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Cisco's New Option

Posted by: Michael Mandel on May 12

I always thought that most of the people who favored expensing stock options really would be happier just getting rid of them. Now, with Cisco’s latest proposal for valuing options, we’ll find out if I was right.

Cisco has proposed issuing securities that would have most of the characteristics of employee stock options—i.e. they would be options on the company’s stock, but they would take time to vest and they would be difficult or impossible to trade. Then the market price of the securities would represent the true value of employee options, which in turn would determine the amount that Cisco has to expense.

In theory, using the market to price employee options in this way is far superior to using Black-Scholes or any other rule. If the people who favor expensing stock options really just wanted to make the accounting better, they would leap at Cisco’s proposal.

However, the market-based approach is likely to put a lower value on stock options than Black-Scholes, precisely because the new securities won’t be tradeable and will take time to vest—maybe a much lower value. That’s why I predict that the pro-expensing crowd will come up with plenty of technical reasons why Cisco’s proposal won’t work, despite its superiority. The real motive for expensing options was to drive companies away from offering stock options, not make it easy for them.

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Reader Comments

Jack Krupansky

May 12, 2005 08:06 PM

Face it, expensing of employee stock options was *always* a red herring. One of the core problems is this silly accounting concept of trying to blend information about operations (business transactions) with information about the balance sheet and liabilities (contracts). The true issue with employee stock options was that they are the introduction of a new "liability" or obligation (contract, not unlike a lease) that *potentially* dilutes the existing stockholder ownership. Yes, accountants *should* have a way of accounting for the per-shareholder weakening of the balance sheet. We already had a way to reflect the effect of options on earnings: "diluted earnings". The extra concept of "expensing" on top of dilution was *never* needed. If everybody had been focusing more attention on the balance sheet and "book value" (especially book value per share), we wouldn't have wasted so much energy here.

The "pro-expensing" crowd made a huge mistake and now Cisco is giving them exactly what they *asked* for: properly valuing stock options, and doing it with an open market mechanism.

One of the most vigorous opponents of employee stock options was Warren Buffett, even though they had *no* impact on his own business. He expended so much energy being the poster-patron for the anti-options crowd when a) it didn't affect his own business, b) it affected primarily the tech sector which he freely admitted that he didn't understand, and c) his focus on this peripheral and irrelevant (to his own business) issue helped to distract him and resulted in his taking his eye off the ball that really needed his concentrated attention: the overly-complex financial structures that infested his own General Re. The potential "harm" of employee stock options was *never* as monumental as the present and growing danger of financial shenanigans such as overly-complex derivatives for which the potnetial liabilities can't even be calculated (assuming you actually go to the trouble of factoring in counterparty risk).

Hopefully Cisco's action will teach a lot of people an old lesson: be careful what you ask for, because you might get it.

My personal advice to the anti-employee stock option crowd: please sit down and please shut up. We *all* have bigger fish to fry (especially the formerly-esteemed Mr. Buffett.)

-- Jack Krupansky

Whitney Ross

May 17, 2005 05:41 PM

The proposed solution is the answer the industry has been looking for since 1995. Anyone who challenges it needs to read or reread FAS 123, FAS 123R and Concept Statement #7 to understand what FASB's preference on the subject has and continues to be.

Unfortunately, it is likely that Cisco misappropriated the idea from the original inventor who created the mechanism in 2004 while Cisco was pursuing other failed efforts. The idea was pitched to Cisco's ESO lobby in Feb. and the company took that idea to the SEC in March. Highly suspicious. Will be interesting to watch how Cisco and the world responds to this potential unethical behavior.

Thank you for your interest. This blog is no longer active.



Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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