Arnold Kling  

Stock Options

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In response to my earlier post on executive compensation, Jonathan Wilde wrote,


First, to answer Arnold's question - since all economic values are subjective, there is no question of there being a 'correct' valuation. All voluntary economic exchanges depend on the two parties valuing the exchanged goods in reverse order.

I have yet to hear a convincing argument for the requirement that options be counted as expenses in the company report. That is not to say that one does not exist; rather, I simply have not heard one.


Let me make an attempt.

First, I want to clear away some underbrush. Established, public companies typically redeem employee stock options by issuing new stock. This dilutes the ownership of existing shareholders, and this can be confusing to analyze.

In a start-up setting, venture capitalists will not tolerate dilution. They typically require entrepreneurs to "set aside" shares of stock to cover stock options. In other words, stock options come out of the entrepreneur's hide.

For analytical purposes, let me assume the venture-capital model, in which stock options are claims on existing shares granted by the owners. Assume that I am the employee, but that the major decisions that affect the firm are made by management.

As an ordinary employee, some of my effort is observable by management and some of my effort is not observable. The observable component can be rewarded with wages and bonuses. The rationale for stock-based compensation is to increase the unobservable component.

However, as an ordinary employee, I have little influence on the company's aggregate value. Moreover, most of what influence I have comes from the observable component of my effort. If the value of the company is only infinitesimally correlated with my unobservable effort, then my stock options will not provide much incentive for me to increase my unobservable effort.

The stock options that you as the entrepreneur grant to me as an employee necessarily reduce your wealth and increase my wealth. If you could obtain another employee for the same wage without granting options, then it would be rational for you to do so. Therefore, the only reason I am getting stock options is because I am willing to take a lower wage.

Suppose that the market wage is $40,000. If you pay me $30,000 plus stock options, then unless I am a fool those stock options have to be worth at least $10,000. From this perspective, my stock options have to be viewed as a form of compensation. That is why they must be expensed.

There are many real-world complications with valuing stock options. There are restrictions on exercise. Options are often "out of the money" when granted. And a case could be made that if options are expensed when granted, then the firm will experience capital gains and losses over time as its outstanding options change value, so these gains and losses ought to be in the income statement as well.

For Discussion. As Warren Buffett says, if stock options are not compensation, then what are they? And if compensation is not an expense, what is it?


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TRACKBACKS (6 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/25
The author at Catallarchy.net in a related article titled Candy bars and movie tickets writes:
    Arnold Kling has posted an entry on the topic of stock options. His entry gives much food for thought, and I will post a thorough reply in the next couple of days. In the meantime, a question about an underlying... [Tracked on September 26, 2003 2:26 PM]
The author at Catallarchy.net in a related article titled Kling on stock-based compensation writes:
    Arnold Kling has responded to my wanting to hear an argument in favor of expensing options on his blog. I appreciate his post which gave me a lot to think about. I was planning to respond last week to his... [Tracked on October 6, 2003 11:16 AM]
COMMENTS (21 to date)
Mcwop writes:

Stock options are simply a low cost means in terms of present value, to offer a stake in the potential future value of a business.

Lawrance George Lux writes:

Stock options must be considered compensation, or they must be considered to be theft of Stockholder equity. Accounting them as expense does not solve the riddle. The only way Stock options can be accounted, is as a Production operation; which must be accounted as showing a Profit or Loss. lgl

Jim Glass writes:

"As Warren Buffett says, if stock options are not compensation, then what are they? And if compensation is not an expense, what is it?"
~~~

Well, stock issued for a contribution to capital isn't an expense. And labor can be a contribution to capital, no problem there. So why should labor contributed to a company for stock *not* be treated as a contribution to capital? That's what Warren should be explaining.

Buffett is an investor who hates to see his stock get watered. Fine and just. But he is about as impartial in this argument as the NRA is on gun control and the AFL-CIO is on foreign imports.

An "expense" is something that is a charge on the income statement that ceteris paribus reduces the company's net income and net worth on its balance sheet.

A stock option need do no such thing. Cases:

#1) A newly hired executive is paid a cash bonus to come on board. The cash charge is a true expense -- a charge on the income statement that reduces reported income and also the company's assets (cash on hand) on its balance sheet, reducing the company's net book value.

This impairment of the company's balance sheet may adversely affect things such as its credit standing and ability to attain financing -- not to mention the length of time it may be able to continue operatings if it is still in a start-up
negative cash-flow stage. Which can be a critical consideration.

#2) The executive is lured not with cash but with a bonus of newly issued stock of the same current value, perhaps through options that he exercises.

This has no effect whatsoever on the company's income or assets. Being that it has none, why should it be recorded as an expense *to the company* that reduces the company's reported income, impairs its balance sheet and thus reduces its credit rating, ability to borrow and so on?

The expense of the stock issuance is not to the company but *to its shareholders* as of before the stock compensation was awarded.

If Warren was one of them I can see why he wouldn't like that at all -- but is he really saying that an expense *to him* is the same thing as an expense *to the company*? C'mon.

If I'm running a new business and issue options to talented individuals to help it grow, offering them a good share of the firm in exchange for their contribtution to its success, this is supposed to be an *expense* that busts my reported income and balance sheet -- possibly breaking covenants made to lenders and suppliers, giving me worse terms with them or even putting me out of business. To make Warren happy?

Stock and option issuance is a shareholder rights issue. No doubt during the boom years insiders got away with giving themselves very sweet stock deals because average investors didn't care because they were making so much too. But those days are over. In the future the full potential dilution effect of all outstanding option grants should be spelled out in big red letters at the front of every annual report.

But here's my question for Warren: Why should a change in ownership be treated as an expense to an operating business?

Daniel Lam writes:


Let me see if I can help out Arnold here with the following reductio ad absurdum. If a company does not have to expense stock or option grants, it can pay cash to its employees without incurring any expense. Here's how.

Simply replace each employee's cash compensation with a grant of marketable stock or options having equivalent market value. No expensing required for this grant. On receipt of the grant the employee sells the securities in the open market, pocketing the proceeds. At the same time the company buys back the securities in the open market, paying out the cash. No expensing required for buying back stock. Result: the commpany has paid cash to its employee without expensing anything.

Of course you can prevent this from working perfectly by imposing ad hoc rules restricting the marketability of the stock compensation. But I think this illustrates quite powerfully that there is something not quite right with the idea that there is some fundamental difference between cash and stock compensation that justifies different accounting treatments.

Mike writes:

I agree with much of the above comment. Additionally,

-From this perspective, my stock options have to be viewed as a form of compensation. That is why they must be expensed.

There are many forms of "compensation" from any given employer. Some employees may value working for a stable or prestigious firm and be willing to take a lesser salary as a result. This must be expensed then. An employer may offer flexible schedules, causing more "expenses". One might be near an employee's home, chalk up more expenses for that.

The argument that it's compensation so expense it is not based on sound reasoning.

Don Lloyd writes:

Daniel,

"No expensing required for buying back stock."

You have correctly identified where the real problem lies. Because it is difficult to distinguish stock bought back to undo employee compensation from stock bought for other reasons, it is not expensed even though nothing could be more logical. Expensing such stock buybacks would quickly accomplish what the supporters of option expensing claim to be trying to accomplish.

Regards, Don

Jim Glass writes:

"On receipt of the grant the employee sells the securities in the open market, pocketing the proceeds. At the same time the company buys back the securities in the open market, paying out the cash. No expensing required for buying back stock. Result: the commpany has paid cash to its employee without expensing anything."

~~
That's what we in the legal biz know as a "sham transaction" and it would be recognized as such by anybody -- IRS, SEC, the company auditor, whoever -- right now without any change of rules at all. Resulting probably in a lot more than "compensation expense" to the company. ;-)

The question regards genuine transactions: Why should a change in the ownership of a business be treated as a business operating expense?

The only argument I see in the basic case (pure stock deal, no money changing hands) is Buffett's: "I'm calling it compensation, and I've always heard compensation's gotta be expensed, so it's gotta be expensed". But that's as sloppy as it is circular. It is linguistic confusion compounded by the fact that the rules are very different for tax (which most everybody thinks of) and accounting purposes.

Look to the substance. Say I entirely own a company worth $1 million. I like my secretary so to make her happy and keep her from leaving instead of paying her $40k cash I pay her $30k and issue her $10k worth of stock, which she prefers. We can call that $10k of stock "compensation" or "a favor for my girlfriend" or "green cheese" or whatever -- the substance is that I have made her my 1% partner in the business via a transfer of wealth *from me*, not from the business. Yet this $10k that didn't come from the business is supposed to be an expense of the business? Well, OK.

Compare that to the case where instead of the secretary I have a key employee that my business *cannot* do without. To keep him happy I make him a full 50% partner in the business by issuing him stock worth $500,000. Are we seriously saying that this stock issuance must be expensed to the business -- so that the act of bringing in a partner produces a charge that reduces the book value of a business by 50%??? Because that more accurately reflects the finances of the business? When the finances haven't been affected a whit?

I don't think so. But if not, then are we proposing special accounting rules for "little people"? Little transfers of wealth from shareholders to employees are business expenses but really big ones aren't?

Admittedly, option arrangements can be vastly more complex than this. But as a first-principle starting point, why should a change in ownership be treated as an operating expense of a business?

Kyle Markley writes:

I've posted an essay that argues against stock option expensing. I think it's persuasive, and there's a slim chance someone here might agree:
http://arbyte.us/essays/Stock_Option_Expensing.html

Lawrance George Lux writes:

Jim,
Your argument lack some persuasion with me. Your Scenario leads me to ask why Gift tax should not be paid on grant to either Secretary or sudden new partner. lgl

Bernard Yomtov writes:

Jim,

Of course issuing stock or options is an expense. When the corporation issues stock to an employee it is foregoing the right to sell that stock on the market. The foregone cash is a cost.

If you regard it as similar to a stock sale then how should it be recorded? If the company sells stock that shows up in the equity section. Where should equity issuance to employees show up? Are you saying it has no place on the financials at all?

Suppose a company owns a piece of real estate, maybe some empty land, not essential to its business. It gives an employee that real estate as compensation. Are you saying that isn't an expense? How does it fundamentally differ from giving away stock?

Don Lloyd writes:

Bernard,

"Of course issuing stock or options is an expense. When the corporation issues stock to an employee it is foregoing the right to sell that stock on the market. The foregone cash is a cost."

It is forgoing the right to sell SPECIFIC shares on the market. It is not impeded in any way from creating fully equivalent shares out of thin air and then selling them instead. This is a distinction without a difference.

The limitation does not come from a finite supply of shares to sell, but from the fact that selling stock on the market is self-limiting as it does not serve the interest of shareholders to do so unless the cash received can be invested by the company at a higher rate of return than the shareholders can expect from the company itself at its current market price.

Regards, Don

Jim Glass writes:

"Your argument lack some persuasion with me. Your Scenario leads me to ask why Gift tax should not be paid..."

This confuses tax and accounting principles which are very different, a constant source of muddling whenever this discussion comes up.
=======

"Of course issuing stock or options is an expense..."

I always enjoy the "of course" argument: *Of course* the accounting standards people never had any thinking reason whatsoever for treating stock transactions as they have for 70 years! ;-)

"When the corporation issues stock to an employee it is foregoing the right to sell that stock on the market. The foregone cash is a cost."

What foregone cash?

Like Arnold said, the secretary's market salary is $40,000, instead the company pays her $30,000 cash and issues her $10,000 worth of stock. The company *saves* $10,000 cash -- which puts it in exactly the same cash position as if it had sold the stock for $10,000 cash to an outside investor: +$10,000.

Cash costs are expenses on the income statement -- but there is no cash cost associated with the sale of stock shares.

The only "cost" associated with a stock sale is the opportunity cost of not being able to sell the same stock to someone else later. But if the sale is at market value it's hard to say even that exists.

In any event, opportunity costs are not expensed. *Everything* a business does has an opporunity cost. Imagine the nightmare an income statement would be if opportuntity costs had to be reported on it.

"If you regard it as similar to a stock sale then how should it be recorded? If the company sells stock that shows up in the equity section."

Whether the $10,000 worth of stock is issued to...
* an outside investor for $10,000 cash, or
* the secretary in lieu of $10,000 cash salary
... the result on the financials is exactly the same, of course -- cash position +$10,000, flowing through to the equity line.

"Are you saying it has no place on the financials at all?"

It appears on the financials just as it always has, as decribed above, of course.

"Suppose a company owns a piece of real estate, maybe some empty land, not essential to its business. It gives an employee that real estate as compensation. ... How does it fundamentally differ from giving away stock?"

There's a very fundamental difference:

Giving away property owned by a corporation reduces the assets *of the corporation*. It reduces the number for equity reported on the corporate balance sheet.

Giving away shares in the corporation reduces the assets *of the owner* of the corporation. It has no effect on the equity line of the corporate balance sheet. It reduces the number for equity reported on the balance sheet of the *owner* of the corporation.

A corporation and its owner are two different entities, accounting-wise, tax-wise, legally, every way.

Let's say you own a corporation and give shares in it to your brother-in-law. Is that an expense of the business that reduces its income and assets?? It seems to reduce only *your* assets.

Add one fact and say that your brother-in-law works for the corporation. What's the sudden magical difference?

Bernard Yomtov writes:

Jim,

Please see my post on the other compensation thread. Sorry for the mixup. I raise two issues:

1. I've never seen a balance sheet item for "equity issued for labor." What would be the balancing entry?

2. Paying with stock is really no different than paying with a promissory note. Both are claims on future cash flows. Whty treat them differently?

Jim Glass writes:

"Paying with stock is really no different than paying with a promissory note. "

Of course it's different. A promisory note issued by the company is a claim against the assets *of the company*. It reduces the net asset position *of the company*.

A share issuance reduces the asset position of the company's *shareholders*. It doesn't reduce the asset position of the company by one whit.

You insist on treating the company and its owner(s) as being the same. They are *different entities* -- accounting-wise, legally, every way. Please acknowledge that.

A note = shares? OK.

Then suppose someone agreed to do work for a corporation not in exchange for salary paid from the corporation's funds, nor for shares in the corporation, but in exchange for a promisorry note not issued by the company but by its onwers *personally*.

Would you account for a *personal* note issued by the owners of a corporation in the same manner as a note issued by the corporation itself?

If yes, explain how. They are entirely different entitites.

And a note issued *by shareholders* is indeed = to an issuance of shares, to the extent that it is a transfer of wealth *from them*, not from the company.

So how could you treat either of them as = to an issuance of a note *by the company*?

BTW you keep asking questions without answering any of mine. So let me try again. E.g...

Imagine you are the sole owner of a corporation worth $1 million, due to an annual reported operating profit it produces of $150,000 and a corresponding discount rate applied by the market.

Say you issue stock giving 50% ownership in it to your brother-in-law. Are you saying this is an *expense* that should reduce the corporation's reported operating profit? I doubt it.

OK, say that instead you have a key employee without whom the business would crater, so you issue him stock giving 50% ownership of the business.

Just because the recipient of the stock transfer is an employee and the transfer is made in recognition of the value of his services, the stock transfer somehow becomes an *expense*??

Are you saying that the corporation now has, after the $500,000 expense, a $350,000 operating *loss*???

I'd say that the corporation has the exact same $150,000 operating profit it would have had otherwise, unchanged to the penny. And consequently it has the exact same $1 million value. The only thing that's changed is who owns how much of that value.

Because -- back to my very first question for Warren -- why should a change of ownership be treated as a business operating expense?

Bernard Yomtov writes:

Jim,

You haven't done very well at answering my question either. How do you account for the exchange of stock for labor? Both entries please.

Further,

"Of course it's different. A promisory note issued by the company is a claim against the assets *of the company*".

It's a claim on the company's cash flows, just like a share of stock is. All else equal, a note reduces the value of the shares outstanding, because it reduces the cash available to current shareholders, just like issuing new stock does.

"Would you account for a *personal* note issued by the owners of a corporation in the same manner as a note issued by the corporation itself?"

No. I would treat the amount of the personal notes as contributed capital, and then the compensation as a corporate expense.

"Say you issue stock giving 50% ownership in it to your brother-in-law. Are you saying this is an *expense* that should reduce the corporation's reported operating profit? I doubt it. "

No this is not an expense.

"OK, say that instead you have a key employee without whom the business would crater, so you issue him stock giving 50% ownership of the business.

Just because the recipient of the stock transfer is an employee and the transfer is made in recognition of the value of his services, the stock transfer somehow becomes an *expense*??"

Yes it does. If I give my brother-in-law $500,000 that's a gift. If I pay him $500,000 to do some work for my company that's a company expense. I contributed $500,000 to the corporation and used it to pay for services.

Similarly with a key employee. Otherwise you have the absurd situation of being able to get labor for free as far as your books go.

"Are you saying that the corporation now has, after the $500,000 expense, a $350,000 operating *loss*???"

Yes I am. And I think GAAP agrees with me.

"I'd say that the corporation has the exact same $150,000 operating profit it would have had otherwise, unchanged to the penny. And consequently it has the exact same $1 million value. The only thing that's changed is who owns how much of that value. "

There is no reason to think the market value of the company would change. Expected cash flows haven't changed, so the company is still worth $1 million.

Lawrance George Lux writes:

Jim and Bernard,
Your arguments do not address the loss of Property right by Stockholders through Stock options and grants. It does not matter whether these are considered an expense or not listed. Corporate Boards did not have the right to reassign Stockholder property to others--as labor payment or as gift.

Stock options and grants for labor or otherwise, must find legal justification; this can be done only if they are considered to be a Production operation, where a Profit or Loss is recorded according to some criterea acceptable to the Courts. lgl

Bernard Yomtov writes:

Lawrence,

All outlays by a corporation involve a "loss of property rights," in your sense, by the shareholders. If a company pays an employee a straight $50,000 slary that is $50,000 less for the shareholders. The presumption is that management and the board believe that the labor thus purchased contributes at least $50,000 in value, this there is no net loss. The same logic applies to stock compensation. If as a result of stock awards my ownership in a coproration from .0001% to .00009% then the presumption is that the value of the corporation has increased at least enough to make up for this. Management may err, of course, but their objective is as described.

Jim Glass writes:

"You haven't done very well at answering my question either. How do you account for the exchange of stock for labor? Both entries please."

I already specifically answered that, with explanation of the appropriate entry. But
some of your comments seem to indicate you're ignoring more than just my questions. E.g,.
re. A promissory note issued by a company...

"It's a claim on the company's cash flows, just like a share of stock is"

As per before, obviously it is *not*. Issuing a million shares of stock produces not $1 of additional claims against the company's cash flow. The market value of the company will be unchanged. Totally unlike a promissory note.

[] Creating a *real* new additional claim against a company's cash flows will reduce the company's reported number for equity on the balance sheet, and its market value.
[] Issuing additional shares has no effect at all on either the company's reported number for equity on the balance sheet or the company's market value.
[] Ergo, issuing additional shares does not create a new additional claim against the company's cash flows. QED.

"All else equal, a note reduces the value of the shares outstanding, because it reduces the cash available ***to current shareholders**** " ,

Jim Glass writes:

"Jim and Bernard,
Your arguments do not address the loss of Property right by Stockholders through Stock options and grants. It does not matter whether these are considered an expense or not listed. Corporate Boards did not have the right to reassign Stockholder property to others--as labor payment or as gift."

Well, I said right at the beginning that compensation paid through stock and options is a corporate governance issue -- not an accounting issue.

Of course corporate boards do have the right to issue shares to whomever -- provided shareholders are fully informed and approve. And if the shares are issued for full market value (in labor or anything else -- labor does have a value!) the corporation and shareholders do fine by it.

To a company facing a cash constraint, such as a start-up, paying market value in stock or options can be beneficial by saving a critical resource. That's not at all uncommon. It's even possible for the corporation to come out ahead by getting *more* than market value for the issuances. Sometimes businesses make good deals and people looking for jobs undersell themselves.

All the recent scandals were the result of the *boom*, not of the long-time accounting rules for options. In many cases like AOL where the top guys took so much the shareholders knew full well all about it and *didn't care* because their stock was shooting up too. In other cases companies started openly handing stock comp out across the full ranks because they figured it was a way cash-free way to pay top compensation. Warren Buffett hated that because as an investor it diluted his stock -- it shifted cost away from the company onto its shareholders

He was right about that. But still, I'm sorry, Warren, stock dilution wasn't a business operating expense in the days of Jay Gould and Jim Fisk and it isn't now.

And in some cases corporate insiders gave themselves sweetheart stock deals that they were able to keep secret by not revealing them to shareholders while they had no cash cost that appeared in the financials. If those people go to jail it's fine by me -- for stealing from the shareholders, yes, but not for stealing from the company if they didn't take any cash or assets from the company. Because the shareholders are not the company.

But all the boom-time scandals are over and gone -- because the boom is gone, so the incentives are gone -- not because of any change of accounting rules. Next boom like this one there will be more scandals, whatever the accounting rules are. Count on it. Just like there always have been in the past.

In the meantime, after a great deal of work, the FASB has decided to give companies the choice of either (1) expensing the market value of stock options against income, or (2) not expensing options but disclosing pro forma net income and earnings per share as if they had.

Most companies are selecting (2) over (1). This is quite proper IMHO, because (1) distorts the financials of the business by attributing an expense *of the shareholders* to the operating business; while (2) reveals to the shareholders the full effect of the potential dilution of their stock -- which is what they need know to evaluate the effect of options on their investment -- without distorting the business's operating financials.

So I'm happy with that.

And that's the end of my logorrheic contribution to this discussion. I'll go away now and give you all a break.

Bernard Yomtov writes:

"You haven't done very well at answering my question either. How do you account for the exchange of stock for labor? Both entries please.

I already specifically answered that, with explanation of the appropriate entry. "

No. You didn’t, for all your bluster. What are the entries?

"A promissory note issued by a company...

"It's a claim on the company's cash flows, just like a share of stock is"

"As per before, obviously it is *not*. Issuing a million shares of stock produces not $1 of additional claims against the company's cash flow. The market value of the company will be unchanged. Totally unlike a promissory note."

If a share of stock is not a claim on the company’s cash flows what is it? It’s true that it is not a claim for a specific amopunt, but it is a claim nonetheless. Finance 101.

[] Creating a *real* new additional claim against a company's cash flows will reduce the company's reported number for equity on the balance sheet, and its market value.

If it’s a debt claim it will reduce the value of its outstanding equity. An equity claim will not.

"[] Issuing additional shares has no effect at all on either the company's reported number for equity on the balance sheet or the company's market value."

This is simply incorrect as a matter of basic accounting. If a company issues additional shares and sells them for, say $10 million, it most definitely does affect the balance sheet. Cash goes up (a debit) by $10 million and equity goes up (a credit) by $10 million. Accounting 101.

"[] Ergo, issuing additional shares does not create a new additional claim against the company's cash flows. QED."

Ergo nothing. Your premises are false, as is your conclusion. If a share of stock is not a claim against the company's cash flows what is it?

"All else equal, a note reduces the value of the shares outstanding, because it reduces the cash available ***to current shareholders**** " ,

Veronica Saquisili writes:

Stock options should not be expensed but recognized and disclosed as a contingency in the financial statements.

Stock options should not be expensed because it would reduce the value of total assets on the Balance Sheet when it really is not true because giving options to employees is like making them as part of the ownership of the company's stock.

I think giving options to employee is a form of investment. The stock options retain the employees of leaving the company, so it is a benefit for the company by not having to pay in cahs for employees but giving options which would cost more in the future.

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