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expensing stock options

What's the big deal with expensing stock options? It seems like it's a good idea to give your employees a stake in the success of the company. Why does expensing them make them less attractive?

Jason
Tuesday, April 06, 2004

Let's say you're a big software company with a stock price that's going up 100% every year. By tossing your employees a few stock options, you can give them the equivalent of thousands or millions of dollars in compensation without spending any cash. In fact, you can lower their base salary at the same time and they won't really mind because they're making so much money off the stock options. Indeed in the late 80s Microsoft salaries were probably 30 or 40% lower than the competition -- those were the years where every employee became a millionaire.

Where do all these options come from if you don't spend any cash for them? Usually, you issue more stock. This has the effect of diluting the existing shareholders. To take a simple example, if you have a million shares outstanding, and you issue another million shares for the purpose of giving stock to your employees at a below-market price (when they exercise their options) now there are two million shares outstanding. If the company is worth as much as it was before, each share has just halved in value. Effectively, you have taken money out of your shareholders' pockets to pay your employees.

Why is this even legal? It's not, unless the shareholders agree to it, and they do, because to the shareholder, they can either pay the employees by having money come out of the company bank account, which reduces the value of each share of the company, or they can pay the employees by increasing the number of shares outstanding, which reduces the value of each share of the company.

Did you catch that? Pay close attention -- I'll give you another example. This is the critical insight. Are you paying attention? Good.

I'm a big software company worth two million dollars. There are a million shares outstanding. Each share is thus worth $2.

Now I need to pay my employees. They need $1 million in salary.

SCENARIO ONE. I pay them cash out of the bank account. My company that was worth $2m is now worth $1m, by definition, because we just paid out $1m in cash. When that million went out the door the value of the company had to be reduced by a million, right? So each share goes down in value from $2 to $1.

SCENARIO TWO. Instead of paying them in cash, I get permission from the shareholders and issue another million shares of stock and give those to the employees. Now there are two million in shares outstanding instead of one million. And the company is still worth $2 million because I haven't spent any money ... nothing has gone out of the compnay. So each share goes down in value from $2 to $1 just because there are twice as many shares around.

Notice the common theme? In both cases the underlying value of the share went from $2 to $1.

What's the different between Scenario 1 and 2?
* In both scenarios the employees get $1 million.
* In both scenarios the shareholders see the value of their shares go down by 50%, from $2 each to $1 each.
* In scenario #2 the company is theoretically happier because they have more cash on hand.

And the clincher:

Under the old accounting rules, if you don't have to expense options, with scenario #2 you show an extra million dollars in profit that you don't show in scenario #1.

So far we haven't mentioned profit at all. Profit is income minus outgo. Income is the same in both scenarios. The only difference is whether that $1m flowed out of the company or not.

Since scenario #1 and #2 are really the same thing, for all intents and purposes, it's not really fair that companies following scenario #2 should report an extra million dollars in profit that the company following scenario #1 didn't have.

In other words, we're really doing the same thing vis a vis the employees and vis a vis the shareholders in both scenarios. So why should the profit be a million dollars more in the second scenario? It doesn't make sense that you're suddenly more "profitable" because you chose to pay employees by diluting shareholders rather than depleting the bank account. To the shareholder, it's the same thing.

The old accounting system meant that the wall street numbers of "earnings per share" are not trustworthy. This made a big difference for many companies which appeared to be hugely profitable in terms of earnings per share.

When investors try to compare companies they look at things like price to earnings ratios (price of one share divided by earnings per share). If you require companies to expense stock options, meaning, you require them to reduce their profit by the amount that they diluted the shareholders by issuing new shares, you make it so that companies will report the same earnings per share whether they used scenario #1 or #2, which is more honest to the shareholders and allows two companies to be accurately compared in terms one another. It means that stock analysts don't have to figure out, themselves, based on the dilution of shares caused by employee stock options, how to compare company #1 and company #2 - they can just look at the earnings and know that employee stock options aren't causing them to take a big dilution hit for one company versus another. In the bad old days the only way to compare the earnings per share of two companies honestly was to dig through the annual reports, figure out the dilution cause by stock options, and try to recalculate the "earnings" yourself based on that information, which was often incomplete or late. Needless to say stock analysts didn't really bother; of course the Motley Fool crowd went along happily comparing PE ratios of companies without realizing that employee stock options meant the earnings figures were distorted in unpredictable ways.

Expensing stock options is a way to make sure that the dilution cause by issuing stock to employees is fairly accounted for in the earnings per share and thus give the shareholders a better picture of the performance of the company per share.

Joel Spolsky
Fog Creek Software
Tuesday, April 06, 2004

so can we have this mini article on the main site please?  Oh such good description - even I understand it now, whilst I didn't before!

i like i
Wednesday, April 07, 2004

Yes, very very nice explanation.

  
Wednesday, April 07, 2004

Looks like Jason hit a nerve with this one.

I can see "JoelOnInvesting" on the horizon. FogSTOCKZ anyone?  :)

oh my
Wednesday, April 07, 2004

Great article.

This prompted me to do a Google search on options vs. restricted shares, which received a lot of press when Microsoft decided to issue shares over options.  I never understood the difference between them.  This article explains it pretty well.
http://www.usatoday.com/money/perfi/columnist/block/2003-07-14-ym_x.htm 

Wow, I've been at work 10 minutes and I feel like I've just become a stock expert.

Kyle
Wednesday, April 07, 2004

Great explanation.

I'm all for proper accounting, the thing is how do you put a current value on a stock option?  There's the whole time value of money thing -- a million dollars in dilution a few years from now isn't the same as a million dollars paid in salary now.  There's the employee retention thing -- I'm sitting on several thousand vested options that are fairly close to being in the money so I'm going to think twice and three times about that the next time a recruiter calls.  The cost of replacing me is money that the company will not have to spend.  Plus, to put a current value on an option you'd need to know what the future performance of the company stock will be.

I just don't see how you can come up with a proper current value for something with so many intangibles.

Tim Stills
Wednesday, April 07, 2004

Good explanation?  Perhaps, but only if you state that you are simplifying for didactic purposes.  Your explanation implies that in the stock option scenario, the company issues a million dollars worth of new shares and expenses a million dollars.  I am reasonably certain this is not the case.  In fact, one of the arguments against expensing options has to do with what the algorithm for expensing them should be.  You need to take into account several things.

Joel glossed over a few points.  The stock options will only be exercised if the stock price goes up.  If the options are exercised, the employee still has to pay for them.  He just gets them at a better than current market price.  Depending on which type of options they are, the employee will be taxed on part of that difference as income.

Also, it is wrong to say that if the employer chooses to pay employees a million dollars more over the course of four years ( a typical vesting period) that the market capitalization of the company goes down by a million dollars.  There is no way to tell how the market will value that extra cash on hand.  During the go go days of the bubble, investors might have down-graded a stock for this "wasteful" practice.  Nowadays it might inspire confidence that the company os solid.  I'm not sure how to tell.

The take home lesson is valid though.  By issuing stock options the company is incurring potential future liabilities and the argument is that these should be accounted for in some way.

name withheld out of cowardice
Wednesday, April 07, 2004

that link should be:

http://www.usatoday.com/money/perfi/columnist/block/2003-07-14-ym_x.htm

  
Wednesday, April 07, 2004

Tim, there's a very easy way to come up with the proper value for a stock option: you put it up for sale on the open market and see what investors will pay for it. They will probably start with something like a Black-Scholes model to figure out the price, depending on the structure of the option. For a major publically traded stock, the value of the options is directly calculable from the volatility of the stock. Indeed when Microsoft abandoned their stock option compensation system, they had J.P. Morgan come in and offer all the employees cash for their options based on (presumably) market prices.

Joel Spolsky
Fog Creek Software
Wednesday, April 07, 2004


I suppose that the Tax implications in scenario #1, is that the 1 Million gets taxed Now through income of the employees, while in scenario #2 it gets taxed in the future and only if the options get exercised. So in general the government would prefer scenario #1 to scenario #2. Is this the driving force for the change ?

PaulB
Wednesday, April 07, 2004

Not really. The driving force for change is that investors want good earnings data so they can decide which stocks to buy.

Joel Spolsky
Fog Creek Software
Wednesday, April 07, 2004

No, the driving force for this change is that management who are paid mostly in options (e.g. Enron, Tyco) do everything they can (including illegal things) to drive the price of the stock up in the short term.  They cash out at a high strike price, and leave the mess for someone else (i.e. the shareholders).

Anonymous
Wednesday, April 07, 2004

> Your explanation implies that in the stock option scenario, the company issues a million dollars worth of new shares and expenses a million dollars.

I'd guess the way it _should_ work is, if for example my shares are worth $1 this year and I issue one stock option to buy at $1 then my expense for this year is $0. If my shares are worth $2 next year then I should expense that option as $1 even if the option isn't exercised that year ... and if the stock volaue goes up again the next year, then I have a further expense for the option for the next year ... but if the option goes "under water" then my associated expense should be zero.

Christopher Wells
Wednesday, April 07, 2004

"So why should the profit be a million dollars more in the second scenario? It doesn't make sense that you're suddenly more "profitable" because you chose to pay employees by diluting shareholders rather than depleting the bank account. To the shareholder, it's the same thing."

Well....this is up for debate.  While I agree that at least having a line item showing newly distributed options is important (it's already being done), I still don't see how you can equate giving away stock options (which for most companies, you can't even buy a cheeseburger with) with paying real money.  They are *not* the same because companies *can* spend that real extra million dollars on real things (like creating products and employing more people). 

Expensing stock options will throw a nasty wrench into the tech economy while giving  us nothing.  A fair compromise is to expense the stocks *WHEN THEY ARE CASHED IN*, especially given that expenses  would be given based on estimates, not real numbers.

( Also is the scenario is a little...no, make that way too simplistic in assuming the value of the company = the value of the cash it has in the bank, but let's not get too complicated here. :) )

Crimson
Wednesday, April 07, 2004

One thing that I would like to remind all the people who are basically saying "we can't expense options because we can't know exactly what they're worth" is that there are already lots of numbers on the balance sheet that come from estimates, formulas and comparative market valuations rather than from real goods and services being exchanged for real money. Accounting now for an expense or income that will be incured later is an accepted accounting principle.

Bill Tomlinson
Wednesday, April 07, 2004

> when Microsoft abandoned their stock option
> compensation system, they had J.P. Morgan
> come in and offer all the employees cash for
> their options based on (presumably) market
> prices.

Getting ANYTHING for an underwater option that you didn't pay for in the first place is a pretty good deal!  The price they offered for the underwater options was reasonable, though it did seem to be somewhat below what you'd expect to get on the open market -- obviously they have to make a profit on the options at some point. 

Or do they?  I got to wondering about that.  An option is essentially a leveraged bet that the price of the underlying security is going to move in a certain direction -- in this case, a bet that MSFT would move up, rather dramatically.  Does JPMorgan really want to make that big a bet?

Perhaps not.  They may be pursuing a delta-neutral strategy.  Here's how that works:

The amount of value an option gains or loses as the value of the underlying security moves is called the delta. 

Suppose you have an option contract to BUY XYZ at $10 at some point in the future.  If the stock price changes, you might make money, or if the option goes underwater, you might lose the price of the option (which includes a commission to the broker.)

But what if at the same time you also have an option contract to SELL XYZ at $10?  The contracts balance each other out -- you are delta-neutral.  No matter which way the market moves, you gain money on one, lose it on the other (and end up paying a commission to the broker to obtain the contracts in the first place.)

That seems stupid.  Why is this a sensible strategy if you're always making zero profits AND paying commissions?

Because if you're big enough, you turn it around: JPMorgan does NOT pay commissions to buy and sell contracts, they COLLECT commissions every time they buy and sell stuff!  Now they're golden -- if they manage to sell both contracts, they make commissions on both sales.  If they don't, the contracts balance each other out and they lose/gain nothing (except what they paid for the contracts in the first place of course.)

If they manage to get a big delta-neutral position in Microsoft, and find enough people to buy and sell both kinds of contracts in equal measure, then it doesn't matter to them whether the stock price goes up or down -- what matters is that lots of options change hands and hence they get lots of commissions. 

In other words, they're betting that MSFT will remain volatile and attractive to options traders.  This strategy turns _randomness_ into _money_. It stops making money only if the stock price becomes predictable and slow-moving.

Anyway, that's just a conjecture.  I don't know if JPMorgan is actually pursuing a delta-neutral strategy or not.  Anyone out there know?

Eric Lippert
Wednesday, April 07, 2004

The other dirty little secret is that companies are/were allowed to deduct stock option compensation expense for _tax_ purposes but then didn't have to on the numbers they report to investors under GAAP.  (Generally Accepted Accounting Principles)

Yes, companies keep two sets of books because the rules governing how you account for things under GAAP and the IRS are vastly different.

So it was the best of both worlds for management.  Lower your tax burden and report better looking numbers than reality to shareholders at the same time!

Jeremy
Thursday, April 08, 2004

James DeLong has an interesting examination of this issue. He represents options as an important way to reward intellectual property in modern corporations.

http://cei.org/gencon/025,03055.cfm


Thursday, April 08, 2004

So, from the corporate viewpoint (not the employees'), if you have to expense options, what is the difference between offering options and offering restricted stock?

bob bechtel
Friday, April 09, 2004

Joel's explanation is not correct.  His math is based on if you actually gave the employees the shares, not if you gave them an option to buy shares.

Giving restricted shares is a variation on this theme and the only difference is that you can't sell the shares for a period of time and they vest over a period of time.

Options are a very useful and very abused compensation system at the same time.  The original thought was that you could let employees participate in some of the upside of a growing company.  They were especially useful for companies that didn't have public stock as you didn't want so many stockholders (for SEC and other reasons)

You could value them by many different ways, but the major problem remains that if the stock loses value, you've given away nothing, and if the stock increases in value you've given away something quite significant.  That's it period.  So you have a problem.  Is it worth nothing or everything?  You don't know.  I know the Black-Scholes model very well but it doesn't apply in this case because you the employee can't trade the options and you the company can't buy them.

Obviously they motivate employees to increase the stock price, however the question is how.  If you have management that only cares about short term spikes, well you get some big abuses.  Same thing if the market goes crazy, should employees reap a huge windfall???

Also remember that if  they end up out of the money that expense didn't really exist and you get a profit for that quarter.  So if you start doing poorly your numbers will look better because you'll get to un-recognize the expense which didn't occur.

I think the only thing that makes sense is to do four things:
 
1. All options are null and void upon any restatement and funds have to be returned.  All option procedes must be held in escrow for three years.

2. All options have to be excercised upon vestment date.  One of the big problems is giving people options without having them expire for a long, long period this makes them much more valuable and hard to value

3. Have a moving strike price based on market indexes.  If the market is going crazy you don't get a windfall because of it.  Conversely if the market is going down but you've held your own you get a reward.

4. All options get correctly expensed on vestment date.  If you are out of the money, no expense, if you are in the money you know the exact expense.  i.e. $110share price -$100 strike price = $10

Now the argument from the accounting side will be that you incurred the expense when you gave the option.  I would say no, you've incurred the expense at the vestment date.  The employee gets the money in three years.

Philip Sugar
Friday, April 09, 2004

There are two problems with expensing stock options:

(1) The "expense" will vary over time as the stock price changes
(2) The "value" of an option may have  nothing to do with the actual cost to shareholders.

Let's look at an example using Cisco's 2003 stock price:

Imagine that in January of 2003, when Cisco was trading around $15, Cisco granted 100 options to various employees with each option having a strike price of $30.  Let's say that these options expire in five years, that is these are January 2008 options, and they vest in two years.  Therefore, the employees would only be able to exercise between January 2005 and January 2008.

Using a Black-Scholes calculator and entering in some educated guesses on volatility and interest rates, we get back a "value" for each option of around $4.  Cool.  Cisco then subtracts $600 from its balance sheet as an options "expense."

So, here's where Cisco stands in January 2003:
stock price: $15
options granted: 100 (Jan 2008) with a strike price of $30
options "expense": $4 x 100 = $400

In January 2003, Cisco is showing an "expense" of $400 that hasn't actually occurred.  Cisco has not spent $400.  They have merely granted their employees some options that may or may not eventually be exercised that were "valued" at $400.

Now, let's fast forward to January 2004:
Cisco has rocketed to $25.  We run our Black-Scholes calculation again and find that the employee options are now valued at around $9.  Hooollly Jesus!  Does Cisco have to subtract another $500 from their balance sheet just because their stock price has gone up?  That seems insane.  And what if Cisco's stock price had went to $10 or $5.  They could add back income to their balance sheet.

All of this balance sheet chicanery would occur without any money changing hands.  And, if Cisco's stock price does not rise above $30 before January 2008, all of the options "expense" would have to be added back to the balance sheet because no actual expense would ever have occurred.

It's also important to note that in-the-money options that don't correspond to actual shares are included in the diluted earnings per share calculation.  Therefore, the expense would also need to be backed out once Cisco rises above $30, otherwise the "expense" would both subtract from the "e" (earnings) and add to the "p" (price) in the P/E.  It would count as a double-whammy against the corporation when it should at most be a single-whammy.

That pretty much covers point (1) above.  Now, let's examine point (2).

Why should investors even care about the "value" of employee stock options?  Answer, they don't, or at least they shouldn't.  Warren Buffett likes to argue that options should be expensed because the corporation is essentially giving away a benefit without showing an expense on the balance sheet.

It is true that options are a benefit and they may end up diluting the shareholder base, but it is also true that the options may end up costing shareholders nothing.  But notice, that in any event, the option will never actually "cost" the company money.  If the option is exercised, it will merely result in the issuance of more shares.  The result is a dilution of earnings, not an actual expense.

For example, a company with $10 in earnings and 100 shares priced at $1 each has a P/E of 10.  If this company then grants employees 10 options that are exercised, there will be 110 shares outstanding giving the company a P/E of 110/10 =  11.  This is the only way that options will affect a company.  There will never be an actual expense; there will just be some additional number of shares issued which results in diluted earnings and a higher P/E.

Because there  is no "expense" involved, what we need is not the Black-Scholes option valuing formula, but a formula that gives us a likely number of shares outstanding given the current number of out-of-the-money options outstanding  (in-the monies are already included on a 1-for-1 basis).

Let's see if we can come up with some type of formula that will do this for us.  What would this formula need to do?  Well, it needs to give us a percentage factor that we can multiple by the number of out-of-the-money options to give us a pro-rated number of shares outstanding.  If the formula spits out 50%, this would mean that there is a 50% chance that the options will eventually be exercised in the money.  So, if there were 100 out-of-the-monies outstanding, we would multiply by 50%, giving us 50 shares that we should add to the outstanding shareholder base. 

This formula would be very similar to the Black-Scholes formula, but instead of giving us an option value, it would give us a likelihood that the option would get to the money before it expires. 

I don't know much about the Black-Sholes model, so I don't know how to convert it to the type of formula I want, so for my purposes, I'll just use the option value as computed by Black-Scholes over the stock price to give me a factor that I will use in an example below.

We'll use Cisco again, and assume 1000 shares outstanding.

In January 2003 we have:
stock price: $15
shares outstanding: 1000
options granted: 100 (Jan 2008) with a strike price of $30
options "expense": $4 x 100 = $400
factor: 4/15 = 0.27

So, to get the pro-rated shares outstanding, we do the following:
1000 + (0.27)(100) = 1027.

Now, instead of a magical $400 expense on the balance sheet, we have increased the number of shares outstanding based on the likelihood that the outstanding options will eventually be exercised in-the-money.  This keeps unnecessary, confusing expenses off the balance sheet and puts the "cost" of the options where it may eventually end up:  expanding the shareholder base.

Now, let's look at January 2004:
stock price: $25
shares outstanding: 1000
options granted: 100 (Jan 2008) with a strike price of $30
options "expense": $9 x 100 = $900
factor: 9/25 = 0.36
pro-rated shares outstanding: 1000 + (0.36)(100) = 1036

If Cisco had earnings of $100 in January 2003 and January 2004, we would get a diluted P/E of 1027/100 = 10.27 in January 2003 and a diluted P/E of 10.36 in 2004.  Under this scenario, options would still be "expensed," but the expense would show up where it belongs, in the P/E and in the diluted shareholder base, not on the balance sheet or income statement.

Sound reasonable?

dino
Saturday, April 10, 2004

What Joel did not go into with his explanation of stock options and his option #1 and option #2 is that after he has completed option #1 his employees have a million dollars and can walk away.  If the company suceeds or fails those employees still have their cash.  With option #2 the employees have a monetary stake in the company.  If those employees keep doing what they are doing and Joel is smart and manages the company well; the company and those options will increase in value.  The employees will have the opportunity to share in that increase in value by either cashing out their options and getting more cash at some later date (if they were to wait until the company was worth 3 million dollars and sold their option for $1 they would make $2 instead of $1).  Or the employees can choose to exercise the options and buy and hold the stock.  You see part of stock options is that they have a life time of anywhere from 1 day to many years.  After that life time ends the options are worthless.  When employees buy and hold the stock they have an opportunity to continue to benefit from the growth of the company. 

Brian Ford
Monday, April 12, 2004

Joel said:

Indeed when Microsoft abandoned their stock option compensation system, they had J.P. Morgan come in and offer all the employees cash for their options based on (presumably) market prices.

Yes, they did.  But when J.P. Morgan arrived they looked at all of the options and only agreed to buy those that were in a range that was close to current value of the shares.  So those employees who had shares that were "under water" but close to having some value were able to get some (small) amount of compensation.

This is a great thing to do if you have some people working at the company who either don't want to work there anymore (and whom you want to leave somewhat more happy) or as a reward to some long struggling folks who need a reward before you change the rules of their compensation.

Brian Ford
Monday, April 12, 2004

I don't think I buy the assertion that issuing a stock option  isn't very different from issuing the stock itself.  When you exercise a stock option it doesn't magically turn into stock, that stock has to come out of the market somehow.  Take the extreme case that a company had three times as many options as shares: If everyone exercised, all hell would break loose.  You'd have to satisfy as many options as you could, then beg the people to sell the shares back so you could satisfy the next group of options.  That would drive the market price of shares way way up, demand would be so high you could name your own price.  Completely the opposite of the "watered down stock value" hypothesis.

Keith Wright
Monday, April 19, 2004

Keith:

I think one of the problems is that companies proclaim two things:

(1) Stock options are a (practically free!) way of aligning employees interests with shareholders

and

(2) The just announced share buy back is helping shareholders.

In fact, Oracle, Siebel and other software companies spend 100s of millions of dollars on share buy backs; these share buybacks are just mopping up the shares issued to employees. (I.e. shares in issue remain constant.) In what way is spending this money not coming out of the pockets of shareholder?

Robert Smithson
Tuesday, April 20, 2004

I'm not defending options.  They obviously cost something.  I just think Joel has the analysis all wrong.

Keith Wright
Tuesday, April 20, 2004

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