary to adjust the value for the risk of forfeiture (probalby determined statistically based upon past experience). In that case, the company would realize an expense and the employee would realize income based upon this adjusted value of the option.

Norm.
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John,

I would support some sort of system that would look at how many options were actually exercised each year and the difference between the exercise price and the actual value of the stock acquired by the employee. This way no "estimates" of the options future value would be necessary. Of course in years where the stock price rises a lot more options might be exercised, and in years when the share price falls less of an options expense would probably be recognized. The biggest failing of this plan is that options issued 5 or 7 or 9 years ago might show up as an expense this year, but that is what is actually happening...

That's what the Internal Revenue Code does for income tax purposes, and the real impact is to convert a certain amount of earnings to paid-in capital on paper. Nonetheless, such a change would not serve investors well because the phantom expense would be great in times of high growth and non-existent or very small in times of contraction, masking the real trends in revenue that the company generates through its normal business activities.

Retroactive information could be provided for the last 5 years so that the investing public would be able to make a judgement about how much "dilution" or "expense" is actually being created by options being exercised. Of course this sort of accounting would be best shown as a footnote to the financial statements, with the aim of not changing reported earnings but as an aid so that investors would be better informed about dilution from options exercises.

Most annual reports already show a three-year comparison. Additionally, annual reports from past years are now available on line, at least on form 10-K, so this information is readily available even to potential investors.

A lot of the arguements against "expensing" options using estimates of future performance might be eliminated by using historical data instead. Also I think this data would best be presented on a yearly basis to minimize quarterly fluctations...

The biggest problem here is that secular economic trends tend to span the entire recent history. As a result, the historical data methods are very unreliable when major changes in secular economic trends occur, yet that's when comparability of information is most crucial.

Norm.
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Howdy Norm,

Ralph wrote: Actually, the company VALUES the option at issue, but it doesn't EXPENSE the option until it vests. Since vested options can be exercised if they are in the money by a leaving employee, the expense does not need to be reversed.

Norm wrote: You need to get your facts straight on this. The actual proposal put forth by Warren Buffet and other advocates of expensing stock options actually generates a phantom expense at the time of grant rather than at the time of vesting. That's also the provision of the option to expense stock options provided by current U. S. Generally Accepted Accounting Principles (GAAP) issued by the Federal Accounting Standard Board (FASB).

Well Norm, you made me go back and re-read the FASB documents. As it turns out, I am right and you are wrong. Quoting from FASB 123:
28. An entity may choose at the grant date to base accruals of compensation cost on the best available estimate of the number of options or other equity instruments that are expected to vest and to revise that estimate, if necessary, if subsequent information indicates that actual forfeitures are likely to differ from initial estimates. Alternatively, an entity may begin accruing compensation cost as if all instruments granted that are subject only to a service requirement are expected to vest. The effect of actual forfeitures would then be recognized as they occur.

The more relevant documcent for this discussion is what FASB proposes in the so-called Exposure Document. Read it at http://www.fasb.org/draft/ed_intropg_share-based_payment.shtml if you like.

It continues the expensing-as-vested concept and quite clearly states that unvested options need never be expensed:
For public entities, the cost of employee services received in exchange for equity instruments would be measured based on the grant-date fair value of those instruments (with limited exceptions). That cost would be recognized over the requisite service period (often the vesting period). Generally, no compensation cost would be recognized for equity instruments that do not vest.

Meaning, at grant date the value of each option in the grant is calculated. Then as each option vests, its previously calculated value is expensed. If an employee had left employ with unvested options on the table, those options never vest and never get expensed.

Anyway, you are wrong about other things in your post, but I don't have the energy.

R:

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Ralph said: A very good alternative to determine "fair-value" is... go to your investment bankers and see who will sell you options for granting at the best terms. Create a market in the options being granted to employees. "Securitize" the asset being marketed.

Norm said: Great theory -- but it is a situation that confronts us. The options that you offer for sale must replicate (1) provisions such as non-transferability and forfeiture upon termination of employment that are part of most employee stock option plans and (2) the benefits to the company of loyalty and dedication that employee stock options tend to foster, with the conseqeuence of superior motivation, efficiency, and productivity on the part of the company's employees. Simply stated, an employee who will share in the growth and profitability of the company through ownership promoted by stock options has a lot of incentive to go the extra mile to make the company as profitable as possible. If you can't replicate those phenomena accurately, you won't have a comparable security.

BTW, don't forget that the risk of forfeiture of stock options due to termination of employment may well vary considerably from one group of employees to another, depending upon the nature of the company.

There are two additional major problems in your proposal. The first is that any actual sale of options would cause an increase in dilution beyond that caused by granting options to employees, with no offsetting benefit of better productivity and efficiency due to improved loyalty and dedication of the company's employees. The second is that the law of supply and demand predicts that the price on the open market will be at the point where the supply matches the demand. Thus, the company's executives could affect the fair market value by offering more or fewer options for sale.


You misinterpret what I mean by "securitize" the asset. I don't mean that the company should somehow foster some fake market in options SIMILAR to the ones they grant to employees. I mean that the company can go to its investment banker and say "how much do I have to pay you to cover these options for me." So on June 1, 2005 the company issues 75000000 options at-the-money to employees. They can go to their investment banker and say "Here are these PARTICULAR options I own, how much do I have to pay you so that when any of these get exercised, YOU get the strike price in cash and YOU issue the exerciser a share of my stock." Looked at as insurance, this is a relatively trivial kind of insurance: insurance companies will tell you how much it will cost to insure a movie star's legs, how much to insure a building against terrorist attack. Telling the company the cost to cover an options grant would be a relatively trivial matter for an insurance company.

But I am guessing the company would get a better quote from an investment banker than an insurance company. Investment bankers can actually create liquidity for the investers who buy this obligation. They can find the price at which they can get investors to take on the risk of the ACTUAL options from the company. Then they can allow investors to sell their portion of that obligation to other investors over the (typically) 10 year life of the options. Just like call options now, the price of these securitized options would change over time tracking the actual changes in stock price and the actual experience of options already being exercised, and other options never vesting.

This is how it is done with mortgages. A bunch of mortgages are "pooled," and then investors buy a fraction of that pool from Freddie Mac who "bundled" the mortgages. Then those investors actually get payments derived from the actual payments of the mortgages in their pool, including payouts of mortgages that get paid off early, etc. As each pool of mortgages ages, differently from other pools, the price at which your share of a given pool changes to reflect its actual performance.

Further, I have read more about the binomial method for estimating options COSTS to the company. It is a Discounted Cash Flow method, meaning the company can make wildly detailed assumptions about how the options will perform in terms of when they will be exercised at what prices etc etc, and just follow each probabilistic outcome back to the current date to come up with a probabilistic estimate of the cost of that option to the issuer (company).

In principle, a company could do its binomial calculation in secret, seek quotes from investment bankers to securitize, and if those quotes were too high, the company could use the binomial estimate and choose to cover the options itself, as it currently does. But if the bids came in below the binomial estimates, the company could claim the lower cost for these options by citing the ACTUAL price it was able to sell some or all of its obligation to service those options to an actual independent buyer.
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I would support some sort of system that would look at how many options were actually exercised each year and the difference between the exercise price and the actual value of the stock acquired by the employee. This way no "estimates" of the options future value would be necessary. Of course in years where the stock price rises a lot more options might be exercised, and in years when the share price falls less of an options expense would probably be recognized. The biggest failing of this plan is that options issued 5 or 7 or 9 years ago might show up as an expense this year, but that is what is actually happening...

No high tech company will ever agree to this, but you are right it would be superior to what is done now. However, it would be suboptimal in these ways:
1) the purpose of expensing is to assign the expense at the same time as the revenue producing activity associated with it. The reason options tend to vest over 4 or 5 years is the company wants you "motivated" to work over that time period. They are essentially when granting the option promising to pay you this extra bonus regularly over the vesting time. SO it really would be nice to recognize that extra pay for the time period it applies to
2) the ACTUAL COST of the option in retrospect is NOT the same as its value before anybody can know how it will all turn out. If the company gave its employees lottery tickets as bonuses, would it make more sense to take the lottery prize and pro-rate it across all the tickets, and call that the expense of each ticket? Or would it make sense to wait until the lottery winner was drawn, and claim that one ticket was 1,000,000 expense and the other 999,999 tickets were no expense at all? It is like that with options: they are a chance on an uncertain outcome, it is the chance itself that is worth something at the time of issue, and the chance itself that OBLIGATES the company to make some kind of payout later on.
3) The amounts of expense in years when the stock rises would be GIGANTIC. The total change in earnings over the last 6 years or so if this were done is they would be REDUCED by 24 BILLION over what was actually reported. By contrast, last years earnings were something like 4 or 5 billion.

So anyway, what you propose would be a lot more honest than what is done, but it would be a bit on the random side in getting that information out.

R:
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OMG - What a long post...
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Ralph,

From your first reply to the same post of mine: Well Norm, you made me go back and re-read the FASB documents. As it turns out, I am right and you are wrong. Quoting from FASB 123:...

If that's the case, this slipped under most folks' radar horizon.

You misinterpret what I mean by "securitize" the asset. I don't mean that the company should somehow foster some fake market in options SIMILAR to the ones they grant to employees. I mean that the company can go to its investment banker and say "how much do I have to pay you to cover these options for me." So on June 1, 2005 the company issues 75000000 options at-the-money to employees. They can go to their investment banker and say "Here are these PARTICULAR options I own, how much do I have to pay you so that when any of these get exercised, YOU get the strike price in cash and YOU issue the exerciser a share of my stock." Looked at as insurance, this is a relatively trivial kind of insurance: insurance companies will tell you how much it will cost to insure a movie star's legs, how much to insure a building against terrorist attack. Telling the company the cost to cover an options grant would be a relatively trivial matter for an insurance company.

Okay. In that case, there's an even bigger problem with your proposal. The problem is that the investment banker is in business to make money, and therefore will (1) calculate the cost under the assumption of worst case rather than most likely case (in this case, the assumption that the company would achieve the best realistic estimate of its potential performance) to minimize the investment banker's risk, then (2) add an appropriate margin for profit into the quoted price. Thus, the quote would greatly overstate the value of the options. Realistically, I'm guessing that the overstatement would be at least an order of magnitude in most cases.

But I am guessing the company would get a better quote from an investment banker than an insurance company. Investment bankers can actually create liquidity for the investers who buy this obligation. They can find the price at which they can get investors to take on the risk of the ACTUAL options from the company. Then they can allow investors to sell their portion of that obligation to other investors over the (typically) 10 year life of the options. Just like call options now, the price of these securitized options would change over time tracking the actual changes in stock price and the actual experience of options already being exercised, and other options never vesting.

It probably would take years, and possibly even a few decades, for this scheme to produce meaningful valuations because it would take that long to build up enough history of performance for the buyers of such derivatives to have some idea what sort of performance to expect under various market conditions -- and it's also likely that the first couple cycles of evaluation would not produce meaningful history because the participants in such a market would not have the knowledge of experience upon which to base their decisions, and thus might not be acting in the manner of knowledgeable investors. This is not a quick fix.

Further, I have read more about the binomial method for estimating options COSTS to the company. It is a Discounted Cash Flow method, meaning the company can make wildly detailed assumptions about how the options will perform in terms of when they will be exercised at what prices etc etc, and just follow each probabilistic outcome back to the current date to come up with a probabilistic estimate of the cost of that option to the issuer (company).

Sure. In fact, the Black-Scholes Formula does just that, but with a much simpler set of assumptions regarding both the economy and the set of possible dispositions. The problem, though, is that economic trends generally are fairly stable, and thus predictable, in the short term, unless there's a cataclysmic event like the "9/11" attack, but they show no pattern of correlation whatsoever in the long term. Thus, the best possible assumption for long-term investment is that the stock will retain its present value or perhaps that the stock will grow in value at the average historical rate of the whole market (slightly over 10% per year, with compounding). Anything else is highly subject to manipulation at the whim of mischievoouw executives.

When you come right down to it, though, this method of valuation does little to benefit investors. The worst abuse of stock option plans is still issuance of too many options, causing the growth in outstanding shares to exceed the growth in the company's revenues. Such situations are immediately apparent with present accounting, as they show up as declining "fully diluted" earnings per share. This figure is the ratio of the net earnings to the sum of outstanding shares and outstanding options, so issuance of too many options makes the denominator grow faster than the numerator. A good thumb rule, BTW, is that the value of fraction of outstanding shares granted in newly issued stock options should never exceed half of the growth in net profits during the same period after the company emerges from its start-up phase.

Norm.
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Take a rest!!!! crpurdum
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From your first reply to the same post of mine: Well Norm, you made me go back and re-read the FASB documents. As it turns out, I am right and you are wrong. Quoting from FASB 123:...

If that's the case, this slipped under most folks' radar horizon.


Part of what stinks about this whole issue is that the top execuctives of multibillion $ high tech companies are spreading this kind of "slipped under the radar" stupidity. This is, remarkably, an amazing instance of know-nothingism on the part of the high techies. Subtracting costs from revenues to estimate profits is a supremely basic concept in accounting. Estimating future costs aso that they can be applied against revenues at the time the revenues are received is pretty basic.

Unfortunately, going to congress yelling and screaming so that you can get congress to do something harmful to the nation at large for your own special interests also has a long and noble history. We have tobacco subsidies, milk subsidies, ethanol subsidies. And now we are working on INCREASING the employee-stock-option subsidies by legislating a lie. Employee stock options are ALREADY subsidized by their tax-deferred treatment.

I am ashamed to be associated with a company which is doing this.

R:
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Okay. In that case, there's an even bigger problem with your proposal. The problem is that the investment banker is in business to make money, and therefore will (1) calculate the cost under the assumption of worst case rather than most likely case (in this case, the assumption that the company would achieve the best realistic estimate of its potential performance) to minimize the investment banker's risk, then (2) add an appropriate margin for profit into the quoted price. Thus, the quote would greatly overstate the value of the options. Realistically, I'm guessing that the overstatement would be at least an order of magnitude in most cases.

You are ignoring the most basic feature of a competitive marketplace: competition. You don't ask ONE investment banker for a bid. You ask FOUR, and you ask them for THEIR advice on how to structure the security and the market. In their greed they'd LIKE to quote you 10x real costs, but in the competition, especially in an auction but other markets work as well, the price will be bid down.

You are also ignoring that securitizing the risk is a CHOICE. I would and FASB would still allow binomial and Black-Scholes estimates. If the investment bankers come in higher than those, you have HIGH confidence that hese are LOW estimates, but you are allowed to use them. If the investment bankers come in lower than those, then you get lucky and get to use the ACTUAL market value.

R:
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The worst abuse of stock option plans is still issuance of too many options, causing the growth in outstanding shares to exceed the growth in the company's revenues. Such situations are immediately apparent with present accounting, as they show up as declining "fully diluted" earnings per share.

I disagree. The worst abuse of stock option plans is that they allow a fictitiously low reporting of costs. There ARE executives who take no cash salary, only options as pay. Is it realistic to say they COST nothing to employ? Suppose you have a CEO who says "pay me nothing, if the stock price (or the earnings number or whatever metric you like) gets above X, just give me 10% of the company." Is it realistic to say that the correct valuation to assign to your saying "O.K." is $0?

Understatement of costs is NOT dilution. Understatement of costs can turn a TRUE loss into a FICTITIOUS profit. If we proceed to dilute that fictitious profit, even by issuing 10 options for every 1 share of stock outstanding, we STILL have a reported profit, and it is still fictitious.

THIS is why companies try to sell the idea that dilution accounts for options. Because they can hide a ream of costs in there.

R:
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Ralph,

I'll answer all of your replies at once.

I am ashamed to be associated with a company which is doing this.

A person of integrity who felt that way and could not change the company's policies would sever the association. I'm not sure whether "sever the association" means selling your shares, resigning from employment, or both.

You are ignoring the most basic feature of a competitive marketplace: competition. You don't ask ONE investment banker for a bid. You ask FOUR, and you ask them for THEIR advice on how to structure the security and the market. In their greed they'd LIKE to quote you 10x real costs, but in the competition, especially in an auction but other markets work as well, the price will be bid down.

I'm not sure to what extent competition really would drive prices of your securities down. When word got around that a few folks lost their shirts on lower bids, others would be a lot more cautious.

You are also ignoring that securitizing the risk is a CHOICE. I would and FASB would still allow binomial and Black-Scholes estimates. If the investment bankers come in higher than those, you have HIGH confidence that hese are LOW estimates, but you are allowed to use them. If the investment bankers come in lower than those, then you get lucky and get to use the ACTUAL market value.

And this also creates a lot of potential for shenanigans. The basic scheme is to form a corporation that (1) underbids substantially for your security, (2) pays its principals very generous compensation (probably including a major bonus for winning the contract), depleting its receipts, and (3) folds, probably through bankruptcy liquidation because it has future liabilities, before the first underlying options vest. The company benefits by getting a bid that's much lower than the best Black-Scholes estimate that its accountants can justify, the principals in the company that acquires the securities make a quick buck, and the originating company gets nothing back when the options vest because the corporation that acquired your security no longer exists. What has really happened here is a transfer of some amount of cash from the originating company to some friends of its top executives who acted as principles of the corporation that acquired the securities.

I disagree. The worst abuse of stock option plans is that they allow a fictitiously low reporting of costs. There ARE executives who take no cash salary, only options as pay. Is it realistic to say they COST nothing to employ? Suppose you have a CEO who says "pay me nothing, if the stock price (or the earnings number or whatever metric you like) gets above X, just give me 10% of the company." Is it realistic to say that the correct valuation to assign to your saying "O.K." is $0?

This scheme usually arises when a company's stock is already essentially worthless. The most famous example is Lee Iacoca's deal with Chrysler Corporation back in the early 1980's. Lee Iacoca did very well, but so did the stockholders of the company -- who otherwise would have lost their investments complety through bankruptcy proceedings (either reorganization or liquidation).

Understatement of costs is NOT dilution. Understatement of costs can turn a TRUE loss into a FICTITIOUS profit. If we proceed to dilute that fictitious profit, even by issuing 10 options for every 1 share of stock outstanding, we STILL have a reported profit, and it is still fictitious.

That's true, but there's a difference between an understatement of costs and a reduction of receipts. Sale of a product below its full retail price is a reduction of receipts -- not an expense.

Suppose that a company decided to sell shares to a group of private investors at a price below the current market price in order to raise capital. How would you account for that transaction? The answer, according to U. S. GAAP, is that you would realize the actual receipt as paid-in capital and that any difference between the receipts and the market value of the shares would be totally irrelevant -- essentially a reduction in the receipts that the company might have realized by selling the same number of new shares on the market over some period of time. So why does it matter that the "group of private investors" happen to be employees of the company exercising stock options? The transaction still represents a reduction of receipts for the sale of stock, compared to fair market value, rather than an expense to the company.

THIS is why companies try to sell the idea that dilution accounts for options. Because they can hide a ream of costs in there.

Rather, you are trying to generate a paper loss when there really is a profit by converting profit to paid-in capital. The biggest problems with such an approach are that the alleged expense reflects a company's performance over a period of several years rather than its current performnce and that variations in the supposed expense would mask what's really happening in the current reporting period.

Norm.
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This has gotten deeper and deeper into the realms of options, but I would like to throw in my 2 cents worth.

Having looked through the reports and finding the options information (it is in the reports if you look for it), my problem with the accounting for options is that the company shows all the plusses (tax benefit, cash from issuance of the shares) as positive cashflow for the earnings announcement but the cost to the shareholders due to dilution is buried in the footnotes and only gets shown when the SEC filings are released months later.

They announce the big stock buy-backs, spending ~$15 billion buying back the company stock, yet the number of shares outstanding stays relatively flat. In an earlier post:

http://boards.fool.com/Message.asp?mid=20831786

I showed where $3.8 billion (~$0.53 per share) in shareholder equity had been transferred to employees through exercises of granted options, but was never counted as a payroll expense.

In another post:

http://boards.fool.com/Message.asp?mid=20769856

I also looked at whether the stockholders would be better off just letting the option grants be added to the total share count rather than having the company buy the shares then hand them out again.

I contend that the buy-backs artificially prop-up the stock price and allows management to make big announcements about benefits to shareholders while the net effect is virtually nil. The way they account for options exercises lets them boost their earnings numbers for the announcement while the effect of dilution only comes out when the SEC filings are released. It is all nice and legal, and I am not sure that the proposed solutions to the problem won't just make the issue even more confusing to the average shareholder.

My choice is to not invest in Cisco stock because the price is impossible to tie to the underlying value of the company and while management continues to see shareholder equity as an unaccounted piggy bank for hiding a large portion of payroll expense.

Steve
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Ralph said: Understatement of costs is NOT dilution. Understatement of costs can turn a TRUE loss into a FICTITIOUS profit. If we proceed to dilute that fictitious profit, even by issuing 10 options for every 1 share of stock outstanding, we STILL have a reported profit, and it is still fictitious.

<\b>Norm said: That's true, but there's a difference between an understatement of costs and a reduction of receipts. Sale of a product below its full retail price is a reduction of receipts -- not an expense.

Suppose that a company decided to sell shares to a group of private investors at a price below the current market price in order to raise capital. How would you account for that transaction? The answer, according to U. S. GAAP, is that you would realize the actual receipt as paid-in capital and that any difference between the receipts and the market value of the shares would be totally irrelevant -- essentially a reduction in the receipts that the company might have realized by selling the same number of new shares on the market over some period of time. So why does it matter that the "group of private investors" happen to be employees of the company exercising stock options? The transaction still represents a reduction of receipts for the sale of stock, compared to fair market value, rather than an expense to the company.


If a company sold shares to a group of private investors at well below market value and that group of private investors turned out to have undisclosed other relationships with the company, you are right that it would not be an accounting issue. It would be CRIMINAL, the people responsible would go to JAIL. This is a form of ebezzlement.

If the company disclosed that the group of private investors had other relationships with the company, then the company would be required to book the paid-in capital at "fair market value," forcing a debit for the difference between price they settled on and "fair market value" to be booked somewhere in their books. This would be the way that the company was prevented from "playing games" with their books.

R:

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You are ignoring the most basic feature of a competitive marketplace: competition. You don't ask ONE investment banker for a bid. You ask FOUR, and you ask them for THEIR advice on how to structure the security and the market. In their greed they'd LIKE to quote you 10x real costs, but in the competition, especially in an auction but other markets work as well, the price will be bid down.

I'm not sure to what extent competition really would drive prices of your securities down. When word got around that a few folks lost their shirts on lower bids, others would be a lot more cautious.


If one of the competitors lost their shirts it would PROVE that they had undervalued the options, wouldn't it? It would be rather strong evidence that not only was $0 an arrogant understatement of the expense associated with granting options, but even that their bid was an understatement.

Whos side are you on, anyway, mine or yours :)

R:
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THIS is why companies try to sell the idea that dilution accounts for options. Because they can hide a ream of costs in there.

Rather, you are trying to generate a paper loss when there really is a profit by converting profit to paid-in capital. The biggest problems with such an approach are that the alleged expense reflects a company's performance over a period of several years rather than its current performnce and that variations in the supposed expense would mask what's really happening in the current reporting period.


You really should read both FASB123 and/or the Exposure Document because they really do address a lot of your concerns. Neither of these documents suggests or requires that the options be expensed in one chunk as they are issued. Rather they are VALUED at the time they are granted (or based on numbers knowable at the time they are granted) and then EXPENSED only as they vest.

R:
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You are also ignoring that securitizing the risk is a CHOICE. I would and FASB would still allow binomial and Black-Scholes estimates. If the investment bankers come in higher than those, you have HIGH confidence that hese are LOW estimates, but you are allowed to use them. If the investment bankers come in lower than those, then you get lucky and get to use the ACTUAL market value.

And this also creates a lot of potential for shenanigans. The basic scheme is to form a corporation that (1) underbids substantially for your security, (2) pays its principals very generous compensation (probably including a major bonus for winning the contract), depleting its receipts, and (3) folds, probably through bankruptcy liquidation because it has future liabilities, before the first underlying options vest. The company benefits by getting a bid that's much lower than the best Black-Scholes estimate that its accountants can justify, the principals in the company that acquires the securities make a quick buck, and the originating company gets nothing back when the options vest because the corporation that acquired your security no longer exists. What has really happened here is a transfer of some amount of cash from the originating company to some friends of its top executives who acted as principles of the corporation that acquired the securities.


And how many years in a row will the company be able to do this? I think for the Cisco's of the world, which should be around as great businesses for decades at a time, this would pretty much be a non-starter as a way of dealing with securitizing options exposure. Chances are they would go with the investment bankers they have used in the past, all of whom have been around for many decades and plan on being around for many decades in the future.

Suggesting that criminal conspiracies would dominate if companies were required to securitize options risks flies in the face of hundreds of years of history of capital markets. It also significantly uderestimates the intelligence of the SEC and the FBI.

R:
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Ralph,

It's really easier to deal with replies if you post only one reply to a post rather than four or five. Unfortunately, the "Replies to your Posts" feature of The Motley Fool does not allow you to reply to more than one of the replies displayed in response to the same post.

If a company sold shares to a group of private investors at well below market value and that group of private investors turned out to have undisclosed other relationships with the company, you are right that it would not be an accounting issue. It would be CRIMINAL, the people responsible would go to JAIL. This is a form of ebezzlement.

If the company disclosed that the group of private investors had other relationships with the company, then the company would be required to book the paid-in capital at "fair market value," forcing a debit for the difference between price they settled on and "fair market value" to be booked somewhere in their books. This would be the way that the company was prevented from "playing games" with their books.


At the risk of sounding Clinton-esque, a lot depends upon (1) how "related" the "related parties" are, (2) what influence the "related parties" have in approving the terms of a deal, and (3) what disclosures the company makes about the transaction. By way of example, the company where I work leased office space from a lessor in which our chairman was a partner -- but he did not participate in the negotiations on either side due to the obvious conflict of interest and there was a note in our annual report disclosing the transaction. Thus, the whole transaction was legal and required no special accounting.

If one of the competitors lost their shirts it would PROVE that they had undervalued the options, wouldn't it? It would be rather strong evidence that not only was $0 an arrogant understatement of the expense associated with granting options, but even that their bid was an understatement.

Not necessarily. In contracts of the type that you propose, there are always "tail of the distribution" outcomes in which the actual liability greatly exceeds the expected outcome -- sort of like the odds of flipping a fair coin ten times and not getting any heads. Statistically, it should happen only once in 1,024 trials, which means that you expect it to happen once if you do the experiment 1,024 times. If you have a thousand people buying your securities, one of them probably will have such an outcome. The fact that it's a "tail of the distribution" event is very little consolation to the investor who gets wiped out.

You really should read both FASB123 and/or the Exposure Document because they really do address a lot of your concerns. Neither of these documents suggests or requires that the options be expensed in one chunk as they are issued. Rather they are VALUED at the time they are granted (or based on numbers knowable at the time they are granted) and then EXPENSED only as they vest.

It's precisely the "expensed as they vest part of the proposal that's most problematic. This leads to options assigned a high value during periods of exceptional growth showing up as large expenses several years later, when the growth may have subsided but the layoffs are not deep enough to touch the people who received the options.

Me: And this also creates a lot of potential for shenanigans. The basic scheme is to form a corporation that (1) underbids substantially for your security, (2) pays its principals very generous compensation (probably including a major bonus for winning the contract), depleting its receipts, and (3) folds, probably through bankruptcy liquidation because it has future liabilities, before the first underlying options vest. The company benefits by getting a bid that's much lower than the best Black-Scholes estimate that its accountants can justify, the principals in the company that acquires the securities make a quick buck, and the originating company gets nothing back when the options vest because the corporation that acquired your security no longer exists. What has really happened here is a transfer of some amount of cash from the originating company to some friends of its top executives who acted as principles of the corporation that acquired the securities.

You: And how many years in a row will the company be able to do this?

In some industries, this is actually commonplace. For example, real estate developers customarily set up a corporation to be the general contractor for each project and take it into bankruptcy at the end of the construction phase when the developed property passes to another business entity (typically a limited partnership in which the developer may be a limited partner that contracted to buy the property upon completion of construction). This process basically prevents any claims that arise from the construction from affecting the property after its completion.

I think for the Cisco's of the world, which should be around as great businesses for decades at a time, this would pretty much be a non-starter as a way of dealing with securitizing options exposure. Chances are they would go with the investment bankers they have used in the past, all of whom have been around for many decades and plan on being around for many decades in the future.

In reality, such occurrances probably would happen with no involvement whatsoever on the part of the corporation's management. Company formed by outside interests with such intent would garner the majority of contracts because they would underbid all players with legitimate intent of investment by a significant margin. When you have six or eight such companies placing bids in the same range and competing for the same contracts from a large number of companies that award stock options to their employees, it's rather difficult to argue that any of them have criminal intent.

This would, however, generate a real expense -- the amount that the company paid for the defaulted contracts.

Suggesting that criminal conspiracies would dominate if companies were required to securitize options risks flies in the face of hundreds of years of history of capital markets. It also significantly uderestimates the intelligence of the SEC and the FBI.

See above.

Norm.
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Steve,

Having looked through the reports and finding the options information (it is in the reports if you look for it), my problem with the accounting for options is that the company shows all the plusses (tax benefit, cash from issuance of the shares) as positive cashflow for the earnings announcement but the cost to the shareholders due to dilution is buried in the footnotes and only gets shown when the SEC filings are released months later.

Not so. If a company grants stock options, it must show the "fully diluted" earnings per share right below the actual earnings per share on the profit/loss statement.

I contend that the buy-backs artificially prop-up the stock price and allows management to make big announcements about benefits to shareholders while the net effect is virtually nil.

If the shares are fairly valued, a share buy-back should have absolutely no effect on the price of the shares. There's a reduction in cash on hand, taken from a combination of paid-in capital and retained earnings, and an concentration of future earnings that should exactly offset each other.

The reality, however, is that most companies buy back their own shares only when the board of directors deems that the shares are undervalued and therefore an attractive investment. This practice distributes the discount from true value at which the company buys back its own shares among the shares that remain outstanding.

The way they account for options exercises lets them boost their earnings numbers for the announcement while the effect of dilution only comes out when the SEC filings are released.

The standard way of accounting for exercise of stock options reflects the actual flow of the transaction. The company issues new shares and realized new paid-in capital equal to the amount paid for those shares. There's no fiction anywhere.

Several years ago, the geniuses in Congress came up with a scheme to generate more tax revenues without raising tax rates. Back when individual income taxes were as high as 90% and the maximum corporate tax rate was only half of that, the geniuses in Congress decided that exercises of stock options by employees and directors should be treated as though the company gave a bonus to the buyer equal to the difference between the fair value of the shares and the amount actually paid for them and the buyer then paid full price. The result was to shift income from the corporation to the individual for tax purposes, with the expectation that doing so would yield a significant increase in tax revenues for the government because most recipients of stock options were senior executives who would be in or very near the top tax bracket. Of course, the Congress then promptly created several classs of stock options, including "Incentive Stock Options" (ISO's) that qualify for special tax treatment....

Anyway, a fiction instituted to generate more tax revenue ought not be what determines accounting standards.

It is all nice and legal, and I am not sure that the proposed solutions to the problem won't just make the issue even more confusing to the average shareholder.

On that, we agree.

My choice is to not invest in Cisco stock because the price is impossible to tie to the underlying value of the company and while management continues to see shareholder equity as an unaccounted piggy bank for hiding a large portion of payroll expense.

The other reality is that the cash generated by exercise of employee stock options really does become working capital for the company. In many companies, this source of cash has completely eliminated the need to borrow cash and associated interest expenses.

An "expense" is something that causes money or other tangible assets to flow out of a business -- which stock options do not.

Norm.
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Norm,

If a company gives an employee stock at a 75% discount to FMV, should the company book only 25% of FMV as "paid-in capital" for the stock issued, and book no expense?

Thanks,
Ralph
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Come on you guys! This debate is so old, I could puke!!!!

Change jobs and/or sell your CSCO stock. There is no news in any of this debate and it sure isn't going to change CSCO policy. If you can't live with it-----get out!!! crpurdum
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Come on you guys! This debate is so old, I could puke!!!!

I agree but for a different reason. The die is cast. Stock options will be expensed in the near future. All the arguing and cajoling against accounting standard boards is useless -- expensing will be done. The popular outcry from shareholders, super-investors like Buffet and Gross, and organizations like CALPERs have assured that it will happen. Congress won't dare interfer again (I don't think). Arguing about whether to expense or not is moot. But now is the time to figure how to value them (and how to expense them), and not whether they should be valued.

glh
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Come on you guys! This debate is so old, I could puke!!!!

I agree but for a different reason. The die is cast. Stock options will be expensed in the near future. All the arguing and cajoling against accounting standard boards is useless -- expensing will be done. The popular outcry from shareholders, super-investors like Buffet and Gross, and organizations like CALPERs have assured that it will happen. Congress won't dare interfer again (I don't think). Arguing about whether to expense or not is moot. But now is the time to figure how to value them (and how to expense them), and not whether they should be valued.


O.K., I'm done with this debate here.

I think the issue is as "straightforward" as does Warren Buffett. I think there are only two ways to get the wrong answer in this debate:
1) To just have so little respect for the concept of Book-Value-Per-Share, that computing earnings so that a company can report POSITIVE Earnings-Per-Share at the same time issuing options or stock in such a way that Book-Value-Per-Share is dropping or flat. Dilution is an actual effect of paying people with options. Declaring a profit when your book-value-per-share is falling is an effect of not booking a cost of doing business as an expense.
2) To be ignorant of the concept of book-value-per-share and the idea that earnings-per-share should be positive when the business is ADDING to book-value-per-share and they should be negative when the business is REDUCING book-value-per-share.

Alright I guess I wasn't quite done, but I am now. Goodbye.

R:
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this is going to become the longest thread on the fool...

LOL

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Ralph,

If a company gives an employee stock at a 75% discount to FMV, should the company book only 25% of FMV as "paid-in capital" for the stock issued, and book no expense?

Generally yes, because that's exactly the same way that the company would account for the transaction if the buyer were an unaffiliated third party. The fact that the buyer happens to be an employee of the company is not material unless the terms of the deal are stipulated in the employee's contract of employment.

If the employee's contract of employment stipulates that the employee may buy some number of shares of company stock at a 25% of the market price, those terms become part of the employee's compensation and the discount should be treated as such. In most corporations that have employee stock plans, however, the stock plan is not part of the contract of employment -- which gives the company the right to modify, or even to discontinue, the plan at any time.

There's also an important distinction in this regard between a company simply selling stock at a discount to fair market value and a company selling stock because an employee exercises a stock option. A stock option is itself a tangible asset with a fair value equal to the discount at which it allows the holder to buy the stock, subject to discounting for any possibility of forfeiture during a vesting period (but note that such discounting cannot make the fair value negative because a stock option carries no liability whatsoever). Thus, the fair value of a stock option will always move in lock step with the value of the corresponding shares. If the difference between the value of the shares and the price to exercise the option is zero on the day of grant, as is the case with most employee stock option plans, the recipient receives a value of zero on that day. Any upward change in value after that day due to either (1) movement of the price of the stock or (2) reduction of any discount from the difference as a vesting date draws closer is a capital gain on the option itself that the holder of the option realizes upon exercise of the option. Since the option already belongs to the holder, this capital gain has no impact whatsoever on the company's books. The option is just like a coupon that allows you to go to the local supermarket and buy certain items in certain quantities at a certain price during some specific window in time.

Norm.
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Ralph,

1) To just have so little respect for the concept of Book-Value-Per-Share, that computing earnings so that a company can report POSITIVE Earnings-Per-Share at the same time issuing options or stock in such a way that Book-Value-Per-Share is dropping or flat. Dilution is an actual effect of paying people with options. Declaring a profit when your book-value-per-share is falling is an effect of not booking a cost of doing business as an expense.

The real value of stock generally has two components -- (1) the book value per share and (2) the present value of future earnings, taking projected growth (which admittedly can be wrong) into account. Thus, the percentage of the stock price represented by book value per share generally will be a negative monotonic function of growth rate (in other words, will decline with an increase in growth rate). As a result, the price to exercise stock options usually is well above the book value per share even at the time of exercise. It's very rare for exercise of stock options to cause a drop in book value per share.

2) To be ignorant of the concept of book-value-per-share and the idea that earnings-per-share should be positive when the business is ADDING to book-value-per-share and they should be negative when the business is REDUCING book-value-per-share.

That's not necessarily true. Book value is the sum of several terms, only one of which is earnings. Paid-in capital also is part of book value per share.

Book value also does not reflect possible changes in value of certain assets. By way of example, I own shares of the Providence & Worcester Railroad (AMEX: PWX) -- a small railroad founded back in the 1860's. The company has significant holdings of real estate purchased during its early years that are still on the books at their 1860's prices. As a result, the "book value per share" is hardly a reflection of the true value of the company.

Norm.
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Gary,

The popular outcry from shareholders, super-investors like Buffet and Gross, and organizations like CALPERs have assured that it will happen.

I would not bet on that. Several companies with VERY deep pockets that have employee stock option plans are threatening lawsuits to block such regulations because their executives will no longer be able to certify, under penalty of perjury, that the statements are an accurate reflection of the company's financial picture and thus will be forced to provide an explanation of the reason for their inability to do so (the fallacies created by the proposed revisions to the rules) under the laws enacted in the wake of the Enron and Worldcom scandals. I, for one, believe that such lawsuits have phenomenally good chances of prevailing on the basis that the Federal Accounting Standards Board has exceeded its authority by promulgating rules that distort the true financial picture.

Congress won't dare interfer again (I don't think).

I would not bet on that, either. Again, there are many companies with very deep pockets that grant a stock options to their employees. In Washington, the golden rule -- and Warren Buffet is far from the most golden.

Norm.
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John,

this is going to become the longest thread on the fool...

Far from it. Some of the boards have threads that go on for hundreds of posts. This thread is around fifty posts or so, and it appears to be just about dead.

Of course, adding tangents about the length of the thread does make it longer....

Norm.
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Several companies with VERY deep pockets that have employee stock option plans

OK, that I don't know. But when I see Intel and other companies that were vehemently opposed to expensing options, now planning to do so, I know that the pressure is really on this time.

Personally, I'd like to see options eliminated entirely. There are better ways to reward performance that don't rape ordinary shareholders as badly. But I can't say that I have ever avoided a company that issues options or sold the stock of one that refused to expense options either. But I do begin to question just who management is looking out for when I see them fighting so hard to avoid expensing. CISCO and DELL are high on my list for paring down. Neither company needs options to maintain or grow their business anymore; greed appears to be the main reason for continuing.

glh
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Gary,

Personally, I'd like to see options eliminated entirely. There are better ways to reward performance that don't rape ordinary shareholders as badly.

You just communicated that you do not understand the intent of employee stock option plans. These plans are not intended as compensation. The employees who participate in stock option plans receive just compensation for their services in the form of salary and other benefits. Here's why most employee stock option plans exist.

>> 1. Such plans align the interests of the employees with the interests of the outside owners by fostering broad ownership of an interest in the company among its employees. This alignment promotes more harmonious working relationships in the workplace and a willingness on the part of many employees to invest the extra effort to ensure the success of their work and thus the profitability of the company. It also provides a lot of incentive for employees to do whatever they can to minimize waste and to work as efficiently as possible.

>> 2. Such plans are very instrumental in keeping unions out of companies. Note that it's extremely rare to find labor unions at any company with a broad employee stock ownership plan. Union organizers depend upon a difference of interests between employees and owners to make inroads among employees. Many companies with unions have been stifled by union demands and impaired or crippled by strikes, pickets, and other union job actions.

>> 3. Such plans promote retention by creating a steep price (forfeiture of unvested stock options that have appreciated since their grant) for voluntary termination. Improved retention goes straight to the bottom line in the form of (1) reduced recruiting and hiring costs and (2) retention of critical knowledge of products, tools, methods, technologies, customers, outstanding issues, and other pertinent matters that a new employee would have to learn from scratch.

Note, however, that all this depends upon one thing -- growth in the value of the company's stock. If the stock does not sustain growth in value, the stock options become worthless and the incentives go away. If an employee stock option plan is structured properly, the rate of expansion of the possible float due to grant of new options is less than half of the rate of growth in the value of the stock after dilution.

Now, why should existing stockholders go for this? Simple -- companies that have employee stock option plans, managed correctly, tend to sustain growth in share price at much higher rates than their competitors because their employees are more dedicated and more motivated to make that growth happen.

CISCO and DELL are high on my list for paring down. Neither company needs options to maintain or grow their business anymore; greed appears to be the main reason for continuing.

You're saying the officers of these companies are maintianing stock option plan for all employees solely because they are greedy???

That does not make much sense at all. Rather, it's more likely that the management of these companies understands the benefits that I described above and perhaps other benefits as well, and consequently that it's in the company's best interest to maintain the stock option plans for those very reasons.

In most companies, there's a truce between employees and management in which the employees do just enough work to keep from getting firee and the company pays what it perceves to be just enough in wages to keep the majority of employees from leaving. Employee stock option plans break this truce by providing reward for everybody whose extra effort makes the company grow.

Norm.
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Hello everybody,

Good discussion on options. Here's a personal side:

I don't work for Cisco, but I do work in the IT side of the business in a large well-established consumer products business. I was hired recently into an 'executive" position in which I receive management bonuses and stock options. I was told when I was hired in April of last year, that because I was not employed all year, that I would be ineligible for either of those benefits until after this year.

In March, I received 66% of the planned management bonus, "because I was doing a great job". Just 3 weeks ago, I learned that I would be granted 1,000 shares in the stock option plan because my boss "thought I was doing a great job and wants me to stick around".

To put this into perspective, I was an independent consultant and founded my own systems integration company back in the hey-day of IT, and grew it to > $1Million in annual revenues. I sold it in 2001 and returned back to being an independent consultant. After the IT market for consulting crashed and off-shoring was the thing to do (and it will never come back to the US) I took this job. So I am used to having an ownership stake.

I have to say, that if there was any doubt whatsoever in me leaving for greener pastures, those doubts are history - as long as my situation remains relatively the same or better. This company has treated me great from a compensation standpoint, and the stock options were a real incentive for me to work even harder to do my part for the shares to stay over the strike price.

Cheers,
'38Packard


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If stock options cost the company only the printing bill for the stock certificates and the clerical labor to fill in the names, why do the companies take a deduction in computing taxable income for their Federal returns in an amount where the tax benefit is a large part of their GAAP net income?

From the Cisco annual report to the Securities and Exchange Commission on Form 10-K for the year ended July 2003:

CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions)

Years Ended July 26, 2003 July 27, 2002 July 28, 2001

Net income (loss) $ 3,578 $ 1,893 $ (1,014 )

Tax benefits from employee
stock option plans 132 61 1,397

If options are "free" Cisco owes the US Treasury $1,590 million for these three years and even bigger numbers for the years of the high tech stock price madness which ended in March 2003.
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