Stock Options: It’s A Darn Shame

It’s a darn shame what’s happened to stock options.

When I first started in Silicon Valley in the 1980s, stock options were seen as a real innovation, a creative way to align employees with shareholders, a way to help employees particpate in the value they were helping to create. Ever since then, and even now, I have remained a believer in stock options.

Then a number of things went wrong: greed, the Internet bubble, stock option expensing, and now the backdating scandals that are making headlines, every day.

To me, greed is the #1 culprit. There’s nothing wrong with stock options, per se. There is something wrong with boards who enable executives to make annual packages in the 10s or 100s of millions of dollars. While I know this sounds a bit like the “guns don’t kill people, people kill people” argument, stock options aren’t the problem; corporate governance is.

Then the Internet bubble exposed the “rising tide lifts all ships” problem with stock options. You could be an average CEO, doing an average job, running your average company, and if Wall Street 5x’ed the stocks in your category, then you made a fortune. That people don’t like this exposes a great irony. On one hand, as shareholders we just want the shares to go up (e.g., “I don’t want excuses, I don’t want to hear about enablers like product quality and customer satisfaction, I want results”). On the other, when the shares go up simply because everyone else’s did too, we don’t like it.

Even if you feel it’s irrational to solve it, there is a simple solution to the rising tide problem: link the option strike price to a stock market index or a market basket of competitors.

But that’s not what happened. Because CEOs were greedy — and boards let them be — the absolute numbers got out of control. So rather than fix the actual problem with options, the country decided to throw the stock-options baby out with the rising-tide bathwater: thus was born stock option expensing.

I think stock option expensing is a bad idea. Why?

• I majored in math at Berkeley and I can barely understand the Black-Scholes model, so I can’t imagine why anyone would want “costs” calculated using it in a P&L statement.

• A P&L statement should include real, known revenues and costs or simple allocations thereof (e.g., it makes sense to depreciate the cost of a factory that lasts 30 years over its 30-year life). I don’t like including probabilistic costs into a P&L and think it’s inaccurate to do so.

• Expensing options has the ironic consequence of making stock options less democratic. If you were trying to solve the executive greed problem, you didn’t solve it. The typical corporate response to option expensing has been to continue granting options (and/or restricted stock) to top management and to stop granting options to rank-and-file employees. So the “fix” actually made the concentration problem worse, not better.

• Eliminating rank-and-file stock options eliminates one of the few ways regular people can have economic class mobility. That leaves winning the lottery, successful stock and real estate speculation, and founding a company as the primary paths to the rags-to-riches part of the American dream.

In fact, the only thing I like about stock option expensing is that it gives a competitive advantage to startups, like Mark Logic. Because startup strike-prices tend to be low, the total value of the grants (strike-price x shares) tends to be small, thus the total expense tends to be small. (What’s more, few startups are measured on GAAP net income anyway).

If stock options didn’t have enough problems, now we have the backdating scandals. These seem to fall into two groups:

• Sloppiness: companies with poor administration would fail to legally approve options on the date they intended, and thus would either knowingly or accidentally backdate them. (Accidental backdating could happen, for example, when an option was granted by unanimous board consent, which is effective not on the date the consent is sent for signature, but on the date the last consent is signed.)

• Fraud/greed: some companies apparently set option dates back in time to build more profit into their grants. There is nothing illegal about pre-vesting shares in stock option grants (e.g., you can start out 2/48ths vested) and there is nothing illegal about granting in-the-money options. It is illegal, however, to backdate options before their actual grant dates and to pretend that in-the-money grants (which have immediate tax consequences) were not.

These things are all bad. But let’s not blame stock options themselves. Let’s blame corporate governance, greed, and sloppiness. Stock options are good. What many companies have done with them is bad. Let’s separate the two.