For more than a decade, technology companies in Silicon Valley and elsewhere have trumpeted employee stock options as the prime driver for innovation, entrepreneurship, and wealth creation. With good reason: Options, which promise executives and employees a stake in the company's success and thus an incentive to work smarter and harder, have fostered a culture that turns new ideas into highly productive, fast-growing companies. And it gives cubicle dwellers in companies from Microsoft Corp. (MSFT
) to Cisco Systems Inc. (CSCO
) a chance to get rich. All that made the tech industry a model for the rest of the economy.
No wonder tech execs don't want anybody messing with that magic recipe. Now, as shareholder and accounting groups clamor to expense options, tech companies warn that such a move risks killing the goose that laid the golden egg. Tech execs argue this measure would force them to cut option grants, especially to their rank and file. "Innovation differentiates us, and a lot of that turns on compensation incentives such as options," says Larry W. Sonsini, chairman of the influential Valley law firm Wilson, Sonsini, Goodrich & Rosati. "We shouldn't lose this tool."
Options clearly have their place, especially at startups that can't afford big cash outlays for talent. But it's time for Silicon Valley to come clean. If tech companies logged the value of their options as expenses last year, reckons Merrill Lynch & Co., their net income on average would have been a startling 67% less than reported. That should be reason alone for tech companies to rethink their excessive use of stock options.
Fact is, expensing options won't do nearly the damage, from lower stock prices to reduced innovation, that Valley doomsayers contend. For one thing, the accounting shift wouldn't change a company's cash outlays. "If stock prices do go down, then that's an indication that there is a problem," says Merrill Lynch tech analyst Steven Milunovich. But he thinks analysts and most investors will realize that companies' situations haven't changed and will track earnings both with and without options, as they have with other noncash expenses such as goodwill.
Even some startups think expensing options won't affect behavior much. Executives at telecom startup TellMe Networks Inc., for instance, say they would simply take a large noncash charge and keep using options. "Most investors will look past this expense," says TellMe President Mike McCue. "To be competitive, everyone has to give stock options. That won't change."
There's even less of a case to be made for large companies to use options as free money. Is there really any justification for Microsoft to get a $2.3 billion aftertax boost or Cisco to get a $1.7 billion free ride when they have billions of real dollars in the bank? Execs say options match up all a company's constituents. "Stock options are an incredible mechanism to get employees, management, and shareholders all aligned," says Scott G. McNealy, chairman and CEO of Sun Microsystems Inc. But studies by Paul Oyer, an associate professor of economics at Stanford University, show that for companies with over 100 employees, options provide no real incentive to anyone besides top execs because employees believe their efforts can't have much influence on share prices.
Granted, expensing options could result in unintended consequences. Notes Rick White, president of the lobbying group TechNet: "You're making it much easier to manipulate earnings if you have to try to estimate the value of options." And if expensing them means startups won't turn a profit for several more years, some venture capitalists may stay away.
The real travesty, though, would be if tech execs make good on their warning that they may exclude the rank and file from the options game if expensing them becomes the norm. But that doesn't have to happen. Instead, execs should take the high road and cooperate with accounting experts on developing a workable method of valuing options. More important, directors could scale back from issuing gobs of options to top execs, since the massive dilution that often results is the main beef of outside shareholders.
Silicon Valley was a hotbed of entrepreneurship and innovation long before stock options became a fixture of high-tech compensation. Calling stock options what they really are--an expense--won't change that.
Hof is BusinessWeek's Silicon Valley bureau chief.
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