Commentary: Expense Options--but Give Startups a Break

By Steve Hamm

These days it's hard to picture Microsoft Corp. as a pint-size upstart, but back in 1985, the year before it went public, its fiscal-year revenues were just $140 million -- with a $24 million net profit. Yet Microsoft's initial public offering turned on the ignition for what became one of the world's largest wealth-creation machines. A share bought at the offering price of $21 would be worth $7,776 today and double that at its peak. At the time, Microsoft employees held 2.5 million stock options. As the share price soared, options attracted the best and brightest from giants such as IBM (IBM ) and Digital Equipment (DEC ) Corp. and helped Microsoft retain its most valuable employees.

If stock options had been treated as expenses at the time, would Microsoft have had a harder time taking off? Possibly. "Microsoft's history is proof that early-stage companies need broad-based stock options," says Joseph Blasi, an economics professor at Rutgers University and co-author of In the Company of Owners: The Truth About Stock Options. "They could not have afforded to offer that kind of employee ownership if stock options were expensed."

Options helped build the tech industry into a powerhouse in the 1980s and fueled America's productivity engine during the '90s. Mandatory expensing of options could make it harder to get that machine humming again -- with a negative impact on both competitiveness and productivity.

Large companies can afford to expense options, but startups could find it harder to bring new innovations to market. Expensing would make it more difficult for startups to recruit, since they use the potential of a huge options payday to lure top talent. It could suppress earnings at a time when startups need credibility with potential customers. Analyst's Accounting Observer estimates that expensing would have suppressed the earnings of the Standard & Poor's 500 by 23% in 2002. The impact on options-heavy startups could be considerably higher. Expensing could also delay their IPOs since post-boom, investors want to see a strong earnings track record.

That's why a case can be made for giving pre-IPO companies a break on stock options. The Financial Accounting Standards Board appears to be open-minded about the matter. While FASB is poised to make expensing of stock options mandatory, its chairman, Robert H. Herz, agrees that startups are different. "Pre-IPO, nonpublic companies are one of the issues we need to address as to whether or not there should be something different in how you account for those companies' stock compensation," he says.

Making exceptions for startups doesn't sound fair to critics of the way stock options have been handled. They think there should be one standard whether a company is public or private. But government rules are full of exceptions -- the graduated income tax, for one. Already, FASB stock-option regs make exceptions for some categories of companies. Non-public companies that expense options get to calculate their valuations using a different formula than the rest.

An accommodation for startups need not be limited to FASB's rulebook. Congress could make exceptions, too. Rutgers prof Blasi is considering the notion that legislators could provide a tax break equal to the option expenses for companies that offer options to most of their employees. His research shows that companies with broad-based equity outperform those that do not.

It shouldn't be difficult to fashion a stock-option deal for pre-IPO startups that's fair to companies, employees, and investors. But time is running out. FASB plans to issue a recommendation by yearend. Microsoft may not need stock options anymore, but all the potential Microsofts out there could sure use a helping hand.

Corrections and Clarifications "Expense options -- but give startups a break" incorrectly described Joseph Blasi as an economics professor. He is a sociologist at Rutgers University. Also, the research referred to in the article was conducted with his colleagues Douglas Kruse, James Sesil, and Maya Kroumova.

Senior Writer Hamm writes about technology from New York.

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