Take The Medicine By not expensing stock options now, tech firms are just prolonging the pain
Hal Plotkin, Special to SF Gate
Thursday, August 15, 2002
The tech sector’s head-in-the-sand reaction to the need to reform stock-option accounting practices is surprising for an industry that likes to pride itself on its supposed ability to respond rapidly and effectively to changing business conditions.
Clearly, that’s not happening this time around.
Last week, the International Accounting Standards Board announced it plans to issue rules that will require stock options to be treated as a business expense starting in 2004. Companies that don’t adhere to those standards will become international pariahs. Once the standards are formally set, investors will have the opportunity to pick and choose between companies that play by the new rules and count all their expenses and those that do not. In short, investors would be nuts to buy stock from companies that put themselves in that latter group.
But that’s exactly where tech executives are stranding their firms. Most of these execs continue to maintain that their companies should be viewed as “special cases,” as they rely more heavily on stock options than other types of businesses — and, they claim, distribute them more widely to employees. They add that if options were counted as an expense, tech firms would not be able to use them as freely to attract the talent they need to compete in the global marketplace. What’s more, many tech CEOs are also standing by their longtime assertion that stock options are not really a business expense in the first place.
By prolonging a battle that’s already been lost, tech execs are further damaging their companies, delaying the recovery they so badly need and shredding what little credibility they have left, particularly with investors who have grown weary of being taken for chumps.
The clear and predictable result of their recalcitrant, stalling approach is to keep a sword of Damocles hanging over the balance sheets of their firms, where it promises to take the heads off any investors foolish enough to buy in before the now-inevitable accounting adjustments take effect either by force of law, because of the new international standards or by marketplace fiat.
Even worse, tech leaders are fighting the accounting change with the same confidence-destroying and ultimately self-defeating tactics that were used to create this mess in the first place: phony, or at least highly misleading, numbers. One of the main goals of their latest effort at misdirection is to fool the public into thinking stock-option reforms will primarily hurt employees, rather than top executives.
That’s the message leading Silicon Valley luminaries such as Intel CEO Craig Barrett, Cisco Systems head John Chambers and Apple Computer founder Steve Jobs have been trying to get across in recent weeks.
But although Silicon Valley’s leading executives may not realize it yet, the debate about whether stock options are or are not a business expense is, for all intents and purposes, already over.
Dozens of top mutual fund managers, and millions of individuals, have already come to that conclusion. The savviest among them understand that current stock-option accounting practices — whose effects are more pronounced in the options-heavy tech industry — give the advantage to company insiders at the expense of outside investors.
Let’s briefly review how that works.
As I wrote in a February column, those pushing for the accounting reform say all costs should be counted before a company reports its profits to the general public, including the undeniable costs involved whenever companies grant stock options. These costs include pushing up a company’s need for cash because less stock is available to be used in mergers or acquisitions or for other corporate purposes. What’s more, when options vest (which means their owners can claim them), they dilute the value of shares already in circulation, which hurts investors who have paid the going rate for their shares.
The law of supply and demand dictates that the more options a company has outstanding, the more likely it is that its stock price will go down. (Actually, it’s even worse than that, because corporate earnings are calculated on a per-share basis, which means the same earnings, or net profits, are divided between a larger number of shares after options vest, pushing the earnings-per-share figure down, which typically sends stock prices in the same direction.)
In truth, the tech industry’s current stock-option accounting procedures are little more than an elaborate pyramid scheme, which is why you see so many top tech executives cashing their options out rather than holding on to them.
Dozens of companies have gotten the message loud and clear about the need for stock-option accounting reform. The mainstream firms that have already voluntarily agreed to deduct the cost of granting stock options from their earnings include General Electric, Coca-Cola, General Motors, Procter & Gamble and Fannie Mae. Tech firms as a group remain the last big holdout, with just a handful of them (most notably Amazon.com and Computer Associates) making the change, which will result in reporting lower, albeit more honest, per-share earnings in the future.
The leaders of the firms that are changing the way they account for stock options say it makes sense to get the pain over with now, while stock prices are weak, rather than do it later, when it might hurt whatever recovery might be ahead. But most tech executives continue to swagger around like power-drunk megalomaniacs, saying they will make the accounting change only if and when the coppers force them to. Some even seem to think they’ll be able to prevent the unfolding accounting reforms from being applied to the tech sector because of that claim about how special they are.
But the evidence fails to substantiate that assertion.
Last month, for example, Silicon Valley’s usually astute and highly respected congresswoman, Anna Eshoo, was embarrassed when the New York Times revealed she had relied on inaccurate numbers about who actually gets stock options in an editorial she penned for The Chronicle. Using data that has also been frequently cited by the Silicon Valley lobbying group Tech Net, Eshoo claimed 10 million Americans had received stock options last year. But the real number of stock options granted to employees in the tech industry is actually a lot lower than that.
When the Times interviewed the original source of the data, the Oakland-based National Center for Employee Ownership, the paper discovered that while seven to 10 million Americans hold stock options, fewer people actually get them each year. What’s more, the center’s actual data shows that only about 3 million Americans got stock options in 2001, and Department of Labor data suggests the figure is even lower. (For the record, Eshoo’s office told the Times her claim was based on an incorrect sentence in the center’s report).
But even those lower numbers are misleading. They say absolutely nothing about who gets the bulk of those options, and how little of them really go to the average employee.
Take Cisco Systems, for example.
In making his case that the options-accounting fight is really all about employee rights, company CEO John Chambers frequently cites figures that show that last year, Cisco’s top 25 executives received just under 6 percent of the company’s stock options, with the rest going to employees. On first blush, that certainly sounds like the executives are putting the employees first. But a far different picture emerges when you analyze what those numbers really mean.
At last count, Cisco had 36,761 employees. That means the top 25 executives are getting, on average, nearly 100 times more options than line workers. And this is at a company where the CEO is boasting about how well its workers are treated.
There is, of course, one other mantra tech executives chant to argue against expensing options. There is, they say, no fully accurate way to place a value on a stock option that has not yet been exercised, because its true value is known only when the option is cashed in, not when it is granted.
But once again, the CEOs are using a shred of truth to fabricate an essentially dishonest argument.
To be sure, an imperfect formula called Black-Scholes (named after its Nobel prize-winning creators) is used to estimate the future value of options. But the world of honest corporate accounting is full of cases in which costs and revenues of one sort or another are estimated. As billionaire investor Warren Buffett has pointed out, many companies routinely boost their earnings substantially by assuming that corporate pension funds will yield exceptional returns, which reduces the liabilities those companies would otherwise have on paper. Since there is no fully accurate way for companies to know exactly how much their pension funds will earn, why don’t executives exclude those figures from their balance sheets as well? Likewise, does a piece of five-year equipment really depreciate entirely over five years? Of course not.
None of these accounting practices are entirely accurate descriptions of reality. They are common accounting conventions, good-faith estimates made by a standard set of rules that allow investors to compare apples with apples — which is better than the alternative of not counting anything, which would undermine, if not totally destroy, investor confidence in public equity markets.
Silicon Valley’s tech-industry leaders want to bury that information in obscure SEC filings that most investors won’t ever see, much less understand. Remarkably, even at this midnight hour, they’re apparently still hoping to find wheels they can grease to keep their Ponzi scheme floating for as long as possible, or at least until their next round of oversize options vest.
So what’s the average investor to do? It’s simple: Just don’t buy their stock.
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