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Tech's Best Option: Drop the Fight

By Rob Hof Sometimes the smartest thing to do in public policymaking is to quit a fight you're losing. That's what technology executives should do with their longstanding battle against counting employee stock options as an expense. Of course, they won't quit -- not yet, anyway. Indeed, when the Financial Accounting Standards Board (FASB), which is pushing new rules to expense options by yearend, holds a hearing June 24 in Silicon Valley, tech execs promise a show-stopping rally like the one they staged a decade ago. That event forced FASB to back down on options reform. But this time, the tech industry's efforts are almost certainly doomed.

True, there's a move afoot in Congress to block FASB's rule. But at best, any such legislation probably will pass the House and die in the Senate. The political winds are simply blowing the wrong way for the tech industry now. Options weren't a direct cause of the executive greed that produced scandals at Enron (ENRNQ), Worldcom, and elsewhere. But public concern about options' involvement, justified or not, makes it virtually certain that FASB will prevail this time.

What's more, a majority of institutional shareholders -- the real corporate owners -- have told Intel (INTC), Apple (AAPL), and others that they want options expensed because they believe it's the only way to compare companies consistently. Even IBM (IBM) recently wrote a letter to FASB in which it declined to oppose the move, and Microsoft (MSFT) now supports expensing.

"IMMACULATE COMPENSATION." The tech industry's position on expensing options isn't just futile, it's unseemly. An industry that prides itself on creating innovative solutions to problems needs to dispense with shrill, unconvincing arguments and threats. It's time to deal with the new reality at hand. To their credit, some execs at least recognize the need to move on. "At this point, it's unrealistic to protect this vehicle," says Eric Hahn, founder and chairman of Proofpoint, an antispam startup in Cupertino, Calif. "If this is what the market wants, we should do it."

It's also the right thing to do. The way unexpensed-options accounting works today, businesses clearly have it both ways. They pay their workers partly with options, but those options aren't counted as an expense -- except on tax returns, when companies are happy to claim the expense because then they get a tax break. If that isn't bad enough, companies routinely buy back stock to avoid dilution of share prices when employees exercise the options.

Because such buybacks aren't counted as operating expenses, they don't show up as the real cash-flow drain that they are. The result: higher reported earnings and cash flow. It's no wonder that expensing backer Reed Hastings, CEO of the online DVD rental service Netflix (NFLX), calls the current options setup "the immaculate compensation."

INNOVATION EDGE. So why do many tech execs continue to fight? Because long ago, options became a religion for them. In the canon of the Church of Everlasting Options, these shares are the holy flame of innovation. Counting options as an expense, goes the gospel, will douse the fire, make outfits look less profitable, and drive away investors. Worse, execs say, they will have to get rid of options for the rank and file, hurting innovation and slowing the economy further. And they threaten the wrath of venture capitalists like John Doerr on anyone who dares to try to rewrite scripture.

The truth is, these arguments don't hold up very well. For one, they neglect to mention that young, privately held companies, arguably the most innovative around, wouldn't be bound by expensing rules because they aren't required to report earnings anyway. So they actually will gain the very advantage over publicly held rivals that expensing's opponents claim they would lose. Indeed, that's precisely why Vinod Khosla, a general partner at Doerr's firm, Kleiner Perkins Caufield & Byers, thinks options should be expensed.

Moreover, options do have real value. The reason they can be a powerful motivator -- and the reason there's such a fuss over them -- is that employees think they're worth something. So why not recognize that somehow? If a business pays its suppliers in options, as startups sometimes do, that's counted as an expense. It's difficult to see why options paid to employees should be accounted for differently.

NO SILVER BULLET. Some tech folks privately concede the point -- but contend that the methods of measuring their value are faulty and susceptible to fudging. It's true that FASB's proposal isn't perfect by any means. The valuation formula it suggested, called the binomial lattice method, still appears to overvalue at least some options, though not as much as the Black-Scholes formula that was initially considered.

Another problem: Outfits will be required to estimate uncertain factors such as when options are likely to be exercised. "There's not really a silver-bullet solution to the valuation problem," says Rick White, chief executive of the industry lobbying group TechNet, which has not come up with a unified alternative proposal.

Tech concerns could focus their energies on finding better ways to measure the value of options. That would be constructive. Instead, their stubborn fight against any kind of expensing threatens to write them out of the debate.

STOCK PRICE IMPACT? Consider, for instance, the industry's last-gasp attempt to save options from expensing -- a bill passed June 15 by the House Financial Services Committee. The House bill would expense options only for a company's top five executives. But if they can be calculated for executives, why shouldn't they be calculated for all employees? That's bad accounting. In any case, it appears the bill won't make it past the Senate.

The most distressing aspect of tech's response to the looming expensing move is what the companies threaten to do once expensing is required -- cut back on equity compensation, especially to non-executive employees. Their reason: The impact on reported earnings will be so high that investors will dump their stock unless they cut back grants. But according to a study by the Analyst's Accounting Observer newsletter, 22% of S&P 500 companies have expensed options with no apparent impact on their prices. That's apparently because investors realize the accounting change itself won't directly affect cash flow.

Nonetheless, a study released June 21 by Bear, Stearns & Co. indicates that on average, those 112 S&P companies that began expensing cut back options grants last year by 40%. While most of those aren't tech companies, a study by the National Center for Employee Ownership says 45% of businesses that currently grant options broadly to their employees -- as many tech outfits do -- say they will cut back options to employees.

SHAREHOLDERS HAVE SPOKEN. Almost none, however, say they will cut executive grants. So threats about slashing non-execs' options undercut claims that the tech concerns are fighting expensing because they want to protect the industry's egalitarian compensation philosophy. Fortunately, says Corey Rosen, executive director of the National Center for Employee Ownership, a strengthening labor market likely will keep companies from making wholesale cuts to employee options.

Tech businesses can do better by their employees and their investors without hurting themselves or the economy. First, they should tone down the rhetoric. The shareholders have spoken, and it's time to accede to their wishes. Second, they should get more engaged in the specifics of how options will be expensed, which is part of what FASB will explore in the Valley on June 24.

Third, companies should look at expensing as an opportunity. Today's rules allow options to avoid being counted as an expense only if they're not tied to performance goals. All other options already must be expensed. So the current system perversely encourages companies to avoid tying grants to how good a job an employee is doing. Without any link to performance, options are far less motivating than they could be. As long as options will have to be expensed, so much the better if they can be used to better motivate employees.

QUIT WASTING TIME.Finally, employers shouldn't assume that options are the only effective form of equity compensation. Microsoft, Amazon (AMZN), and others have moved to offering restricted stock, which are actual shares that vest over a period of years. They also must be expensed, but restricted shares always have some value, in contrast to options, which are worthless when their strike price falls below the company's stock price.

Because restricted shares are therefore more valuable to employees, companies can give out far fewer. In Amazon's case, it's giving out less than one-third the amount of restricted stock as it did options. So even though restricted stock is likely a similar motivator, the impact on earnings is far less.

Let's face it: The war is over. It's time for the tech industry to quit wasting time, money, and energy, and get back to what it does best: Invent the next big things that will produce real wealth for us all. Hof is San Mateo bureau chief for BusinessWeek

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