Stock Options - Why not expense them?

originally published at blogs.sun.com/pdiamond June 24, 2004:

Just came from the rally in Palo Alto to oppose FASB ruling that stock options should be expensed. For those who do NOT have access to stock options, the answer seems pretty simple:

* "These people are making lots of money off stock options, taking advantage of opportunities we don't have and inaccurately reflecting their expense on their companies' bottom lines. Of course they should be counted as an expense when they are granted"

I'm sure alot of this is also reflective of the abuses which have been widely reported, of CxOs making million$ while their companies went down the tubes.

Now here's another view of reality - for those of us who have

* made some money (thank you, Netscape) and
* not made any yet (I am still optimistic, Sun),

it also seems pretty obvious.

All those options we have been granted which we do NOT exercise, because they are "underwater", e.g.:

* Netscape /AOL options at $75 when the stock price was $20,
* current Sun options at $12 (and I know many people with options well above that price) with the stock a little over $4,

are irrelevant to anyone. They are no more expense to the companies which granted them than they are profit to the employees who are not exercising them.

If and when they are exercised, then let's talk about how the companies should expense the benefit received by the employees. I admit to being ignorant as to how this is handled today. This seems to be a much more relevant issue than trying to assess some current value on some theoretical future benefit, which in many cases will either not happen, or will occur at a totally unpredictable level.


the following comments were provided:

It simply isn't true that underwater options have no value - they do, and there are well established methods for estimating just what that value is: ever heard of the Black-Scholes formula? I actually have a teeny bit of financial experience, and I'll say flat out that there's no question that options ought to be expensed at their present fair market value. If you think your options are truly worthless just because they're underwater, why aren't you ready to throw them away? On the very slim chance that you are, I'd be perfectly happy to take those "worthless" pieces of paper off your hands. The bottom line is that the issue isn't whether there's a cash expense of any sort at issue, but whether present shareholders' future earnings per share are at risk of dilution from option grants outstanding, which they surely are in the case of both Sun and AOL. PS - Either there's something wrong with your blog's preview function, or this post is about to have its paragraph breaks zapped for no good reason. Of course, we'll know which alternative is correct by the time you're reading this ...
Posted by Abiola Lapite on June 25, 2004 at 12:20 AM PDT #

Abiola. You are correct there is some value today to a Sun stock option at $60/share. However, if that value is less than the value when the option was awarded, the decrease in value must be accounted for. Nothing I have seen has suggested any method for this. An unrealized gain on behalf of the awarder? If an option expires without exercising (which could very well happen to that $60/share option at some point), how then should it be accounted for if it was expensed before? The fact is, under accrual based accounting, expenses should be realized when they are incurred. For an option, that shoud be when it is exercised. This would be a very reasonable method. Any other method must require a rectification in case the value differs from the original expense.
Posted by Mark Harrison on June 25, 2004 at 02:43 AM PDT #

Mark,

You're right that expenses should be generally realized when they are incurred, but I see no reason why that should preclude the expensing of options, any more than the fact that a lot of capital expenditure is paid for upfront precludes its amortization over a period of many years.

For public companies like Sun and AOL with long trading histories, and therefore plenty of volatility data to work with, it is simple enough to carry out an initial estimation of the value of a given option grant at the time it is made; this can then subsequently be periodically re-evaluated on, say, an annual basis, just as as with goodwill and valuation reserves. The stock (pun intended) argument, typically made by those who stand to gain the most from options schemes, that there are no good ways of valuing such financial instruments is simply nonsense, as much trickier derivatives are valued all the time on Wall Street, and just because an option is underwater doesn't mean it has no value and shouldn't be accounted for.

Finally, I know for a fact that all of the top-tier investment banks routinely take into account the value of options outstanding when they make their calculations of how much companies are worth, just as they do the same with warrants outstanding; I know this because I used to work in one, and this was part of my job. The current status quo does nothing to fool professional investors who know enough to read SEC filings carefully from cover to cover, but for the average Joe buying MSFT or SUNW it is nice to have this information upfront rather than hidden in an obfuscated manner in the back pages of an EDGAR 10-K report.

Posted by Abiola Lapite on June 26, 2004 at 07:34 AM PDT #