In early 2001 Amazon.com was forced to offer an exchange of employee stock options that were ‘underwater’. Shares of the e-tailer, which had once enjoyed a market capitalization that nearly eclipsed bricks-and-mortar competitors like Barnes & Noble and Borders combined, had fallen on hard times along with so many other internet and technology companies. Because of the option exchange or ‘repricing’, Amazon.com incurred variable accounting treatment for around 15 mn stock options.
A year later this company which been under attack for accounting and disclosure practices silenced many critics with plans to do what virtually no other technology or ‘new economy’ company has been willing to: voluntarily expense the cost of its stock options.
‘As a result of the exchange program, we incurred variable accounting treatment. It was due to that experience, and our discovery that despite expensing the sun still rose in the east, so to speak, that we had confidence to move forward,’ explains Amazon.com spokesperson Bill Curry.
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are now working to create a single model for the expensing of options. FASB chairman Robert Herz recently went so far as to testify before Congress that he would vote in favor of expensing options.
In addition to Amazon.com, a number of companies have sought to take the lead and begin expensing options before any rule changes. General Electric, Coca-Cola, Disney and the Washington Post Co are among the growing list of ‘expensers’.
For technology companies, however, the trend toward expensing has become a causus belli. ‘Stock options are a vital tool, especially for recruiting people for start-ups with little money,’ says Jeff Peck, who runs the International Employees Stock Options Coalition in Washington, DC, which has a high concentration of tech companies and their trade associations as members. ‘They’re an incentive tool. They also create the environment where everyone is an owner. That kind of partnership capitalism enhances productivity.’
The reason technology companies in particular are so adamantly opposed is one of arithmetic. They rely on options more heavily and have distributed them more widely than companies in other sectors. If they expensed options, the hit to earnings would be significant. With the exception of Amazon.com, the sliver of technology companies opting to expense, such as Iomega and Computer Associates, used options on a more limited basis.
‘The decision won’t have a huge impact on our earnings,’ says Robert Cirabisi, VP of IR at Computer Associates. ‘We disclosed that the impact would be about $0.02 per share in the initial year of adoption [2003], but it graduates over time as options vest. Historically, we weren’t issuing a lot of options. It was typically 5 percent per year of our shares outstanding. Our new plan covers 45 mn shares over ten years. We have roughly 580 mn shares outstanding, so it’s a small percentage of the total.’
Turning up the heat
The coalition of tech companies seeking to keep the cost of options from biting into their earnings has powerful friends. In February a bipartisan group of 40 members of Congress voiced a ‘strong opposition to any proposal’ that would require companies to treat stock options as an expense.
Some investors and analysts are equally nonplussed by the argument. ‘It doesn’t matter to me at all,’ says Tom Friedberg, a senior research analyst at Colorado-based Janco Partners. ‘I consider stock options a form of compensation, but I think it’s very easy to look at a company’s 10K and find what I need – the number of stock options, when they were granted, how many are outstanding, how many are exercisable.’
In a bid to dismiss the argument for expensing, technology companies have also been moving to voluntarily disclose more information. In November 2002, more than 30 tech companies, including many of the sector’s blue-chips like Cisco, Intel, Siebel Systems and Sun Microsystems, announced they would voluntarily disclose comprehensive information about employee stock options on a quarterly basis.
On the other hand, more disclosure, powerful friends and ambivalent investors may not be enough to turn the tide against expensing. In addition to FASB and the IASB’s stated intentions, many investors appear committed to the cause. According to Thomson Financial, nearly 68 percent of some 40 portfolio managers and analysts polled are in favor of expensing options. In 2001, the Association for Investment Management and Research (AIMR) found that over 80 percent of analysts and portfolio managers would like to see stock options expensed on the income statement.
Some investors are taking matters into their own hands. Ann Yerger, research director of the Council of Institutional Investors, which represents institutions with more than $3 tn in assets, says she is aware of a number of different investors who have filed resolutions calling for the expensing of stock options at over 100 companies. ‘We endorse those resolutions,’ she says. ‘We have also sent letters to the IASB in support of its effort. My prediction is that at least one of these resolutions will pass.’
The death of options?
The Black-Scholes model, the most widely used for valuing options, is also widely maligned. Critics label it unpredictable because it tries to predict what an option might be worth. This is especially bad for tech firms given their share price volatility.
‘Even if you believe options are a cost, which we don’t, the question is how do you value them accurately,’ says the Stock Options Coalition’s Peck. ‘There’s no accurate method. For companies that distribute them broadly and are subject to strong stock volatility, you’re forcing them to, in all likelihood, inject materially inaccurate information into the financial statements.’
The battle over the expensing of stock options is all or nothing for Peck and technology companies. Companies that have been heavy users, Peck believes, would find it too expensive to continue using them, at least in significant quantities, and some, such as Dell, have said they will reduce their use of stock options.
However, if there is no plan B for options in the aftermath of new accounting rules, there may be an alternative to options. That alternative is restricted shares, which convert into common stock over time. It’s a compensation tool quickly gaining favor with companies like Progressive Insurance, Cendant and Amazon.com.
‘We want people working here to think like owners,’ says Amazon’s Bill Curry. ‘Once we made the decision to start expensing, that opened up many new ways to create ownership. So we went to restricted stock units. What’s driving this decision is the goal to more perfectly align employee interests with external investors’ interests.’One knock against restricted shares is that employees are getting something for nothing. When a company isn’t performing well, they still have the value of their shares. Some companies do, however, offer restricted shares with strings attached. Still, the use of restricted shares on a broad scale is new.
‘Recently, some companies have begun replacing options with restricted stock throughout the company, rather than for the top executives,’ says James Reda, principal and compensation practice leader at Buck Consultants in Atlanta, Georgia. ‘I think we’re seeing confusion over how it will all come out – whether restricted stock can be used for all employees, or just top executives – and there’s no survey that will answer that question. I don’t think there is a reason why you wouldn’t give it across the board. But most of the companies I know who have distributed restricted shares to the top executives weren’t sure what the reception would be from investors.’
But as Amazon.com’s Curry notes, one influential investor has been quite adamant – and public – in his approval: ‘Warren Buffet sent our CEO, Jeff Bezos, a letter congratulating him for the decision.’
The question is whether tech companies lose their ability to acquire and motivate talent if robbed of a tool some see as dangerous and others argue are essential. Will we miss out on the next Intel for the sake of avoiding earnings inflation? Or as, Amazon.com has so far found, will the sun still rise in the east?
Tech players & stock options
If Iomega expensed options, its 2001 net loss would have changed from $93.3 mn to $95.7 mn – less than 3 percent difference.
If Amazon.com had expensed options in 2001, net losses would have nearly doubled, from $567 mn to $963 mn.
According to a survey by the trade group American Electronics Association, public high-tech companies grant stock options to an average of 84 percent of their employees, and 60 percent of such companies provide options to all of their employees.
In 2001 the technology sector granted 3.1 bn stock options – more than any other sector in the S&P 500. That represents 42 percent of the 7.4 bn options granted by S&P 500 companies in 2001, according to a Bear Stearns study.
