19 May 2003  Research & Ideas

Expensing Options Won’t Hurt High Tech

Will expensing stock options harm the competitiveness of start-ups? Not likely, say Zvi Bodie, Robert S. Kaplan, and Robert C. Merton in this Harvard Business Review excerpt.

 

Editor's Note— (One cure for stock option abuse, say proponents, is to change accounting rules so that option grants are reflected in a company's principal financial statements. High-tech start-ups blister at that idea, saying it would harm their ability to recruit and retain top-notch employees.

A recent Harvard Business Review piece argued that options are an expense, plain and simple, and should be accounted for in that way. In this excerpt, the authors address what they call a fallacy: that expensing options will hurt young businesses. —Ed.)

Opponents of expensing options claim that doing so will be a hardship for entrepreneurial high-tech firms that do not have the cash to attract and retain the engineers and executives who translate entrepreneurial ideas into profitable, long-term growth.

This argument is flawed on a number of levels. For a start, the people who claim that option expensing will harm entrepreneurial incentives are often the same people who claim that current disclosure is adequate for communicating the economics of stock option grants. The two positions are clearly contradictory. If current disclosure is sufficient, then moving the cost from a footnote to the balance sheet and income statement will have no market effect. But to argue that proper costing of stock options would have a significant adverse impact on companies that make extensive use of them is to admit that the economics of stock options, as currently disclosed in footnotes, are not fully reflected in companies' market prices.

More seriously, however, the claim simply ignores the fact that a lack of cash need not be a barrier to compensating executives. Rather than issuing options directly to employees, companies can always issue them to underwriters and then pay their employees out of the money received for those options. Considering that the market systematically puts a higher value on options than employees do, companies are likely to end up with more cash from the sale of externally issued options (which carry with them no deadweight costs) than they would by granting options to employees in lieu of higher salaries.

The claim simply ignores the fact that a lack of cash need not be a barrier to compensating executives.
— Zvi Bodie, Robert S. Kaplan, and Robert C. Merton

Even privately held companies that raise funds through angel and venture capital investors can take this approach. The same procedures used to place a value on a privately held company can be used to estimate the value of its options, enabling external investors to provide cash for options about as readily as they provide cash for stock.

That's not to say, of course, that entrepreneurs should never get option grants. Venture capital investors will always want employees to be compensated with some stock options in lieu of cash to be assured that the employees have some "skin in the game" and so are more likely to be honest when they tout their company's prospects to providers of new capital. But that does not preclude also raising cash by selling options externally to pay a large part of the cash compensation to employees.

We certainly recognize the vitality and wealth that entrepreneurial ventures, particularly those in the high-tech sector, bring to the U.S. economy. A strong case can be made for creating public policies that actively assist these companies in their early stages, or even in their more-established stages. The nation should definitely consider a regulation that makes entrepreneurial, job-creating companies healthier and more competitive by changing something as simple as an accounting journal entry.

But we have to question the effectiveness of the current rule, which essentially makes the benefits from a deliberate accounting distortion proportional to companies' use of one particular form of employee compensation. After all, some entrepreneurial, job-creating companies might benefit from picking other forms of incentive compensation that arguably do a better job of aligning executive and shareholder interests than conventional stock options do. Indexed or performance options, for example, ensure that management is not rewarded just for being in the right place at the right time or penalized just for being in the wrong place at the wrong time. A strong case can also be made for the superiority of properly designed restricted stock grants and deferred cash payments. Yet current accounting standards require that these, and virtually all other compensation alternatives, be expensed. Are companies that choose those alternatives any less deserving of an accounting subsidy than Microsoft, which, having granted 300 million options in 2001 alone, is by far the largest issuer of stock options?

It is not the proper role of accounting standards to distort executive and employee compensation by subsidizing one form of compensation relative to all others.

A less-distorting approach for delivering an accounting subsidy to entrepreneurial ventures would simply be to allow them to defer some percentage of their total employee compensation for some number of years, which could be indefinitely—just as companies granting stock options do now. That way, companies could get the supposed accounting benefits from not having to report a portion of their compensation costs no matter what form that compensation might take.

About the authors

Zvi Bodie is a professor of finance at Boston University's School of Management.

Robert S. Kaplan and Robert C. Merton are professors at Harvard Business School.

Excerpted with permission from "For the Last Time: Stock Options Are an Expense," Harvard Business Review, Vol. 81, No. 3, March 2003.

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