From odlyzko Sat Jul 20 09:08:20 2002 To: tg.donlan@barrons.com Subject: "Optional Equity' Dear Mr. Donlan, You are absolutely right that "corporate stock options are failing to align the interests of employees and shareholders," and I do agree with much of what you write. In particular, I fully agree with you that the revered Warren Buffett is wrong in claiming that options are just another form of employee compensation. However, I do feel that a new accounting treatment of options is called for. Your argument that "[f]ootnotes already provide all the information about options necessary for analysts and investors to adjust earnings, if that's what they want to do," which echos what other opponents of options accounting reform are saying, is more than a little contradictory. If all the information about options is in the footnotes, and is kept there, then it does not matter whether options are expensed or not. Applying your argument, since all the information will still be there in the footnotes, those who like earnings reported according to current standards will simply perform the calculation and get it. You can't have it both ways. Either all the information is available, in which case the formula used for computing reported earnings is irrelevant, or else there is some inability or unwillingness among investors to properly evaluate a company's financials and makes them concentrate on a single number, the official earnings figure. If we are to judge by the vehement opposition to options accounting, the defenders of the current system implicitly believe (and believe very strongly) in the second alternative. My view is that a special accounting treatment of options is required, something that avoids the distortions of the current (non-)treatment, and also avoids the pitfalls of expensing options. Warren Buffet's famous claim, If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into calculations of earnings, where in the world should they go? ignores the central point of options, that they are a form of compensation, but compensation provided by shareholders, not by the company itself. Now if the only purpose of corporate financial accounts was to reflect the position of shareholders, then expensing options would be more sensible (although there would still be problems). However, those accounts serve other purposes as well. If I am a bank, I don't care very much what the ownership of donlan.com is. If Joe Blow has options that (when exercised) might make him a 50% owner of donlan.com, that is pretty much irrelevant to me. What I care about is whether donlan.com as an operating entity will have enough cash to pay off the loans I extended. (Actually, it would be a slight positive from my point of view to know that Joe Blow has such options, since when exercised, they would bring in some cash to the company, together with tax credits. Thus from a bank's point of view, options are a positive factor, one that should be added and not subtracted from the company profits.) Similarly, if I am an enterprise considering signing a long term contract with donlan.com, I am again interested in whether this company will have the resources to deliver on its commitments, develop updated products, etc. A couple of years ago, a colleague of mine at AT&T Labs - Research asked me about a piece about options by Bill Parish, that he saw posted at . (Unfortunately what is at that URL right now is a different version from the one I commented on.) I responded with the comments below, which constructed a very simplified (almost to the point of being unrealistic) example showing the effects of options on company financial reporting, as well as on gross economic aggregates. Something like this example could probably be simplified some more, but the effects of options are so complex that I am not sure one can do much better than this. Unfortunately our current accounting and tax standards are already full of various kludges that distort financial accounts (such as the giant AOL Time Warner writeoff, which dragged a change in equity position of shareholders through the profit/loss statement). My guess is that the accounting profession will need to come up with new standards, ones much better adopted to the complex financial strategies as well as to an environment where much less enterprise value is tangible. I would be happy to discuss this in more detail with you. Sincerely yours, Andrew Odlyzko -----Please note new address----- Andrew Odlyzko University of Minnesota Digital Technology Center 499 Walter Library 117 Pleasant St. SE Minneapolis, MN 55455 odlyzko@umn.edu email 612-624-9510 voice phone 612-625-2002 fax http://www.dtc.umn.edu/~odlyzko Comments sent to a colleague on Nov. 9, 1999: Larry, That sensationalist posting by Bill Parish, http://www.billparish.com/msftfraudfacts.html has much substance, but it is way too sensational, and makes a fundamental mistake by confusing capital and operational accounts. This is not too surprising, in that options are curious instruments, and the accounting profession has not figured out how to treat them properly. In particular, the comparison with derivatives, which Parish makes, is pretty apt. There are all sorts of distortions and possible instabilities that options introduce. An analogy might be drawn with an owner of a rental property, who finds that the rents coming in are growing, while real estate and income taxes are decreasing. He is happy, until he discovers after a decade that he now owns only half the property, with the other half having been signed over gradually to an outsider over the years, while that outsider was taking care of the taxes. To explain some of the problems that Parish discusses, and his basic mistake, let us consider a very hypothetical example. Let's suppose you have a great idea for a speech recognition system that is going to blow everything else off the market, and you quit AT&T to pursue it. Suppose you get some friends to put up $1 million to form a company called LRR, Inc. They get 1 million shares in this company, while you do not put up anything aside from your ideas. However, for each year before the IPO that you work for the company, you get options for 200,000 shares at an exercise price of $1 each, good for 10 years, and you also get paid a minimal wage of $50,000 per year. Let's assume you are the only employee of LRR, Inc., and all secretarial, development, and other work gets contracted out. Assume total expenses (including your salary) run $200,000 per year. Let's assume that in year 5, just as the original funds are about to run out, you do strike pay dirt. Your system works flawlessly, and the world beats a path to your door. LRR, Inc. licenses its technology for a total of $50 million per year (money to start coming in in Year 6), and company expenses are negligible. Your shareholders now do an IPO, and sell 100,000 of their 1,000,000 shares to the public, and those shares start trading and continue trading at $1,000 each. (This is again not realistic, but feasible, and keeps things simple.) Thus one could say (more on this later, since it is not really accurate) that LRR, Inc. is now valued at $1 billion by the stock market. Since company profit (before taxes) will be $50 million (minus some negligible sum for expenses), if we assume a corporate tax rate of 30%, we get aftertax profits of $35 million, and earnings per share are $35. You yourself are still collecting just the $50,000 per year in cash. Thus LRR, Inc., is a very nicely profitable business. Parish would say, though, that LRR,, Inc. has a wage debt of $999,000,000 (the $1 billion value of the million shares you can acquire through exercise of the 1,000,000 options you have acquired in those 5 years, minus the $1 million you would have to pay the company for those shares). A few months after the IPO you decide to exercise your options. (For simplicity let's assume options vest immediately.) Say you do one of those typical cashless exercises, in which your stock broker puts up the $1 million that you owe LRR, Inc., and sells those shares right away on the open market or privately to Warren Buffett for a total of $1 billion. (Let's assume, again for the sake of simplicity, that this huge sale does not affect the market price.) You get $999,000,000 in cash (ignoring commissions), on which you have to pay ordinary income tax, so you get left with a miserly (:-)) $600 million or so. Parish would say that the "actual earnings" of LRR, Inc., are (before tax) $ 50,000,000 from licensing revenues + 1,000,000 from you for the million shares - 1,000,000,000 for "wage expense not charged to earning" Thus he would claim that LRR, Inc. is committing fraud, by claiming to make a big profit, while concealing a giant loss. On the other hand, I would claim that what is happening is a reallocation of company ownership, which does affect share owners, but does not affect the operations of the company (at least not right away). As far as LRR, Inc. is concerned, separate from who owns it, it is ahead by $1 million that it got from you. The company never had a "wage debt" of $1 billion to you, since you could not claim any cash from it. What you had was a claim on ownership of the company. Shareholders who might have thought they were buying 10% of the company when they purchased 100,000 shares find themselves owning just 5%, since there are now 2 million shares. Thus the options you had were a hybrid, clearly meant to compensate you for your work, but with value dependent on the fortunes of the company, and the eventual payoff coming from diluting the ownership stakes of the other shareholders, not from the operating entity LRR, Inc. Even though you did not put up a penny of cash, you were a hybrid of a standard wage laborer and an investor. The above analysis explains the problems with Parish's analysis. I don't think fraud is the right word for the financial practices of Microsoft and other companies. However, Parish is quite right that employee options do introduce huge distortions into the financial world. Just how large those distortions are has only recently begun to be realized. The FASB and the IRS have inconsistent rules, and neither set of rules reflects reality accurately. To see the distortions that arise, let us consider the example of LRR, Inc. further, with the additional details that after getting $50 million in licensing revenues in Year 6, the company will get $60 million in Year 7, $70 million in Year 8, and so on. Expenses will stay negligible. Also, for comparison, let us consider a company, call it RRL, Inc., which is similar to LRR, Inc. in having a single key technical guru, but one that develops text-to-speech technologies, and again, just like LRR, Inc., has no revenue in years 1 through 5, and then starts getting $50 million in Year 6, $60 million in Year 7, ... The only difference is that the guru of RRL, Inc. never got any options, and works for a salary of $500,000 per year. Thus when RRL, Inc. does an IPO, all the equity is owned by the investors. At the time of the simultaneous IPOs of LRR, Inc. and RRL, Inc., LRR has burned through $1,000,000, whereas RRL has spent $3,250,000. As operating entities, LRR and RRL might at first glance appear equivalent, since each brings in the same amount of licensing revenue, and has just about equally negligible expenses. (RRL pays $450,000 per year more in salary to its technical guru, but that is small change compared to the revenues, once those start flowing in.) However, after the accountants and the taxmen are done, the two companies will appear very different. 1. Distortions from FASB accounting: Current shareholder accounting, as dictated by FASB, basically tries to ignore options as much as possible. (FASB did try to introduce new rules that would have brought in some sanity recently, but the high-tech industry managed to squash that effort.) Consider LRR, Inc. When it does its IPO, it has 1,000,000 shares outstanding, and so, looking forward, aftertax earnings per share might seem to be $35. However, the IPO documents filed with the SEC will have to show that you own 1,000,000 options that are vested, so those who read those documents will guess that you are not going to tear them up, and that any earnings will soon have to be spread over 2 million shares, not the 1 million that are outstanding. Thus on a diluted basis, earnings per share (aftertax) will be $17.50 in Year 6, and the total stock market valuation of the company is really $2 billion (assuming $1,000 price per share in trading after the IPO). This part is pretty well understood by financial analysts, and taken into account in their reports. The revenues and profits of RRL, Inc. are basically the same as those of LRR, Inc. Hence we might expect that when RRL does its IPO, if it also started out with 1 mission shares, those ought to trade at $2,000 each, since the market caps of the two companies seemingly ought to be the same. The fun now starts when we consider what happens in years 6, 7, and so on. For both LRR and RRL, revenues and pre-tax profits (if they were both to face a 30% corporate tax rate) are almost the same, $50 million and $35 million in Year 6, $60 million and $42 million in Year 7, etc. Thus shareholders of both LRR and RRL appear to be facing a 20% increase in earnings per share. Suppose, though, that your contract with LRR, Inc., calls for you to continue getting options on 200,000 shares (with exercise price the market price at time of grant, and with immediate vesting) each year that you stay employed at LRR, even after the IPO. In that case, in Year 6, you will be able to create another 200,000 shares, so that there will be a total of 2,200,000 shares. Thus the 20% increase in total earnings will translate into only a 9.1% increase in earnings per share! LRR, Inc., will be doing fabulously, but the other shareholders are likely to be disappointed. If the LRR shareholders realize what is likely to happen, they will surely push down the price of LRR shares as compared to those of RRL, Inc., whose shares will be enjoying the full 20% increase in profits. The trouble is that FASB accounting does not make it clear just how much of an overhang from outstanding options there is. Thus unlike the case of IPOs, where reasonably complete accounts are presented in the offer filings, in the annual reports one has to dig through the documentation to find out what might happen. There is considerable evidence that most investors are not aware of the problem. There is more accounting fun involved than just the actions above. Suppose that at the time in Year 6 that you exercise your options on 200,000 shares, stock price of LRR, Inc. has risen to $1,500 on the greatly improving prospects of the business. Since the exercise price was $1,000 per share (the market price when you got the options), you get $100 million (before taxes, assuming that you again did a cashless exercise, and did not hang onto the shares). However, the company will be getting from you $200 million (200,000 shares times $1,000 per share). This will not show up in the revenue, since it is really the proceeds of a stock sale. What LRR, Inc., does with that money depends on its management. They may spend it on repurchasing shares on the open market, to prevent dilution of previous shareholders. If they spend the $200 million they got from you, the net increase in the number of shares will be 66,667, and so the dilution will be by only 3.3%. If they want to prevent any dilution, they will need to come up with another $100 million. (Microsoft used to do that, using up its regular earnings to purchase up all the shares created by employee stock option exercises.) They may also decide to just let the full 10% dilution take place, and use the $200 million for other purposes. The above scenario is obviously exaggerated to the point of implausibility, but something like this has been happening on a large scale. The extent of employee options activity has only recently been realized. The first person to get publicity with an analysis of the situation appears to have been Andrew Smithers, an English financial analyst. He made some claims that earnings of U.S. corporations were exaggerated by up to 50% through options activity. Other analysts have since gone over his computations, and disputed his conclusions. Apparently he made the same mistake as Parish, by counting the potential profits on option holdings against operating earnings. However, even if one corrects for this mistake, apparently one finds that the giant options binge that U.S. corporations have been on over the last decade (which greatly intensified over the last 5 years) has resulted in options holdings by employees that amount to something like 10-15% of the total number of shares. This means that earnings per share growth estimates ought to be substantially reduced, both for the last few years, and for the future. 2. Tax accounting distortions The above analysis ignored taxes. However, those introduce their own serious distortions, distortions that to a large extent magnify those of FASB accounting. Consider again LRR, Inc., at the point a few months after the IPO, when you cash in your 1 million options. The IRS considers the difference between the market price of the 1 million shares you acquire (however briefly), namely $1 billion, and the price you pay, namely $1 million, to be an expense to the company. Hence LRR, Inc. has, for tax purposes, a loss of $999 million in Year 6 of the company. This wipes out any federal corporate income tax liability, and changes the after-tax income in Year 6 from $35 million to the full $50 million. Furthermore, it leaves LRR, Inc., with a huge tax loss that can be carried to future years, or else, through the magic of modern investment banking, used for creative financial maneuvers, such as purchases of companies with healthy earnings that need to be shielded from the taxman. Conclusions: Although LRR and RRL at first glance would appear to be identical as operating entities, they look very different to investors. Just how different is in general impossible to tell without lots of detailed information (for example, what were the strike prices of the options of various employees, and how quickly will those options be cashed in?). In general, though, a company using stock options will have major advantages over one that does not. It will conceal from shareholders some of the claims against their holdings that options represent, and will also have big tax advantages. On a micro scale, options have many advantages. Comparing LRR and RRL, we see that LRR required a much smaller investment from its founding shareholders. LRR's technical guru was much more motivated to work hard, and (with reasonable vesting schedule on options grants) this guru will have a much harder time leaving the company than the guru of RRL. On a macro scale, there are also some advantages to options. However, as Parish points out, they do introduce serious distortions. Aside from giving big advantages to companies that use options in raising funds, acquiring other companies, etc., there are other effects. For example, gains from exercise of stock options are not counted as wages. Yet surely folks who go to work for Microsoft accept sub-par salaries and lack of employee benefits in the expectation that options gains will make up for them. Policy makers, such as Alan Greenspan, who look at the slow growth of officially measured wages, may therefore be fooling themselves, in that wage inflation may be manifesting itself through options gains, and not through the usual statistics. Also, economists who have been puzzled by the decreasing role of corporate income tax may have been misled as to the causes. Sometimes this (relative) decrease in the share of federal taxes paid by corporations has been ascribed to multinationals taking advantage of globalization to move money through tax havens. Instead, what may have been happening is that options exercises and the resulting tax credits may have been shifting taxable income from corporations to employees. Many of the effects of options are understood in isolation. However, just as with derivatives, it is not clear what the cumulative effect would be, especially if there was a major turn in the economy. It certainly seems that options have strengthened the bull market on its way up. Will they also magnify the move down? One danger of options that I have not seen written up is that of an avalanche of sell orders they might precipitate. In the case of LRR, Inc., consider the options at a strike price of $1,000 that you might get in Year 5. Suppose that share prices in Year 6 run up to $2,000, and then there is some sort of general market downturn, and LRR's share price slides to $1,500. The press is full of stories about how the stock market bubble is deflating, and we are about to face the fate of Japan in the 1990s, with a decade of a stagnant or declining stock market. Under those conditions, somebody who has bought shares at $1,000 in Year 5, might well decide to hang in. After all, this might be a false alarm, and even if there is a further downturn, he might figure the shares he bought for $1,000 are unlikely to go down much below $1,000, and eventually the company will do well, and stock price should rebound. After all, shares last forever, and so he has a piece of a nice business that should eventually do well. Your situation is different, though; if stock price dips below $1,000, your options will be worth little, and your time horizon is much shorter, namely the life of the options. Thus you might very well be tempted to sell out sooner than a regular shareholder. If other options holders do the same, we could have a much faster and deeper slide than would otherwise be the case.