January 10, 2005
Future of Stock Options
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Jack Horgan - Contributing Editor

by Jack Horgan - Contributing Editor
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The FASB is part of a structure that is independent of all other business and professional organizations. Before the present structure was created, financial accounting and reporting standards were established first by the Committee on Accounting Procedure of the American Institute of Certified Public Accountants (1936-1959) and then by the Accounting Principles Board, also a part of the AICPA (1959-1973).

How Big an Issue is this?

According to David Zion, analyst at Credit Suisse First Boston, aggregate earnings for the S&P 500 would have declined by approximately 8% in 2003, versus 19% in 2002 and 20% in 2001, if employee stock options had been expensed. Further, 12 companies in the S&P 500, including Apple Computer and Nvidia, would have posted losses instead of gains last year had they expensed options. Pat McConnell, analyst at Bears Stearns, estimates overall earnings at companies in the S&P 500 would fall roughly 3 percent next year. Michael Mauboussin of Legg Mason Capital Management analyzed this data further. He found that the average stock grant was 10.5% of sales for S&P 500 companies with sales under
$1 billion but drifted to about 0.7% for companies over $5 billion. Last spring only 117 of S&P 500 used the fair value method.

According to a Bear-Sterns analyst, the 2003 reported operating earnings of the 100 largest Nasdaq-traded companies would have been 44 percent lower if they were required to expense stock option compensation.


In June the House Financial Services Committee approved on a bipartisan vote of 45-13 a bill to restrict any expensing standard from the Financial Accounting Standards Board to options granted to a company's top five officers.

The bill would also delay implementing any standard for a year, until completion of an economic impact study by the departments of Labor and Commerce. The measure has over 100 sponsors in both parties.

The House of Representatives passed a bill on July 20, 2004 which would only expense the stock options of only the top five officers of a company (HR 3574). The House sent a strong message that broad-based employee stock options are about jobs, competitiveness and employee ownership - not accounting. The bill passed the full House by a 312-111 vote with very strong support from both political parties.

In the Senate, in October 2004, 53 bipartisan Senators sent letters to Securities and Exchange Commission (SEC) Chairman Donaldson urging a delay until field testing can be conducted and an accurate valuation model can be achieved. The Senate companion bill to HR 3574, had a total of 31 bipartisan cosponsors. Congress failed to include stock options legislation in a final omnibus appropriations measure that was passed on November 20, 2004. Efforts to work with the Congress on stock options legislation will likely begin anew in January 2005 when the 109th Congress convenes.

Anna Eshoo, Democrat U.S. Rep. from Palo Alto who is the author of legislation to protect broad-based stock option plans and study the expensing issue more carefully said "This issue cuts to the heart of job creation, economic growth and competitiveness. Stock options have been a critical tool for workers to share in the success of their companies. Yet if FASB's proposal is put into effect, it will severely curtail broad-based stock option plans for rank-and-file employees."

Minority Leader Rep. Nancy Pelosi, D-San Francisco, issued a statement calling FASB's action regrettable, and said that if the SEC didn't force the accounting board to rethink its rule, Congress might get involved "through oversight, legislation, or both.''

Sen. Richard Shelby, an Alabama Republican and chairman of the Senate Banking Committee, argues that Congress should not interfere with the independent body of accounting experts.

How to evaluate the cost of stock options?

The Black-Scholes model is commonly used to evaluate the value of a call or put stock option which is a contract to buy or sell respectively shares of stock at a given price on a certain day. The inputs to the calculation are the stock price, the option price (strike), the time to maturity, the risk-free interest rate and volatility or variation in stock price over the option life. The value is constanty changing as investors, market-makers, and arbitragists re-evaluate the probability of the underlying stock reaching a given strike price and the risk-reward associated to it.

The Black-Scholes model dates back to the paper “The Pricing of Options and Corporate Liabilities" by Fischer Black and Myron Scholes in the Journal of Political Economy 81, 1973. Black and Scholes derived a stochastic partial differential equation governing the price of an asset on which an option is based, and then solved it to obtain their formula for the price of the option. The 1997 Nobel Prize in Economics was awarded to Robert C. Merton and Myron S. Scholes (Black had died) for their work on options pricing model.

Underlying Assumptions
No dividends paid during the option's life

Option can only be exercised on the expiration date (European exercise terms)

Markets are efficient (can't predict direction of market or individual stock)

No commissions are charged

Interest rates remain constant and known

Returns are lognormally distributed
Options can be freely traded during their lifetime and there is a very active market for these options. A less popular and more complex approach to evaluation is the binominal or lattice model which uses a “discrete-time” model of the varying price over time of financial instruments. This model is able to handle a variety of conditions for which the Black-Scholes model cannot be applied.

Crtics of using these models for evaluating stock options point to numerous differences between employee stock options and call and out options. First, the Black-Scholes model deals with publically traded stock, while non-public companies have no stock price history. Using data from publicly traded companies in the same industry is flawed. Second, employees are restricted in numerous ways, e.g. vesting period and non-transferability, from exercising their stock options. Third, call and put options are short-dated and have a certain lifetime while employee stock options are long lived and are exercised at unpredictable times.

In essence the Black-Scholes and binomial models require one to predict the future price of a stock even when the stock is yet to be traded. Supporters say that stock options clearly have value and that an intelligent estimate is better than assigning no value at all.

The Future

I believe that executives will still and always reap considerable rewards regardless of this or any other promulgation of FASB. I believe that investors will continue to make good and poor investments regardless of how much information is made available. The market will adjust to this regulation as it did to the dot.com bubble. The real question is how the ruling will impact non-executives at high tech companies. Will they still have a chance at the brass ring? The question is also how the ruling will impact future as well as existing startup firms in attracting needed talent.

Many in testimony before congressional committees and FASB hearings predicted enormous difficulty for small companies in complying with these regulations and in attracting talent in the future.

There can be a significant cost in evaluating the stock option expense. Small firms are unlikely to have this expertise in house and therefore will be forced to go outside to consultants.

If companies continue to grant options at the same rate as the past, they will have lower earnings. In some cases this could mean the difference between being profitable or not, having a net worth or not. Under the Federal Acquisition Regulations, companies with negative net worth are not eligible for government contracts. If a company is seeking to borrow money, it will have difficulty borrowing with a negative net worth and operating losses caused by expensing requirements. Therefore it is likely that fewer stock options will be granted.

Imagine you are a founder of a new startup and you wish to recruit others to help you implement your vision. How successful would you be if you took out a Help Wanted ad that said: “Wanted talented people to leave current employment for a position with less pay, fewer benefits, longer hours and significant risk.” Somewhat later you might want to recruit salespeople with an ad “Wanted superior salespersons for missionary selling of unknown product from unknown company.” Having co-founded a high-tech venture funded company, I fully appreciate that there are other benefits from
participating in a startup than the lure of stock options. However, it is difficult to explain these intangibles to family and friends.

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-- Jack Horgan, EDACafe.com Contributing Editor.


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