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Extreme stock options


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June 13, 2005

Extreme stock options

Michael Mandel

In a comment, Terence Lim takes exception to my suggestion that stock options should be on the balance sheet rather than the income statement:

Would you believe me if I told you my company had zero costs? I pay everyone in stock options, from the supplier to the worker for contributing to my company's "intellectual capital". My profit margin is 100%! Amazing company, but would you touch the stock with a barge pole?

Sure I'd be happy to invest--if I thought that all those people really were contributing to intellectual capital that would produce a successful product in the future. Let's consider a company which is in the business of the creation of new products, and all the actual manufacturing/production is farmed out to a supplier (pretty common these days). We can do the accounting in two different ways--one where all the costs are put on the income side, and one where they are all put on the balance statement.

Company 1 (stock options on income statement):

Labor payments=$100,000 (expensed value of stock options)

Supplier payments=$20,000

Outstanding shares held by the public=1000

Current revenues from current product=$60,000

Future revenues if new product works=$200,000

Reported profits=-$60,000

Company 2 (stock options on balance statement):

Labor payments=0

Supplier payments=$20,000

Stock options given to workers=1000 shares, fully vested

Outstanding shares held by the public=1000

Current revenues from current product=$60,000

Future revenues if new product works=$200,000

Reported profits=$40,000

In the first case, it looks like the company is running a big loss on current production. Moreover, there's no place on either the income or balance statement where the investment in intellectual capital for the next generation of products is being reported.

In fact, the second company is presenting a much more accurate picture. It's making a profit on the current generation of products, and the stock options really represent compensation for investment in intellectual capital, which will pay off in the future on the next generation of products.

Of course, we don't know whether the investment in intellectual capital is going to pay off or not...but that's where the risk comes in.

08:42 AM

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And, what's the exit avenue? How will these stockholders ever liquidate their holdings?

Stock issuance without a clear and no-risk option to liquidate would attract only the desperate and the financially incompetent, leading to the lowest quality of product/service.

Also, profit of $1 or zero cash investment is infinite (or zero; it's a singularity), not "100%."

Posted by: Carol Anne Ogdin at June 13, 2005 12:37 PM

So much of the discussion over incentive stock options would simply *go away* if we just recognized the honest truth that these options are in the form of a contract, not completely unlike a lease. There are long-term obligations or liabilities, like a lease, and there are actual expenses at times, like a lease.

The real problem is not one of accounting, but an emotional debate over the moral attitude toward employees. To some bean counters, employees are merely "workers", mechanical cogs in the machine, whose true value is measured solely by the sweat of their brow. To them, there can *never* be a justification who compensating people for capabilities that they refuse to acknowledge exist.

Options should be based on their incentive value and the likely future value of the employee contributions to the business.

If we could sort out the schedule for actual expenses from the balance sheet liabilities, we'd make some real progress. Unfortunately, the nature of the debate is such that the proponents of "expensing" will be satisfied only if you agree to recognize that an employee is a worker is a commodity.

-- Jack Krupansky

Posted by: Jack Krupansky at June 13, 2005 12:38 PM

Michael,

you make a valid point on intellectual capital, but I believe companies have already found ways to put "next generation of products" on the balance sheet. Benefits of stock options (on balance sheet)will not commensurate with the disadvatages.

In company 2,do you truly believe that labour costs are zero ie. all workers' efforts go to creating next generation products and none to producing current products? We both know it's a mixture of both, but stock options provide an easy avenue for misrepresenting the workers' efforts (and distorting the financial health of the company).

Also, like Dax, I cannot agree with your theory of the behavioral effects on workers by choice of accounting style (the original premise of "Stock Options Redux").

Posted by: Terence Lim at June 14, 2005 04:57 AM

Carol,

I think you got a little confused.

Profit margin = profit/revenue x 100%

There are no zeroes or infinites involved; costs are zero in the example, NOT revenue.

Posted by: Terence Lim at June 14, 2005 09:42 AM

Expensing stock options is a silly idea since they may, or may not, have any value to the holder. If they have to be recorded then put them on the balance sheet or in the notes so that they are accounted for at the very least. Expensing them just creates a bookkeeping nightmare for the company and for the holder.

I have had many stock options in the past that have proved worthless. So, quantifying them can be pointless regardless of the company and its prospects as they may become more of less valuable with the passage of time.

Being "just a worker" is not such a low calling by the way. And being a potential shareholder (when options are exercised) cannot change ones status by itself. The act of sharing in the risks and rewards of ownership does not separate you from where you are on the ladder nor does being low on the ladder make you less a human being.

Altogether a simplistic statement to equate them in that manner.

Posted by: Harold Anthony at June 14, 2005 01:41 PM


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