In the debate over whether or not options are a form of compensation, many use esoteric terms and concepts without providing helpful definitions or a historical perspective. This article will attempt to provide investors with key definitions and a historical perspective on the characteristics of options. To read about the debate over expensing, see The Controversy Over Option Expensing.

Tutorial: Employee Stock Options

Before we get to the good, the bad and the ugly, we need to understand some key definitions:

Options: An option is defined as the right (ability), but not the obligation, to buy or sell a stock. Companies award (or "grant") options to their employees. These allow the employees the right to buy shares of the company at a set price (also know as the "strike price" or "award price") within a certain span of time (usually several years). The strike price is usually, but not always, set near the market price of the stock on the day the option is granted. For example, Microsoft can award employees the option to buy a set number of shares at $50 per share (assuming that $50 is the market price of the stock on the date the option is granted) within a period of three years. The options are earned (also referred to as "vested") over a period of time.

The Valuation Debate: Intrinsic Value or Fair Value Treatment?
How to value options is not a new topic, but a decades-old question. It became a headline issue thanks to the dotcom crash. In its simplest form, the debate centers around whether to value options intrinsically or as fair value:

1. Intrinsic Value
The intrinsic value is the difference between the current market price of the stock and the exercise (or "strike") price. For example, if Microsoft's current market price is $50 and the option's strike price is $40, the intrinsic value is $10. The intrinsic value is then expensed during the vesting period.

2. Fair Value
According to FASB 123, options are valued on the award date by using an option-pricing model. A specific model is not specified, but the most widely used is the Black-Scholes model. The "fair value", as determined by the model, is expensed to the income statement during the vesting period. (To learn more check out ESOs: Using The Black-Scholes Model.)

The Good
Granting options to employees was viewed as a good thing because it (theoretically) aligned the interests of the employees (normally the key executives) with those of the common shareholders. The theory was that if a material portion of a CEO's salary were in the form of options, she or he would be incited to manage the company well, resulting in a higher stock price over the long term. The higher stock price would benefit both the executives and the common shareholders. This is in contrast to a "traditional" compensation program, which is based upon meeting quarterly performance targets, but these may not be in the best interests of the common shareholders. For example, a CEO who could get a cash bonus based on earnings growth may be incited to delay spending money on marketing or research and development projects. Doing so would meet the short-term performance targets at the expense of a company's long-term growth potential.

Substituting options is supposed to keep executives eyes on the long term since the potential benefit (higher stock prices) would increase over time. Also, options programs require a vesting period (generally several years) before the employee can actually exercise the options.

The Bad
For two main reasons, what was good in theory ended up being bad in practice. First, executives continued to focus primarily on quarterly performance rather than on the long term because they were allowed to sell the stock after exercising the options. Executives focused on quarterly goals in order to meet Wall Street expectations. This would boost the stock price and generate more profit for executives on their subsequent sale of stock.

One solution would be for companies to amend their option plans so that the employees are required to hold the shares for a year or two after exercising options. This would reinforce the longer-term view because management would not be allowed to sell the stock shortly after options are exercised.

The second reason why options are bad is that tax laws allowed managements to manage earnings by increasing the use of options instead of cash wages. For example, if a company thought that it could not maintain its EPS growth rate due to a drop in demand for its products, management could implement a new option award program for employees that would reduce the growth in cash wages. EPS growth could then be maintained (and the share price stabilized) as the reduction in SG&A expense offsets the expected decline in revenues.

The Ugly
Option abuse has three major adverse impacts:

1. Oversized rewards given by servile boards to ineffective executives
During the boom times, option awards grew excessively, more so for C-level (CEO, CFO, COO, etc.) executives. After the bubble burst, employees, seduced by the promise of option package riches, found that they had been working for nothing as their companies folded. Members of boards of directors incestuously granted each other huge option packages that did not prevent flipping, and in many cases, they allowed executives to exercise and sell stock with less restrictions than those placed upon lower-level employees. If option awards really aligned the interests of management to those of the common shareholder, why did the common shareholder lose millions while the CEOs pocketed millions?

2. Repricing options rewards underperformers at the expense of the common shareholder
There is a growing practice of re-pricing options that are out of the money (also known as "underwater") in order to keep employees (mostly CEOs) from leaving. But should the awards be re-priced? A low stock price indicates the management has failed. Repricing is just another way of saying "bygones", which is rather unfair to the common shareholder, who bought and held their investment. Who will reprice the shareholders' shares?

3. Increases in dilution risk as more and more options are issued
The excessive use of options has resulted in increased dilution risk for non-employee shareholders. Option dilution risk takes several forms:

  • EPS dilution from an increase in shares outstanding - As options are exercised, the number of outstanding shares increases, which reduces EPS. Some companies attempt to prevent dilution with a stock buyback program that maintains a relatively stable number of publicly traded shares.
  • Earnings reduced by increased interest expense - If a company needs to borrow money to fund the stock buyback, interest expense will rise, reducing net income and EPS.
  • Management dilution - Management spends more time trying to maximize its option payout and financing stock repurchase programs than running the business. (To learn more, check out ESOs and Dilution.)

The Bottom Line
Options are a way to align the interests of employees with those of the common (non-employee) shareholder, but this happens only if the plans are structured so that flipping is eliminated and that the same rules about vesting and selling option-related stock apply to every employee, whether C-level or janitor.

The debate as to what is the best way to account for options will likely be a long and boring one. But here is a simple alternative: if companies can deduct options for tax purposes, the same amount should be deducted on the income statement. The challenge is to determine what value to use. By believing in the KISS (keep it simple, stupid) principle, value the option at the strike price. The Black-Scholes option-pricing model is a good academic exercise that works better for traded options than stock options. The strike price is a known obligation. The unknown value above/below that fixed price is beyond the control of the company and is therefore a contingent (off-balance-sheet) liability.

Alternatively, this liability could be "capitalized" on the balance sheet. The balance sheet concept is just now gaining some attention and may prove to be the best alternative because it reflects the nature of the obligation (a liability) while avoiding the EPS impact. This type of disclosure would also allow investors (if they desire) to do a pro forma calculation to see the impact on EPS.

(To learn more, see The Dangers Of Options Backdating, The "True" Cost Of Stock Options and A New Approach To Equity Compensation.)