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Why Incentive Stock Options Matter

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Incentive Stock options? What the heck are those? Many readers are old hands when it comes to knowing the definition. That's because many readers are employed by companies that offer them. But for those readers who run their own small businesses and thus have no need, or for those working for companies that don't offer them at all, an incentive stock option is the right but not the obligation to participate in the value growth of the company with no capital expenditure through the use of company-granted options.

To get more specific, typically an employee will "given" the right to buy shares of the company at a pre-set price (usually the price of the stock on the first date of employment or the average share price over the month in which the employee begins work, but there are 1,000 different nuances) after reaching milestones of tenure within the company. Also, for most employees that have had or have them currently, they vest over a period of time, usually three to five years, thus the employee could never be 100% vested and able to cash in from day one. The company generally wants some payoff from the employees' hard work before it makes the payoff.

The company makes the payoff? Yep. Isn't that an expense? Yep. This is the part of the article where we make a ninety-degree turn. While employee stock options in a company are a way to retain and get the best work out of an employee, the theory being that with a vested interest, employees will work harder for the company to achieve the ultimate payoff - buying company stock at a cheap price - I'm coming at this from a shareholder's point of view, and that is where we will focus our time here today.

Let's start with a simplified example. Most companies will set aside a small percentage of stock for employee stock options so that they can participate and have a vested interest in the success of the business (or so the story goes). But in reality, the cashing in takes place as follows: the employee simply notifies the company of its intent to exercise, then simultaneously buys the shares at the exercise price of say $5 and sells the same shares at the current market price of $30. The employee thus pockets $25 per share in the transaction. The greater the number of shares exercised, the greater the reward. Wow! $25 per share of free money from God!

Not so fast. That $25 had to come from somewhere. It wasn't created in thin air in Fed-like fashion. It came courtesy of the shareholders who never knew it. Back to our simplified example, which is grossly exaggerated to help make the point. Say a company has 100 mln shares of outstanding stock from which it has set aside 2 mln shares for employee incentives. That leaves 98 mln of float in the hands of the general public and founding owners.

Why not just authorize 2 mln shares above the 100 mln for a 102 mln share total? Because that would dilute the current shareholders' interest by 2% when the extra 2% of shares gets used up by employees cashing in. Nope, have to be sneakier than that if you are going to put one over on the shareholders.

So instead, the company sells the shares to the employee at $5, but buys them back for $30 in a cashless transaction (except for the fortunate employee). But look what that does. The company has just effectively paid the employee an additional $25 per share cash over and above their regular salary. It's the same thing as saying, "You give me $5 and I'll give you $30. But to make it easy, I'll give you $25 so you don't have to come up with the exercise money."

Now to drive it home. . .let's really exaggerate and say that employees have the right to collectively buy 100 mln shares by exercising options at an exercise price of $5 per share. Meanwhile, there are 100 mln shares total outstanding at a current price of $30. Then every employee decides to exercises their incentive stock options at the same time to cash in.

Here's the math on that one. The company has to go to the market to buy 100 mln shares at the market price of $30. Why? Because the company has no shares to grant since all 100 mln are owned by the public and (presumably) founding officers. So the company spends $3 bln. But the employees pay the company back at only $5 per share for a total of $500 mln. Thus this costs the company $2.5 bln to replace the shares granted to employees when the exercise is netted out.

Everyone get that? It just cost the company $2.5 bln of hard cash to buy replacement shares when the employees exercise. Now it never happens in real life that every employee exercises at the same time for every outstanding share. As noted above, this is exaggerated. However the principle holds true. EVERY EXERCISE AT LESS THAN MARKET PRICE COSTS THE COMPANY THE DIFFERENCE. That is rarely reported as an expense in the P&L statements and usually considered an "off budget item". Sounds like Congress!

But suppose an employee actually has the money to exercise his/her options and wants to own the shares instead of merely taking the cash? Anyone work for Microsoft? It's pretty frequent occurrence there and with many other companies too. So the employee exercises and buys the shares from the company at $5. All's well, right? Nope. The company can't just grant the shares. For that would be dilutive to current shareholders. No, in order to keep the shares outstanding from increasing, the company must buy the shares at $30 in the open market to replace the shares granted over to the employee. Again, a $25 per share expense.

Now we are beginning to see the big picture. Employee stock options are an expense to the granting company that often goes unreported. In fact, the Federal Reserve has recently concluded that gross corporate earnings since 1997 (I think that's what I saw and now can't find the article) should be reduced by 9.5% annually to account for the corporate expense of stock options. Another survey (again can't find the article - someone let me know if they know the source) concluded that real percentage returns would actually be 2.5% lower if incentive options were shown on the corporate P&L's.

Doubt those figures? Microsoft was reported to have spent $6 bln buying back its shares to satisfy its incentive obligations to employees, which is to suggest that MSFT has over-reported earnings by under-reporting real expenses from incentive activity over the past X number of years by $6 bln. Again, wish I could find those figures, but the characterization is accurate.

Lest you think I'm the only one pointing out that the King is naked, Warren Buffet beat me to the punch. He has been calling for years for companies to disclose their incentive option activity as an expense in the P&L in order to more accurately reflect a company's real return to its shareholders.

Fortunately, that debate is coming to the forefront of GAAP through FASB, FTC, and SEC accounting investigations. While the practice may be generally accepted as an accounting principle, it isn't sound business practice nor is it fair to shareholders. It's deceptive if unreported and soon to meet the increased scrutiny of disgruntled owners. "Surprise! We've had to restate our earnings for the past three years because of incentive stock options!" Get ready, it's coming to a company near you.

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