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August 21, 2003

Much Ado About Options

d“And I know what’s been on your mind,
You’re afraid it’s all been wasted time”
     -The Eagles, Wasted Time

Although it has been more than three years since the now infamous economic bubble burst, regulators, congressmen, and press remain remarkably insistent on identifying a blame agent for the excesses of the late 1990s. This is despite the fact that economic bubbles exist precisely because everyone is caught up in the game: the SEC approved every S-1 filed in the late 1990s; congressmen welcomed the tax income from excessive capital gains (and even planned for it indefinitely); and the press as you know, hailed Enron’s rise as much as its demise.

The latest target of this well-intentioned group is stock options. Its seems that stock option instruments, as opposed to human greed, malfeasance, and corruption, were so dangerously alluring that they encouraged otherwise ethical men and women to commit fraud on our economic system. It seems that options offer way too much upside for executives without the appropriate downside exposure, encouraging them to take unnatural risks as leaders of corporate America.

The first strike in the war against stock options is the insistence that they be expensed on a company’s income statement. The argument is that options represent a grant of value from the corporation to the employee and therefore should be expensed on a GAAP accounting basis. While companies are not currently required to expense options, they are required to disclose the exact nature of all option grants in their financial statements. Many believe that the FASB will require the expensing of stock options in the future.

The second strike against options came on July 15, when Microsoft Corporation announced that it would forgo all future stock option grants in favor of restricted stock grants. Business Week heralded “Microsoft’s Bold New Pay Plan,” and many others speculated that this single action represented the beginning of the end for stock options. Newsweek even jumped in on the action, declaring “options have lost a lot of their allure.”

Despite these reactions, many questions lack succinct answers. Should stock options be expensed? What about restricted stock? Is restricted stock better for employees? Is restricted stock better for shareholders?

Stock options, like publicly traded call options, represent the right to buy a stock at some point in the future. They are typically granted “at the money,” which means that employees only make money if the stock goes up above its current price, and their economic gain per share is limited to the increase in stock price above the strike price. Restricted stock, on the other hand is an outright grant of a share of stock, with certain limitations on when that stock is “earned” and when it can be sold. Unlike stock options, restricted stock retains much of its value, even if the stock price of the company falls.

Should stock options or restricted stock be expensed? The answer to the question is an easy one: it doesn’t matter. Stock prices, just like any other financial asset, are valued according to the predicted future cash flows discounted back through time, as appropriate for risk. In fiscal 2003, Microsoft generated nearly $16B in operating cash flow and will likely do more than that in fiscal 2004. Neither the choice of equity compensation nor any decision to recognize such offering as a GAAP expense will have any measurable impact on this cash flow. New grants of either options or restricted stock will represent future dilution, and the company will need to earn a return above and beyond that dilution in order to generate value for shareholders.

Mutual fund managers understand this; they have understood it for some time, and they adjust for it in their calculations. To suggest that a mathematical non-cash accounting change will affect future stock prices, especially when the exact numbers have been available to shareholders for many years, drastically underestimates the collective intelligence of the stock market. Smart investors have already accounted for this future dilution, regardless of the actions of the FASB, and therefore these future grants are already reflected in stock prices.

Recent events in the market support this claim. In the week following Microsoft’s restricted stock announcement, the stock barely moved. Perhaps more noteworthy, since Amazon announced it would begin expensing options on July 23, 2002, its stock is up 275%. Should we expense options on corporate income statements? Wall Street’s response is a collective and accurate yawn.

Are restricted stock grants better for employees? Overall, the likely answer is “yes,” but it is not a resounding one. If a stock falls below its granted price, restricted stock grants still have value, while options are worthless. However, an employee, who is granted the exact same economic value in terms of restricted stock will make less money on the upside as compared to someone granted the same economic value of stock options. Seemingly, this “extra upside” is that which tempts executives to behave badly.

One downside to restricted stock for employees in that taxes at ordinary income rates must be paid on the day that restricted stock grants are earned (i.e., the day that the shares are vested), despite the fact that the employee has not realized cash value for this grant. Said employee will be digging into his or her pocket to pay cash taxes on non-cash income. This can negatively impact employees without the cash flow to support such activity, and will likely encourage most employees to sell stock in order to raise money to pay the taxes.

Is restricted stock better for shareholders? This is the question that seems to go without much scrutiny. Compensation consultant Watson Wyatt Worldwide calculates that employees would be better off with stock options if a company’s stock price went up more than 10-15% annually, and would be better off with restricted stock in the scenarios that range from negative 99% return up to a positive 10% return. As the historic return in the stock market is approximately 10-12%, it is hard to understand why investors would favor an incentive package that is more appealing to employees when the corporation underperforms the historic market. Is seems to fly in the face of good sense.

In addition, restricted stock grants could encourage a form of widespread corporate conservatism. If an executive is granted $2MM worth of stock, he or she might have incentive to help increase the price to say $2.3MM, or 15%. That said, the incremental $300K is peanuts when it comes to protecting the value of the $2MM already on the table. There is a huge difference between corporate sustainability and corporate value creation. GM traded at $38 per share in 1994, and since it is $38 per share today, it has “sustained” value for the past nine years. Is this the type of behavior we hope to encourage?

Are options more risky? Unquestionably. But risk and reward have always been correlated, and that is why over the long run, stocks have outperformed bonds. The difference in performance between stocks and bonds is known as the “equity risk premium.” Yet, executives with restricted stock incentives are likely to encourage behavior and returns more in line with bonds. This may be good news for startups in Silicon Valley, who can prey on the stagnation in innovation at large companies, but it will do little to benefit the overall U.S. economy and could actually harm U.S. global competitiveness.

Another frequently discussed benefit of restricted stock over stock options is that it has more value, and therefore employers can offer fewer grants. The conclusion is correct, but the premise that employers can reduce the financial impact of executive compensation is flawed. Employers are likely to offer fewer absolute shares, but the value in each share, because of the downside protection, will be much greater. At the end of the day, the financial value of the executive compensation remains unchanged.

This was certainly the case with Microsoft. After its initial announcement, the press broadly embraced the idea that Microsoft’s 2004 restricted stock GAAP impact would be less than it had been using stock options. However, when Microsoft fully unveiled its plans for 2004 restricted stock grants, it predicted the impact to be the exact same $0.24 per share that it calculated for its option grants in fiscal 2003. In 2003, Microsoft gave out $4B worth of stock options to employees. In fiscal 2004, Microsoft will give out $4B in restricted stock to employees. This is another reason that Wall Street failed to react to this supposedly significant event. More yawns.

So why would Microsoft make such a decision if it is of little difference or even potentially negative for shareholders? While granting restricted stock is relatively common among more mature public companies, rest assured that this highly successful company spent many brain cycles on the issue. Also recognize that to classify Microsoft’s decision as altruistic is to fail to appreciate the most competitive and properly self-interested company of the past 30 years. As it turns out, there are many reasons Microsoft would favor such a move, even at the sacrifice of enduring more conservatism in the future.

As a reward for its dominance, Microsoft currently enjoys remarkable operating margins of nearly 50%. These margins are not particularly supportive of the arguments made in anti-trust hearings that the company faces incredibly strong competition. As such, anything that helps reduce GAAP earnings could be deemed a positive. Secondly, and also relating to recent litigation events, it is certainly in the company’s best interest to appease Washington. As congress is currently focused on these seemingly devilish things known as options, it would be in Microsoft’s political interest to play to its concerns.

Most importantly, Microsoft is under enormous pressure from Wall Street to distribute its $50B hoard of cash in the form of a dividend. With this cash position likely to grow by more than $10B in fiscal 2004, this pressure is not likely to subside. With stock options, Microsoft employees who have not exercised their options would fail to participate in any large dividend (because Microsoft historically used non-quals instead of ISO’s, which required taxes to be paid at ordinary income rates and not capital gains, it is unlikely that any employees had exercised their options). As many are speculating that the company may be pressured to undertake a one-time balloon dividend of up to $25B, this is quite significant. This likely helps explain why Microsoft also arranged for J.P. Morgan to purchase all current employee options, instead of letting those options remain in place and simply granting restricted stock for future compensation.

For the most part, the arguments regarding stock options and restricted stock are indeed much ado about nothing. In either case, decisions to include them in GAAP accounting results will have little if any effect on stock prices. Additionally, they both represent equity claims on the corporation, and most companies are likely to encourage some form of equity participation by their employees. The one key difference, however, is that restricted stock will encourage executives to become shepherds of corporate value protection – not creation. And that subtle difference flies in the face of the fiduciary duty of the board of directors to “enhance” shareholder value.

Posted by Bill Gurley on August 21, 2003 at 08:00 AM | Permalink | Comments (0) | TrackBack

DISCLOSURE: The information contained Above the Crowd has been obtained from sources believed to be reliable but is not necessarily complete, and its accuracy cannot be guaranteed. Any opinions expressed herein are subject to change without notice. The author is a general partner of Benchmark Capital, a venture capital firm in Menlo Park, Calif. Benchmark Capital and its affiliated companies and/or individuals may have economic interests in the companies discussed herein. © J. William Gurley 2005-2006. All rights reserved.