Rogue Missives Friday, July 18, 1997

Part 2:
A Virtual Example

Consider Seymour CyberScience (SECY), my brainchild. The company has a product that can capture your dreams on a microchip, and it's ramped up production after several years of intensive R&D. The cadre of top officials have worked for virtual peanuts but have been collecting sizeable stock options that vest over a five year period. After two rounds of venture capital financing, the company goes public, using the IPO money to build an advanced new production plant and to market the DreamVision (R) chip to middle America.

A Dynamic Worth Considering

Expenses run high, but after nine months as a public company, earnings turn positive ($0.08 a share), short-sellers panic, and the stock skyrockets. The venture capitalists cash out some of their chips for a fortune, and a few years later, so too do some of the original employees. Options granted when the stock was at $10 a share (adjusted for splits) allows the lucky employees to buy shares now worth $100. SECY has 20 million shares outstanding but has handed out options covering half-again as many. The folks who had been working for peanuts find their options are now worth $900 million as they pay $10 to exercise each option and immediately sell the shares on the open market for $100, or a $90 per share profit.

This is a happy scenario that fulfills everyone's dreams. But back to options accounting, here's how things work. As SECY's star technicians cash out their options, generating $900 million in capital gains, SECY gets to expense this amount as compensation. Figure a 40% tax rate, and SECY will save itself $360 million in taxes, most of which still makes it to the U.S. Treasury by way of individual capital gains taxes on the executives cashing out. Yet the funny thing about this compensation expense is that it never affects earnings the way other normal labor costs do. Had these sizeable option grants been expensed over the course of the vesting period, there's no way SECY reports its first profitable quarter during that first year as a public company. In fact, with profits now a long way off, the stock might flounder, a successful secondary offering might have never happened. In that case, the stock may not have risen to $100 and those options may not be worth anywhere close to $900 million.

That, at least, is the vision of how things might have been had the FASB not backed off its original 1992 proposal (which had been under development since 1984) to change the way firms account for options. Venture capitalists, securities firms, members of Congress, and top executives from Silicon Valley, where options are like the sacraments, all raised a fuss. In effect, they charged that anything that curtailed the granting of stock options, and so substantially changed the rules for creating earnings, would choke off the very lifeblood of the U.S. economy: the high-tech start-up company.

Still, what the FASB was trying to do made a certain sense. If you're using options to compensate your top talent and you eventually get hefty tax benefits when those options are exercised, then why not call a spade a spade and expense the things, charging them against earnings now. The tax benefit doesn't disappear, it just trickles down all along the way instead of five or ten years down the road when the options are actually exercised. Investors who may not be hip to the sleight-of-hand that disguises these labor costs might benefit considerably from making it plain. After all, how exactly can old SECY earn, say, $50 million a year when about $140 million in compensation is just ignored? It's tempting to say that nothing much would really change -- except the reported earnings of those companies most committed to stock options. And that's only a scary prospect if we assume that earnings and the valuation models they support are set in stone like holy writ. If earnings are culturally created (by accountants, no less), why not fiddle with the creation if you can find a way to make them more useful, more forthright?

Ah, the naivete of accountants!

Part 3: A Compromise Found

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