A spate of companies are bowing to the wisdom d’jour that grants of stock options to employees are the equivalent of salary and should be treated as compensation expenses in corporate income statements. That is their privilege, and if it staves off new laws it will be a good thing.
Stock options – used increasingly by all types of companies but especially useful to start-ups and risky tech ventures – are now at hazard of being trampled by a herd of panicked legislators. To get a feel for Capitol Hill these days, view the cattle stampede scene in Red River.
Herewith, some facts, taken largely from CEI’s The Stock Options Controversy and the New Economy (June 2002):
· Stock options are increasingly democratized. A survey of 756 firms for 1994-97 found that employees other than the five top execs held 67% of options outstanding. Another analysis found that 86% of the value of options granted by the S&P 1,500 in 1999 went to such employees.
· Options are designed to align the incentives of employees and shareholders, and to encourage the employees to think of the organization as a whole rather than their particular unit. They solve problems created by the gap between the expertise of techies and financiers, attract employees who believe in a company’s prospects, and serve as a mechanism by which employees give each other cross-guarantees of their belief and commitment to the enterprise.
· Options are closely tied to a tectonic shift in the nature of “capital” from tangible to intangible. In 1998, before the last great bull run-up, tangible assets accounted for only 31% of the value of non-financial companies; 69% was based on intellectual property, know-how, internal synergies, and other intangibles. (In 1978, 83% of value rested on the tangible assets.) Intangible assets are created largely by the minds of employees, and options forge a partnership between mental capital and money capital.
· Treating options as expenses will produce strange numbers. Value will be estimated when the option is granted in year 0. Part of that value will be charged against earnings for each of the next five to ten years, as long as the option is still live. But by year 5, say, the value of the option will be different, up or down, depending on the stock price. So in year 5 the company will charge off an expense that is clearly wrong. One awaits with anticipatory schadenfreude the discovery by future packs of journalists that these companies are misleading investors! Something must be done!
· According to experts, the Black-Scholes options pricing model is not designed to deal with options having the characteristics of those granted to employees, so the initial value will not even represent an accurate starting point.
Can options be abused? Of course. Should they be fully disclosed? Without a doubt. Are very difficult issues of accounting involved? Of a certainty. Should they be represented on the balance sheet? This might be an excellent idea. Should their value be depreciated after they are exercised? An interesting possibility. Are grants to top executives a substitute for pay? Yes, ever since Congress’ 1993 “fix” of capping salary deductions at $1 million.
But Congress does not help investor confidence by lurching around like demented bovines stomping on a complex financial and entrepreneurial ecosystem. If the legislative herd is not settled down, the financial markets will end up like Dan, the cowboy in Red River who falls under the stampede and can be identified only by his checkered pants.
Invasion of the Idea Snatchers: Defending Technological and Artistic Innovation
A Forum on Intellectual Property Rights
July 22, 2002
8:00am – 2:00pm
Senate Caucus Room (Rm. 325 Russell Senate Office Bldg.)
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