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Why the options party is over

Transamerica Investment Management portfolio manager Kenneth Broad says that Silicon Valley's arguments against expensing stock options are not only a prime example of faulty accounting but they are also driven by self-serving myth.

It is unfortunate that it took the current stock market debacle to refocus investor outrage on the gross inequity of options accounting.

The fact is that options have been a convenient method for simultaneously inflating the reported strength of earnings, cash flow and the balance sheet under current accounting rules.

Here's why:

Earnings are overstated because the current accounting "cost" of options when granted at-the-money is exactly zero, despite having very real economic value to the recipient and equivalent cost to the issuing firm's shareholders.

Cash flow from operations is enhanced by reduced cash compensation expense and the tax benefit recognized upon the exercise of options.

Lastly, the balance sheet is buttressed by the cash flow benefits as well as the strike price proceeds collected when options are exercised--in essence an evergreen equity offering at below market prices.

The strength of many tech balance sheets can be traced to this prolific issuance of equity for options, acquisitions and underwritings. It's easy to see why the tech industry is fighting so hard to keep options from being expensed: No one likes to lose a free lunch.

Silicon Valley's disingenuous arguments against the appropriate expensing of options are predictable and largely representative of the tech industry's self-serving position. It is time to debunk some common options myths perpetuated by the tech crowd:

It's easy to see why the tech industry is fighting so hard to keep options from being expensed: No one likes to lose a free lunch.
• Options do not directly align the interests of management with shareholders in many instances. Those who perpetuate this fallacy ignore the asymmetric return profile of options, which is akin to that of a lottery ticket. Returns can be huge on the upside and 100 percent on the downside. As a result, options can (be an incentive for) imprudent risk-taking, especially when combined with short vesting periods. Restricted stock grants, with long vesting periods, provide a much tighter alignment of interests. Unfortunately, restricted stock grants are seldom used because they must be expensed.

• The diluted share count does not capture the real economic cost of options. Diluted share count only measures the historical options liability at a particular point in time. It does not appropriately reduce the earnings stream being capitalized to reflect substitution of options for cash compensation. Enron's Jeffrey Skilling admitted the benefits of this substitution effect during his congressional testimony, "You issue stock options to reduce compensation expense and therefore increase your profitability."

• Options often do not promote outright stock ownership. Most companies grant options annually to their employees, and anecdotal evidence suggests employees are often quick to sell their stock after exercising. This is typically for diversification reasons, which defeats the purported purpose of building a direct ownership stake.

• Expensing of options will not cause Silicon Valley's level of innovation to grind to a halt. It will simply put their businesses on a level playing field, in terms of accounting, with those that pay cash or restricted stock or virtually any other form of compensation that is expensed. What it will end is the charade of inflated financial results that enriches VCs and employees at the expense of unwitting investors.

• Options are most definitely a form of compensation. To argue otherwise is absurd. As Coke's CFO stated, "there's no doubt that stock options are compensation--if they weren't, none of us would want them."

• Options are not impossible to value. Options pricing using Black-Scholes provides a reasonable approximation of value and Coke's novel method of averaging actual bids from multiple investment banks is brilliant and probably the optimal pricing method. Just because an expense must be estimated, like the value of goodwill, depreciation or loss reserves, doesn't mean it should be ignored.

Options are not inherently bad; they just need to be accounted for in the same manner as other forms of compensation.

The tech industry is simply afraid of the ugly truth: After taking options into account, much of Silicon Valley's economic miracle is really just a giant wealth transfer machine.

Perhaps the most fascinating aspect of the options debate is that expensing options is just a bookkeeping entry, a noncash charge, like goodwill amortization, that tech firms are already so good at pro-forma-ing out of existence. Nothing changes in the actual operations or cash flow of the corporation.

So why is the tech industry so afraid of this phantom charge? Because it will serve to highlight for less sophisticated investors just how badly they've been getting diluted.

Greenspan's recent comments on this topic are quite revealing: "If investors are dissuaded by lower reported earnings as a result of expensing, it means only that they were less informed than they should have been. Capital employed on the basis of misinformation is likely to be capital misused."

Let's look at the minority who are opposed to expensing options: It is primarily the tech industry, the venture capitalists who back them and the politicians who receive large checks from them. Virtually every other group--including academics, investors and regulators--agrees with Warren Buffett's simple Socratic line of reasoning: "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"

The tech industry is simply afraid of the ugly truth: After taking options into account, much of Silicon Valley's economic miracle is really just a giant wealth transfer machine. The tech industry needs to wake-up and realize that the bubble by which it benefited so greatly is finally over.