Don’t cry for the corporations or executives too much. If you read some 10-Ks, executives are covered under an employement contract with defined seperation benefits. Many times you will see language like:
“he will be entitled to a “gross-up” payment in respect of any excise taxes he might incur.”
Translation: The executive will be paid for any excise taxes withheld due to the tax regulations.
This was definately part of the Clinton tax package. You remember the one that passed the Senate due to Al Gore’s tiebreaking vote. The tax package that allowed the government to achieve a balanced budget during the Clinton years.
Also, just because a corporation can’t deduct a cost for tax purposes doesn’t mean they won’t pay the cost anyway.
Yeah, but what I see first hand, working for a large corporation, is that a major portion of the compensation of the very upper level management are bonuses (called “variable compensation”) that is directly tied to the stock price. So even if you eliminated the options, they’re still financially driven to get the stock price up.
Unfortunately, for public companies, I don’t see how you get around this. Ultimately the stock holders are the owners of the companies, and they demand that the stock price rises and dividends flow. The whole system hinges on stock price. If your company’s stock price gets too low, relative to the assett value of the company, you’re going to be gobbled up by another company and probably at least partially dismembered. If your stock price drops too far, your financial rating gets lowered and the cost of capital (actually the cost of money) gets higher, making it more difficult to grow.
Of course, getting the stock price up isn’t the problem - if you do it in a real and sustainable manner. That’s a good thing, as it means the company is actually becoming more valuable. Lying and cheating is obviously the problem. Also, stock prices have become so disconnected to the actual value of companies, and not because of lying execs: the market has such an irrational, emotive component that causes stock prices to rise and fall based on “feelings” and events that have nothing to do with the companies in question.
It has been suggested (John McCain was championing this, I believe) that board members not be allowed to hold stock in their company at all, and I think it may not be as crazy as it sounds. The conventional wisdom is that a personal investment in their company aligns board members’ interests with the shareholders that they represent. That’s obviously not always the case, however, and in some instances (Jason’s post above has some good examples) it even creates a conflict of interest in which said board members screw the shareholders to feather their own nests.
I don’t know any non-crazy ideas to solve the problem. I think when the person takes the job they should have the stock’s current price as their “base level” or somesuch, and then they can earn salary based on that. If they go below it, they don’t get paid. Penalties for workforce reduction as well.
And if they bankrupt the company they get one punch in the stomach from every person that loses their job and then get catapulted into the ocean. The catapult would be of sufficient power to ensure a minimum airtime of 30 minutes. There would be special computer-controlled guns that would pelt the person with dung while in mid-air.
My other idea is that they’re declared a x% owner of the company based on how much stock they own, are not allowed to ever sell that stock, and that they receive the same x% of the actual, uncooked profits as their salary. When they quit, they have to just give that stock away to their replacement. If the company posts a loss, they pay back their salary to the tune of x% of the loss. If they can’t, it’s catapult time.
Have you or someone you know been recently laid off? :D Very imaginative employement agreement.
I keep my severance package materials (which I thankfully did not have to accept) close at hand as a reminder to not get to dependant on my current job or company.
>Basically, they’re saying options should be listed as expenses. So - how do you value an option?
I’m not sure anyone clearly answered this original question. It’s not a simple answer – there’s no perfect way to do so.
Here’s the basic premise of the problem: the current reporting of earnings doesn’t take into account “in-the-money” exercisable options. In-the-money exercisable options are options to acquire shares for a purchase price per share that’s less than the current market price per share (the listed stock price). So the perceived “problem” is that those options could readily be exchanged for shares, and therefore it’s inappropriate to list the company’s profit per share (return to shareholders), without presuming that these options were exercised for shares. Since there’d be more shares outstanding after the exercise of those options, the actual earnings per share would be less than what’s outstanding.
But that “problem” has been ridiculously exaggerated, and there’s no clean way to deal with it anyway. It’s been exaggerated because the current reporting requirements already require companies to disclose option particulars – so the information is already publicly available: nothing is being hidden from investors. So essentially the objection is that people are too stupid to do the calculation themselves, and therefore need it presented differently.
But the reason it’s not currently presented is because there’s no way to perfectly calculate the ultimate “expense” when an option is issued – key to remember is that the exercise price of options is always the per share when issued (so there’s no immediate benefit - and option holders only get any benefit if the price goes up and they exercise their option). It’s possible the share price will go down below the exercise price of the options before they are exercised (which has happened a lot lately, obviously), making them valueless. It’s also possible the company will issue a lot more shares, making the ultimate dilution to shareholders when the options are eventually exercised for shares less meaningful. Or the company could repurchase shares, making it more exaggerated.
So in order to “expense” options, you essentially have to predict all of these contingencies. The most accepted way for doing so is a very complicated formula called the Black-Scholes model (you can get a sense for it here: http://bradley.bradley.edu/~arr/bsm/pg04.html), but even though its perceived to be the best method of predicting the ultimate the expense, it’s inherently inaccurate since you’re dealing with contingent events.
It’s all a ridiculous red herring, really, since all of the information that can accurately be disclosed is already required to be disclosed. What this is clearly all about is just a discomfort with the fact that senior officers of public companies make a lot of money when their company’s stock goes up, which annoys people because: (i) people think it’s too much money for anyone to “fairly” make (I guess they should be petitioning professional athletes and actors then); and (ii) more importantly, the fact that the stock went up often isn’t related in any significant way to the performance of the executive.
All of the new “corporate accountability” rules are ridiculous, and provide illusory security to the six-packers. What people are overlooking is the fact that all of the current scandals resulted from breaches of the current laws – the actions that people were pissed off at were already illegal, today. The only legitimate concern should be the enforcement of the existing legislation (and increasing the penalties, if you think as I do that they were inadequate).
Sorry for the long post. Hopefully it was of some help.
>As long as those who are running the company are also deciding how much they get paid for it
They don’t. Compensation of executives of public companies is decided by a compensation committee composed of independent (non-employee) directors. By, for the last 20 years at least, the compensation of senior officers of companies has not been decided by the folks running the company.
You’re arguing that the actual value of the options can’t be determined; I agree. However, it doesn’t matter; the actual value of the stock itself can’t be determined at any point in time, only what people are willing to pay for it. The same applies for with options. The actual net value of MSFT doesn’t vary by 3% a day, only the price people will pay for it. Employee option grants are compensation, and compensation should be expensed at the market value of the compensation. I don’t see what the difficulty is; do you think if the company was selling the options on the open market, people would refuse to buy them because they couldn’t figure out what they’re worth? They can’t do it perfectly, but they can bet on a future stock price this way just as easily and accurately as they can by shorting the stock.
The “anger about executive pay” is a red herring; only the usual liberal suspects are pissed off about that. Everyone else is angry because companies are inflating current earnings by not properly accounting for the future potential of stock dilution through options.
Take Ebay; this is from a Motley Fool article:
eBay issued 19.55 million options last year – what does that mean? The way I gauge options is to compare them to the total number of diluted shares outstanding during the year options were issued. So for eBay, we take 19.55 million divided by 280.595 million diluted shares, as of the end of 2001. The result, 0.0697, tells us that eBay’s 2001 options represented just shy of 7% of total shares outstanding. That’s a huge number. At that rate, eBay could dilute shareholders’ interests by 40% in just five years.
Currently, if you want to see how much potential dilution (or future liability if it’s done through buybacks; it’s the same thing) a stock has outstanding in company-issued options, you need to:
Find the DEF-14A proxy statement.
Take the number of options given to any given executive, multiply that by the inverse of the percentage of total options for the year that executive received.
They don’t even put the total goddamn number anywhere, you need to derive it yourself.
‘So essentially the objection is that people are too stupid to do the calculation themselves, and therefore need it presented differently.’
Perhaps they should just sent me a copy of all their invoices every year. I mean, I can calculate everything myself, right?
>You’re arguing that the actual value of the options can’t be determined; I agree. However, it doesn’t matter; the actual value of the stock itself can’t be determined at any point in time, only what people are willing to pay for it.
I disagree - arguably the best definition of “actual value” is what people are willing to pay. The actual value of the shares at any given time is what people are willing to pay at that time. No, I’m arguing that you don’t know the actual value of the expense, because it might not be an expense at all, if the option is never exercised (because the option grantee doesn’t have the opportunity, or elects not to, exercise while it’s in the money).
>They don’t even put the total goddamn number anywhere, you need to derive it yourself
Are you stating that there’s no requirement to state the aggregate outstanding options? If so, that’s a difference between Canadian and U.S. securities law that I wasn’t aware of and, like you said, it’s a stupid omission since you can get the aggregate amount looking at the option grant percentages disclosed in the executive compensation chart attached to the annual meeting proxy circular.
I’m fairly certain that you can see the number of options that a company issues to top executive, and for sure you can see precisely how many options are exercised (as well as stock sold and bought) for the top executives of any company.
Again, Desslock expresses my puzzlement on the valuation of options: many options are never exercised, due to the stock price never hitting the point where they make money (even taking into account that you usually get them at a decent price point.) Thus those options never cost the company any value at all. James, I think your argument is that they are worth the cost of a similar option to the public at the time of issue, but I assume that would be valid only if the company would have offered the same number to the public had they not been issued to employees.
By the way, it’s a fallacy to think that options only go to top executives. Many companies, such as the one I work for, offer them at all levels of the company for good performers.
That’s why I said guessing the future exercise percentage and stock price is pointless: the market for options determines it for you.
If the company prints some new stock, there’s a 100% chance that all other shares will be diluted. Options are between a 0% and 100% chance that all other shares will be diluted. What’s the current cost of the chance the option will be exercised? What you can sell it the option for in the market. Why not put that as an expense (or net worth, whatever it should be stuck under, as long as the value’s right?)
>They don’t even put the total goddamn number anywhere, you need to derive it yourself
Are you stating that there’s no requirement to state the aggregate outstanding options? If so, that’s a difference between Canadian and U.S. securities law that I wasn’t aware of and, like you said, it’s a stupid omission since you can get the aggregate amount looking at the option grant percentages disclosed in the executive compensation chart attached to the annual meeting proxy circular.
I’m not entirely sure; for example, Ebay’s proxy lists the total shares outstanding and the weighted average.
However, the weighted average is useless: the weighted average of (1,000 @ 10, 1000 @ 20) is the same as that of (1,000 @ 5, 1000 @ 25), yet the amount that would hypothetically be exercised at some future point at 8 is different for the two sets; 0 in the first set, 1,000 in the second set. Basically, you have to work through the proxies for the last n years and try to assemble a data set of what the options were all issued at.
Why are they doing this, instead of the much-clearer market-value expense method? In my opinion, the companies must think they’re getting something by not clearly stating the outstanding value of their options. The harder information is to get, the more likely something will be mispriced because of it, and in general they can keep their stock price higher than it would be otherwise by not being above-board about the future dilution potential. And in whose interests does it work if the stock price is higher than normal? Why, the people with the options, of course.
Using fair-market value expensing at issue time also clears up how to value repricing; just treat it as a new issuance.
Another annoying side effect of options not needing to be expensed is that you can completely eliminate the tax liability of any company by just issuing enough options to cover up your profits. Check out this story:
It all adds up to serious distortions in the balance sheet, when the entire point of the balance sheet is to provide a clear picture of how the company’s doing.
“How does that change the cost to shareholders in dilution though the option?”
OK - I’ll reveal my ignorance here. When I exercise my options, through my local broker (which is how I do it), am I not acquiring stock from the current pool of company stock, albeit at a subsidized rate? Or are new shares generated just for me?
>If the company prints some new stock, there’s a 100% chance that all other shares will be diluted. Options are between a 0% and 100% chance that all other shares will be diluted. What’s the current cost of the chance the option will be exercised? What you can sell it the option for in the market. Why not put that as an expense.
That’s a good summary. The reason I’d argue against putting as an expense is because it’s a contingent expense, and quantifying it at all is misleading since your estimate is likely wrong, and perhaps materially wrong. Why force companies to play that sort of guessing game, and require the introduction of numbers that we know are going to be inaccurate, and potentially misleading?
But there should be full disclosure of: (i) the number of shares that can be acquired pursuant to outstanding options, and the number that are currently ‘in the money’, and (ii) the particulars of all option grants to the top 5 executives, as well as the number of shares the executive group can acquire pursuant to options. That way, to the extent investors want to see how much the earnings/loss per share are potentially diluted by options that may one day be exercised.
But introducing expense approximations is a mistake, in my opinion, because it’s inherently inaccurate and will just create additional opportunity for companies to report their results in inconsistent ways.
>Another annoying side effect of options not needing to be expensed is that you can completely eliminate the tax liability of any company by just issuing enough options to cover up your profits
That’s true, but due to the inconsistent treatment of options by the tax legislation and GAAP. I completely agree that should be resolved (either way).
>OK - I’ll reveal my ignorance here. When I exercise my options, through my local broker (which is how I do it), am I not acquiring stock from the current pool of company stock, albeit at a subsidized rate? Or are new shares generated just for me?
New shares are generated for you, although the maximum number that can be issued pursuant to option grants is approved in advance (by the shareholders, if the number is changed after the company is a public company, and the listing exchange(s)).
But companies are not required to reflect that option pool of stock when expressing their earnings/loss per share (because the shares aren’t actually issued yet, they are just reserved for issuance), which is the perceived problem – if you include those options, there are actually more securities outstanding, and therefore the earnings per share are less, because the earnings should be divided by a larger ownership pool.
I can see the “inaccurate estimating” objection; I disagree (companies guess on depreciation expenses and pensions, too), but that makes sense. What I don’t get is that everyone who opposes expensing (that you see arguing in public, at least) says the current situation is just fine; why, you can look at the footnote and calculate it all yourself!
Requiring a list of all the options granted at, say, 1% intervals in the current price would be ok, but I’d really prefer the (highly accurate according to Warren Buffett) estimated expense at time of issue.
The tax thing is way slimy; it effectively makes the employees pay more on their compensation than the company would have if they’d kept it. Bleagh.
I certainly didn’t expect to see a thread on option valuation here. I secretly suspect that Desslock is trying to sell an interest rate collar to Jason. Either that, or Jason wants to get reimbursed for Qt3 reading and internet connection charges as a business expense. :)
