Commentary: Options: Clearing the Fog for Investors

By Timothy J. Mullaney

In the wake of corporate scandals and cooked books, investors and regulators are clamoring for clear, uniform, and credible accounting. For tech companies, that means coming to terms with the out-of-favor currency of the bull-market era: stock options.

To hear accounting reformers tell it, tech companies have gotten away with stockholder murder by using options as free money, a form of pay that magically doesn't appear on income statements. Their answer is for companies to come clean on options: Swallow hard and report them as expenses.

Is this a move to clarity? As a matter of fact, no. Instead, it could undermine the very transparency that the markets are demanding. Options expensing exaggerates what options really cost. The method is too complex for most investors to understand and will result in companies devising their own standards for reporting earnings--exactly what reformers don't want.

Here's the real way to give investors no-bull numbers they can count on: Instead of expensing options, include them in the share count used to calculate earnings per share. Net income wouldn't change. This idea may not seem tough enough to some investors. But its virtues are accuracy and simplicity. It tells investors how much of their company and its cash the option holders could claim, without exaggerating.

This would require a change in accounting rules. Today, companies try to come close to such a figure by reporting earnings on a fully diluted per-share basis. But those figures exclude options whose strike prices are higher than the price of the company's stock. In today's depressed market, loads of these shares go uncounted. Using all the options--let's say, producing a superdiluted earnings per share figure--would highlight the potential impact of new shares should the other options come into the money. That would cut earnings per share by 15% to 20% at most tech companies, while net income would stay the same.

The advantage is more accurate numbers. Look at Siebel Systems Inc., a San Mateo (Calif.)-based maker of sales-force automation software and one of tech's most aggressive option issuers. Last year, Siebel made $254.6 million, or 56 cents per share. Including all options in the share count, the same profit would have been 33 cents a share, about 40% lower. That's fair because Siebel's options, if all were exercised, would also boost the share count by about 40%. And as opponents of expensing options have pointed out, they don't cost the company a cent in cash. But if Siebel had expensed options instead, it would have reported a $467 million loss, or $1.02 a share--even though Siebel generated $593 million in cash.

Indeed, expensing options often produces profit numbers wildly out of whack with cash flow although the two numbers ought to move in tandem. Last year, for instance, eBay Inc. turned $748 million in sales into $252 million in operating cash flow. If eBay had expensed options, it would have posted a $14.5 million loss, not the $90.4 million profit it actually reported. Why? Mostly because the formulas for expensing options penalize volatile stocks--even though eBay's profit growth was rock solid. Stock volatility doesn't alter the economics of a business. So why should it drive earnings?

Tech can take the the high road by selling the Financial Accounting Standards Board on a rule that recognizes superdilution as the best way to disclose and explain options. It's simple. It produces numbers that are actually true. Isn't that the point of reform?

Mullaney covers technology finance from New York.

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