In the third of my three posts on stock options, I would like to address the issue of expensing stock options on a company’s income statement. I think that this policy, which was developed by the Financial Standards Accountability Board (FASB) as FAS 123r, is nonsensical.
The decision to expense stock options had its origins in the period following the Enron and WorldCom scandals and the dot.com bust. Congressional hearings were held to uncover the causes of the scandals and one focus of legislator and media outrage was people making money through stock options—though options were clearly not causative of the scandals. You may remember that no less an eminence than Steve Jobs was investigated by the SEC regarding options he was issued by Apple’s board.
What followed the decision to expense stock options was a decade in which fewer stock options were granted to fewer people, which has been documented in at least two studies. That can’t have been the public policy objective.
No Sense, or Nonsense
Here is my analysis of why expensing stock options makes no sense, particularly for the companies that have received early stage venture capital. Let me begin by confirming that I am not an accountant; I don’t want to be an accountant; you don’t want me to be an accountant; the world doesn’t want me to be an accountant; the world probably has enough accountants already; and, my favorite accountant is Bob Newhart, who famously left the profession (involuntarily) because “getting within a few dollars was good enough for me.”
But I do know enough about accounting to believe that the accounting treatment of a transaction should follow the substance of the transaction, and that expensing stock options does not follow the substance of the transaction. It attempts to make an income statement item out of what is actually a balance sheet item.
Argument For Expensing Stock Options
The argument for expensing stock options is that they are a form of compensation and should be treated like cash compensation as a current-period expense against income. Warren Buffett made this argument to Berkshire Hathaway shareholders as early as 1998. (He is not an accountant either.)
If employees didn’t receive stock options, this line of reasoning holds, companies would have to pay them more in cash. This is the main argument buttressing the policy to expense stocks options in the period in which they are awarded.
In large public companies, with which Warren Buffett is mostly concerned, this argument may hold true. Options are closer to cash compensation because there is a liquid market for large company shares and these companies are managed for steady, predictable earnings. Options are granted at market prices and the rise in their value is as predictable as is the rise in company earnings.
The federal mind finds comfort in the orderliness and predictability of steady results at large companies and tries to spread these results throughout the economy by promulgating rules, including for smaller, more volatile public companies and private companies for which the argument doesn’t hold true.
Argument Against Expensing Stock Options
There is little market for private company shares. Stock options in these companies are inherently risky. The value of options is based on a 409A valuation that is highly dependent on assumptions. They will be worthless if the Strike Price* is under water when the options mature. If the private company fails, or is acquired at a price below the option strike price, or is never acquired, the options are worthless and the previous expensing of the options is shown to have been arbitrary.
Smaller public companies are somewhere in between. The market for their shares may be limited. Earnings may be less predictable, and share prices may be more volatile. Options are, therefore, more at risk than is the case in large public companies.
As these three scenarios suggest, the problem lies in a “one size fits all” rule that is best suited for large public companies.
When stock options are issued, they have no cash effect on the company (besides a de minimis transaction cost that we will overlook). Therefore, they don’t affect a company’s income statement or cash flow statement. The options are a contingent claim on the company’s shares, i.e., the company must issue additional shares to the holders when options mature and are exercised.
If the granting of options is not, as I am arguing, an expense, then how should they be accounted for? The substance of the transaction is that issuing stock options has no cash effect on the company. When they mature and if they are exercised, they dilute existing shareholders (whose percent ownership declines predicated on the number of new shares issued). All other things being equal, the value of outstanding shares will fall by the value of options exercised, minus the cash received by the company for the option strike price. Earnings per share (EPS) will also decline by a like amount.
The likeliest effect of issuing stock options will be to increase the company’s cost of capital—to the extent that the company raises capital by issuing new equity rather than debt.
From an accounting standpoint, it should be possible to calculate a company’s cost of capital considering the cost both before and after options are granted, and providing a footnote to help shareholders understand the consequences of stock options on their ownership interest. And that’s what I think should be done.
I would like to see a return to the day when stock options become a more widespread way for people working in companies to benefit from the share appreciation in those companies. Changing the accounting treatment of stock option grants to more closely mirror the substance of the transaction would likely reverse the decline in option grants and have the effect, once again, intended for stock options–to spread the wealth more widely.
*The strike price is the price at which a holder of stock options can turn them into actual shares. It is supposed to be Fair Market Value (FMV) at the time of grant. If a public company’s common shares are trading for $10, the FMV for the option at the time of grant is $10. For a private company the math is more complicated because there is not a ready market for trading its shares and there may also be multiple classes of preferred shares with seniority to the common shares into which stock options generally convert. Private companies attempt to establish FMV by using the last round of investment—if within 12 months—or a calculated FMV based on the Black-Scholes model. Since private companies often have multiple classes of shares, including Preferred Shares, the FMV strike price for an option may be well below the price at which preferred shares were last bought. “Underwater” means the strike price for the option is below the current price of the shares themselves and there is no incentive to exercise the option; it is worthless.