Options Are Expenses
I should be able to stop with the title, because it seems obvious that options are expenses. As Warren Buffet said, “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”
It’s hard to argue with that logic, but special interests don’t heed to logic. (If I had millions on the line, maybe I could convince myself that options shouldn’t be expenses, too.) The arguments against options are:
(1) They are hard to value;
(2) Expensing options will overburden the technology industry and the US economy;
(3) If companies buy the stock on the open market to replace the shares they give, shareholders are not worse off.
There are probably other, equally ridiculous, reasons but I’ll limit myself to this list.
(1) It is true that stock options are hard to value — they are even harder to value than exchange-traded options because options given to employees have a longer term-to-maturity — but they are far from impossible to value. There are standard option-pricing formulas that will give good approximations of the value of the option.
Also, there are other items that effect the P&L that can be even harder to value — pension liabilities and assets; reserves for returns, asset impairment, insurance losses; and depreciation schedules, just to name a few. The difficulty of valuation does not mean that we should not value at all — it is much better to be approximately right than precisely wrong.
(2) Nothing like a statement: “we can’t make a profit if you make us keep ALL of our expenses on our books.” If that’s true, then maybe you shouldn’t exist.
Of course, the logic goes the other way as well — maybe because these companies have been inflating profits there is has been overinvestment (and the subsequent crash) in the technology sector.
(3) I can’t believe this argument even exists. It’s true that if you purchase shares on the open market with shareholder cash that the number of shares does not increase. But where is the shareholder’s cash?
The real reason for the battle is that executives want to take money from our pocket, put it in theirs and not tell us. And if they have to tell us, we might tell them to stop.
It’s sad that there is any debate about expensing options. It’s distracting from the real issue: how should companies value and expense options? Of course, if I was one of those executives, I wouldn’t want to tell my shareholders how much they’ve been paying me either.
Don Lloyd said,
September 13, 2005 @ 9:26 pm
Brian,
No matter how company executives abuse stock and option grants, the fact that it seems obvious that they should be expensed is not any kind of evidence that they should in fact be expensed.
When a company grants stock or options to executives or employees, it is the existing shareholders that are effectively giving up a portion of the future appreciation of their stock and a portion of their rights to any future dividends. The company itself suffers no expense. If a company can sell its products for more than the sum of the cash costs of its factors, it will accumulate cash at a rate that has nothing to do with exactly who owns the future stock appreciation and dividends. If a company sees its stock price rise and become more volatile, the addition of a larger pseudo-expense masks, not clarifies, the true profitability of the business of the company.
It is a strange expense indeed that shareholders would root for to be larger, as that implies that the stock has appreciated to their benefit.
As far as WB’s question goes, that is really what should be obvious. The grants of shares and options are effectively contingent offers of partnership made by the existing shareholders to the executives and/or the employees.
There can be no question that company executives severely abuse their ability to grant both stock and options to themselves and their employees. However, the pseudo-expense cure is far worse than the disease.
It is the buying back of stock with shareholder cash, with little or no attention paid to price, that is the real problem. At a minimum, executives cannot be allowed to mask the degree to which they routinely are misappropriating the ownership rights of the existing shareholders.
Regards, Don
Brian said,
September 14, 2005 @ 10:27 am
Don,
I think we agree in a lot of respects: options dilute shareholders, options have been abused by management, and options are compensation.
You, however, argue that companies suffer no expense. This is simply not true. Companies can pay their managers in cash or in stock. The form of payment should not determine the accounting treatment.
If there is no expense for options, then they should pay all their “partners” in stock and improve margins. But nothing really changed: the company is still paying for the services of the managers, albeit in different form. If we don’t expense options, the company will be receiving a gain through the services of the manager without incurring an expense.
When valuing a company, we should look at the ongoing expenses of the company. To the extent the option expenses are indicative of future options expenses, they should be included. To the extent, they are due to abnormal fluctuations in stock price, we should eliminate or add expenses.
Income statements contain many one time items that need to be adjusted to create a run rate for the future — options are just one of those items. While it is true that a good analyst should be able to come to the right number even if expenses are excluded from the income statement and itemized elsewhere, it is better to include past expenses for the benefit of the general public. (The general public that was fleeced by accounting gimicks and their own greed just a couple of years ago.)
You say something that interests me further: the cure of expensing options is worse than the disease. Is this because of the variability of the income number due to stock price changes or something else?
Also, is there a better way to discourage managers from overcompensating themselves than by making them expense options? Currently, the diluted number of shares outstanding underestimates the true dilution due to stock options because it only counts in-the-money options. It sounds like you think it would be better to change this calculation?
Thanks for your comments.
Don Lloyd said,
September 14, 2005 @ 3:19 pm
Brian,
Having just lost a long comment that I am neither able nor willing to reproduce, suffice it to say that the main problem of the proponents of expensing of both stock and stock option grants is a failure to understand that a company and its shareholder owners are distinct and separate entities. It is only the shareholders that end up paying for the benefits that grant recipients potentially receive.
Regards, Don
Don Lloyd said,
September 15, 2005 @ 7:49 am
Brian,
There are a presumably unlimited number of possible arguments that demonstrate the illogic of expensing stock grants, and by extension, option grants, but I’ll just present one of those here.
For every possible pattern of new share stock grants to executives and employees, there exists the possibility of duplicating the pattern exactly by the use of fractional stock splits.
Every existing shareholder is given new shares in proportion to the number of shares already owned, say 2%. This would be accurately described as a 1.02 to 1 stock split.
Subsequently, all of the shareholders re-distribute all of the new shares that they have received to employees and executives so as to match the quantities that they would have received in a particular stock grant program.
We now have two alternate mechanisms that result in the exact same result for all parties concerned.
Logic demands that the question of expensing must be path and mechanism independent. We have two choices. We can either expense both stock grants and stock splits, or we can expense neither.
Since stock splits are economic non-events, no person in their right mind would call for expensing stock splits.
Thus, expensing stock grants would be illogical.
This example also clearly shows that the benefits to the employeesand executives are actually being paid by the existing shareholders, and not the company.
Regards, Don
Brian said,
September 15, 2005 @ 1:54 pm
Despite the fact that you could end up with the same share distribution, your example violates the exact idea you claim I misunderstand: the shareholders and company are distinct entities.
After the stock split, everyone would own the same percent of the company — the stock split is a non-event. Then the shareholders give some of their shares to the management, presumably as compensation for employment. But why should the shareholders directly compensate the management? The company directly receives the benefit of their employment and the company pays their salary.
Management works for the company and has an obligation to the company and the board; the board works for the shareholders. The structure doesn’t allow for the direct compensation of managers by the shareholders.
It is true that the shareholders are diluted when stock options are issued. But they also lose value when the company pays management in cash. The form of payment should not matter!
An equivalent transaction to giving the options to management is to sell those same options in the open market and give the cash proceeds to management. The cash proceeds would obviously be compensation and should be expensed.
Shares used as payment for the ongoing expenses of the company should be expensed. Otherwise, I would create a company that pays its management, suppliers, and everyone else in equity. Despite economic reality, my profit margins would be 100%!
Whether or not something is expensed should depend on the reason for the payment and not the form of the payment. Compensation is an expense and the form of the compensation should not govern the accounting.
Don Lloyd said,
September 15, 2005 @ 2:40 pm
Brian,
“Whether or not something is expensed should depend on the reason for the payment and not the form of the payment. Compensation is an expense and the form of the compensation should not govern the accounting.”
Without being sure of your economic background, the partial payment of compensation by equity-based means is or can be effectively a mutually beneficial exchange between the company shareholders and the employees.
The company must compete on the labor market for the hiring and retention of its employees. Rather than pay 100% cash, there is some optimum mix between cash, fringe benefits and equity compensation that most benefits both the company and its employees.
Just as fringe benefits like health insurance cost less to the company than an equivalent plan would cost the employee himself, equity-based compensation is worth more, in properly limited amounts, to the executives than it costs the shareholders.
This is, for one thing, a tax-related issue in which the employee takes home larger amounts over time because of time-distributed capital gain taxes than they would net after combined ordinary income tax rates often approaching 50%. The law eliminating the company tax deduction for salaries over $1M is also a large factor.
The health insurance issue, is, of course, tax related as well as only the company can deduct premiums from their taxes.
Regards, Don
Brian said,
September 15, 2005 @ 8:01 pm
I agree, there are valid reasons for using equity-based compensation. I’m not saying there isn’t.
But I don’t see how your statements in your last comment imply that options are not a compensation expense.
Don Lloyd said,
September 15, 2005 @ 9:58 pm
Brian,
Ideally, companies exist for the benefit of their shareholders. Period.
As above, it is entirely possible for shareholders to enter into a mutually beneficial voluntary exchange with executives such that the executives agree to accept less cash salary in exchange for receiving fractional split shares from the shareholders. The company itself only sees a benefit from this agreement, and suffers no expense.
However, the process is inefficient and costly to carry out. Exactly the same result can be achieved by direct grants of new shares to the executives. Thus, the charging of a pseudo-expense to achieve the same exact result is illogical and wrong.
When a company creates and gives up new shares, it is not sacrificing anything except the negligible cost of paper and ink. If a company dropped new shares from a hot air ballon over NYC, has it suffered an expense? No. All that has happened is that the company is now owned by a different matrix of people in different amounts.
A company cannot own a part of itself in any real economic sense. For a company itself, its shares have no economic scarcity value as it can costlessly create new shares in effectively unlimited quantities. It is only limited by the injury to the existing shareholders that would result.
Regards, Don
Brian said,
September 16, 2005 @ 6:49 am
Don,
At this point it seems like we are going in circles and the marginal benefit of discussing this further is approaching zero. Thank you for your comments — I hope readers will learn something out of the debate.
Thanks,
Brian