The True Cost of Issuing Stock Options
The recent stock exchange debacle that followed the unprecedented speculative bubble has again drawn the attention on the question of stock options, their usefulness and the governance that surrounds their issuance.
In his latest book, “The Roaring Nineties” Nobel prize laureate Joseph Stiglitz provides an extremely well thought out analysis of some important societal questions, in particular the necessity of coherence between US domestic and international policies in the economic and financial arena and the damage that the lack of such coherence can do to the perception of the USA abroad in such varied areas as foreign policy, globalisation, trade policy, development aid and fight against poverty.
A topic which is extensively developed in his chapter 5 on “Accountancy” is the question surrounding the issuance of stock options. Professor Stiglitz notes the important role these instruments have played in giving smaller entrepreneurial companies the possibility to attract high calibre talent at a stage in their development where they could not otherwise afford competitive remuneration packages to key collaborators. He then proceeds to describe in detail number of the abuses that resulted from the excessive use of options and the unfortunate direct and indirect consequences that ensued.
Being personally a strong believer in the usefulness of stock options as a tool to provide appropriate incentives to management, it seems to me all the more unfortunate that the premises of the discussion concerning the accounting treatment of stock options appear flawed, weakening unnecessarily the overall strength of the argumentation put forward.
Indeed, the description of the abuses that occurred as a result of the excessive issuance of stock options is largely correct. These include, in the main, making nearly irresistible the personal incentives stock option holders (management) had in maximising short term profits sometimes to the detriment of the long term interests of shareholders, leading to the temptation of misrepresentations, obfuscations and, in the worst cases, to actual accounting frauds. Such manipulations were clearly motivated by the desire to ensure that, upon exercise, stock options would yield handsome (and often unwarranted) immediate profits to their holders.
However, in the argumentation put forward by the author, there is confusion between the costs of stock option issuance to the company and the economic costs of the same options to the shareholders.
From an accounting point of view, there is no major difference to the issuing company between the accounting treatment of the exercise of a stock option at a given “strike price” and the exercise of a conversion option in a convertible bond at a specified conversion price. The main difference between these two procedures resides in the fact that the issuing company has the use of the “capital” represented by the principal amount of the convertible bond (which is entered until conversion as a liability on the balance sheet) between the time of issuance and its conversion into equity (and pays interest for the privilege), while it only receives the “capital” represented by the payment of the “strike price” of an option at the time it is exercised which is then immediately added to shareholders equity with no corresponding liability.
It therefore seems appropriate that companies be submitted to similar disclosure requirements relating to stock options as they are in the cases of stock splits/dividends and/or issuance of convertible bonds. These are all well tried and tested procedures that have been in force for decades and have fully served their purpose. These requirements should include, in particular, the obligation to get prior approval of shareholders for the issuance of options as well as reporting earnings of a pro forma “fully diluted basis” which would assume the exercise of all outstanding options.
This approach would avoid having recourse, for accounting purposes, to a subjective “valuation” of the options granted which, from the issuing company’s point of view, is not to be considered as a cost.
It would nevertheless be appropriate that such a valuation be included in the proposals made to shareholders regarding issuance of options so that they can measure the “dilutive” impact of their decision on their equity as well as provide them with a more accurate view of the remuneration of management since they are asked to share with the company (and not through the company) the total cost of the remuneration package. This valuation could be validated by appropriate experts, i.e., accountants or investment bankers. Boards of Directors should therefore only have the power to propose allocations of individual stock option packages to individuals subject to ratification by shareholders rather than being free to make such allocations within an “authorised” overall ceiling. Under existing procedures there was nearly total opacity in this process whereby shareholders, having authorised the issuance of options, were nevertheless unable to relate specific allocations to the compensation packages of management thereby allowing conflicts of interest to develop between management, the Board and themselves.
There is no doubt that, during the recent bubble, the excessive issuance of stock options influenced executives and gave them strong incentives to manipulate accounting rules in order to misrepresent a company’s operations with the aim of influencing the stock price and consequently the value of their own options. In this endeavour they were indeed aided and abetted by accounting firms and bankers as well described by the author. It does not, however, follow that the non inclusion of the value of options as a “cost” against earnings was the direct cause of these accounting manipulations.
It seems to me that the whole controversy surrounding the position taken by the FASB and the SEC stemmed from their flawed initial analysis on the nature of the financial significance of options on company accounts. The insistence that the “value” of options be considered a “cost” to the issuing company (rather than a dilution of shareholder’s interests) left the field wide open to the efforts of company managements and other interests (politicians financed by contributions) to oppose successfully appropriate disclosure measures. The argument put forward by Professor Stiglitz that such disclosure would have “reduced the profits” of reporting companies by significant amounts appears incorrect. The whole accounting controversy contributed also to deflect, temporarily, the attention from the unrelated accounting manipulations and also from the real cost born by the shareholders in terms of per share profits* (which underpin the stock market prices) as they slept comfortably through the seemingly ever increasing value of their investments.
In summary, I think it fair to say that the analysis of Professor Stiglitz, the main conclusions of which I fully share, would be strengthened rather than weakened by dissociating the question of accountancy of options from the abuses that took place in other areas in which the existence of options may have weighed. It would be a shame if, as a result of the rude awakening of shareholders and regulators to the realities embedded in stock options, new rules (i.e. imposing a charge against earnings) would render prohibitive the correct use of these valuable instruments.
Paul N. Goldschmidt
* This phenomena was further enhanced by the fact that for companies reporting losses, dilution through issuance of options actually reduced the per share loss rather than increasing it, obfuscating the fact that if profits eventually materialised the reverse effect would become true.