Jan

3

When a company like Apple decides to reward and motivate employees through grants of stock options, shouldn’t they be able to choose between the number of options granted and the date (thus price) of options? Shareholders want both effective ways to motivate employees, and minimal dilution of their holdings caused by new share issues via employee options. Apple can’t know when and by how much stock shares will rise or fall, so they have an incentive to issue options at the lowest possible price. They would naturally pick the lowest share price during the quarter.

Management’s goal is to both offer the least-cost compensation to employees and the least-impact-to-shareholders compensation and motivation. So if the goal is to provide $100,000 to an employee via options (and the marketplace of similar tech companies influences what employees expect or think just..without enough compensation, Microsoft hires away more key Apple employees), the fewer share options Apple offers to equal a $100,000 value, and the less the dilution to shares outstanding. Do New York Stock Exchange or SEC regulations require Apple to report on a day-by-day basis the number of share options granted? Or must they report potential “exposure” to shareholders from possible dilution that options grants might cause? Yesterday’s news report on Apple says:

“The company also said that the scale of the manipulation of share options grants was much wider than previously revealed, extending to 6,428 grants for executives and other employees on 42 separate occasions”

And continues:

“Apple is the highest-profile of more than 160 companies under investigation for turbo-charging executive pay by backdating share options. By pretending they were granted on dates when the share price was low, companies were able to artificially inflate the profit made when the options were exercised.”

Why can’t a company like Apple just issue 100,000 shares of stock to itself and dole out to employees options for that stock at any price the company wishes? I assume tax issues are key along with SEC regulations. Or are there major shareholder concerns? I would think the main Apple shareholder concern now is that federal government regulators will continue to distract Apple executives from their work. The whole thing should be a matter for the stock exchanges to deal with. No one knows what the ideal rules should be for granting options. Competing stock exchanges have an incentive to discover and enforce them. The SEC has no such motivation.


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2 Comments so far

  1. Greg Rehmke (comment from friend and reply) on January 3, 2007 11:48 pm

    A friend in the investment industry comments on my options post (and I respond after):

    “I read your article on stock options and I must confess I disagree. The goal of stock options is/should be not just another compensation mechanism, i.e. a substitute for cash, but a way to align the incentives of management with those of shareholders, especially long term incentives. Backdating options not only implies lack of transparency and almost fraud, but completely misses the point of options. The options should provide incentives to management to work towards long term stock price appreciation (the alignment of incentives I mentioned before) not just a way to provide quick compensation without it explicitly appearing in the P&L (stock option accounting is a murky matter at best).”

    My response: I wanted to argue that firms decide first on the amount to be awarded (I read this argument in a series of WSJ columns). Companies could award 1000 options worth $10 each or 500 worth $20 each (when exercised). Why do they have to issue options at the current, or any past, market price? I assume because if the option is awarded below the market price, they have given something of value that has to be accounted for internally and is taxable as income. They are awarding employees the right to buy stock at some set price at some future date.

    You are right that the transparency is key and options grants haven’t been transparent. I assume that in trying to minimize exposure to accounting issues and taxes, companies assumed, or chose to believe, that they could date options with broad flexibility within each reporting period.

    Motivating employees for long-term price appreciation is certainly a major goal. Giving them stock options already worth significant sums, that don’t vest for, say, six months, gives them incentives to push stocks up and to keep them from falling. And to keep their intellectual capital applied withing the firm for the six months vesting period, or longer.

    If they receive options to purchase stock at or near current market value, the value of the options could be erased any day.

    Greg

  2. Adam Nelson on January 4, 2007 10:59 am

    Options became an important method of compensation following FASB’s decision that time value wasn’t an expense. Essentially granting a 10 year at the money option is treated as a costless transaction (but paying cash or granting shares would have resulted in compensation expense). Because few analysts look that hard at footnotes, a company that didn’t pay at least in part with options would appear to have higher compensation expense.
    Dilution is reported for all in the money options on the income statement(that’s now the primary difference between diluted and basic EPS for most companies) and in the footnotes with tables showing price ranges and options outstanding (as well as annual grant, exercise, and cancelled option amounts).
    Once companies have to estimate and expense the time value associated with option grants, they are very likely to follow Microsoft’s lead and shift to share grants, mostly due to employees undervaluing their options.

    In my spreadsheet jockey days, my preferred solution was to pull out of operating cash flow an estimate of what the exercised options cost the company to grant (to remain undiluted). Not perfect, but it was trivial to impliment and allowed a basic comparison between firms with differing option policies.

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