Stock options compensation and opportunity cost

Arnold Kling links to a paper titled "The Trouble with Stock Options" by Brian J. Hall and Kevin J. Murphy, and quotes the following excerpt from it...

glasswater.jpg

When a company grants an option to an employee, it bears an economic cost equal to what an outside investor would pay for the option. But it bears no accounting charge and incurs no outlay of cash. Moreover, when the option is exercised, the company (usually) issues a new share to the executive, and receives a tax deduction for the spread between the stock price and the exercise price. These factors make the ?perceived cost? of an option much lower than the economic cost.
...This insight provides a strong case for a requirement that options be expensed. The overall effect of bringing the perceived costs of options more in line with economic costs will be that fewer options will be granted to fewer people: stock options are likely to be reduced and concentrated among those executives and key technical employees who can plausibly affect company stock prices.

...after which Arnold asks...

When a high-tech company gives stock options to a secretary, is this because the secretary over-values stock options and accepts less compensation otherwise? Or is it because the firm undervalues the options and overcompensates the secretary? Or are options correctly valued by both sides?

First, to answer Arnold's question - since all economic values are subjective, there is no question of there being a 'correct' valuation. All voluntary economic exchanges depend on the two parties valuing the exchanged goods in reverse order.

I have yet to hear a convincing argument for the requirement that options be counted as expenses in the company report. That is not to say that one does not exist; rather, I simply have not heard one.

Setting aside the issue of tax code, which is mangled beyond coherency, the first part of the quoted excerpt from Hall and Murphy argues that granting options to employees bears an 'economic cost' equal to the cash that an option sold on the market would generate. In the post I would like to concentrate on this common argument for expensing options - the opportunity cost argument, which says that granting options as compensation results in an opportunity cost to the company that must be expensed.

I have not seen any clear cut definition of opportunity cost in the Austrian literature, so what follows is simply from deduction from first principles:

Ends = states of satisfaction we'd like to achieve
Means = scarce resources used in attempt to attain those ends
Opportunity cost = highest valued end given up when a means is used to attain a particular end

For example, using a glass of water as the means, potential ends might be:

A) watering your fern
B) satisfying your thirst
C) satisfying your dog's thirst
D) drenching your head
.
.
.

If you prefer end B over all other ends, and choose to employ your means (glass of water) to attempt to satisfy your thirst, your opportunity cost is the next most highly valued end the glass of water could have been used to achieve. If your next most highly valued end had been drenching your head, the opportunity cost of using the glass of water to satisfy your thirst would be drenching your head.

A key point is that the only reason that opportunity cost is even an issue in this discussion is that the glass of water is scarce. If the quantity of glasses of water was adequate to achieve all potential ends, no end would have to be given up.

Similarly, in order for X options given to employees to be considered an opportunity cost, the end achieved (using options as compensation) would have to preclude the possibility of the other ends.

However, nothing prevents the company from using X options as employee compensation, and afterwards, selling another X options over the market. The shares are simply created out of thin air. Yes, they dilute the value of outstanding shares, but from the point of view of the operational expenses of the company, they essentially cost nothing. It may be wise for the CEO to both use X options and sell X options on the market, and if so, nothing stops him from doing so. This is not a discussion about whether it would be wise to do so in all cases.

In contrast, if it is desirable to both drink the glass of water and also drench your head, there is only one glass of water. Taking one action precludes the other. Not so in the case of options. Thus, there is no opportunity cost.

If anyone has any counter-arguments, Austrian or otherwise, please give them. This is a topic that I have given a lot of thought to, and I have yet to be convinced that options should be expensed even though the vast majority of the popular media say so.
------------------------------
Follow-up posts:
Employee compensation: cash vs. stock
Candy bars and movie tickets
Stock options compensation and opportunity cost II
Kling on stock-based compensation

Share this

The concept of opportunity

The concept of opportunity cost was developed by the Austrians in the 19th century, so I'm sure with a little digging I'll be able to find something written by the Masters on the subject.

In the meantime, here's a link to a defense of Richard Cantillon from accusations of having an objective value theory - http://www.mises.org/journals/scholar/Thornton8.pdf

Ahh, that working paper by

Ahh, that working paper by Thornton is interesting. I had searched the Mises Institute website a few weeks ago but had not seen that paper, I believe since it looks like it was posted on 9/3/03. Also, both HA and MES make little mention of the topic. I'll have to read the paper.

Since the concept of

Since the concept of opportunity cost is so old, and a cornerstone of modern economics, its not a surprise to me that MES or HA don't go into it in detail, as its rather settled theory/law. Its also pretty straightforward as a concept, as you laid out in the post.

Since the concept of

Since the concept of opportunity cost is so old, and a cornerstone of modern economics, its not a surprise to me that MES or HA don't go into it in detail, as its rather settled theory/law. Its also pretty straightforward as a concept, as you laid out in the post.

It doesn't seem that way. I've seen many justifications by numerous people including econ professors at well-known places including Harvard Business School that using stock as compensation results in an opportunity cost equal to the cash that would have been generated had the same amount of stock been sold over the market. I can't see how this makes any sense as the stock is not scarce from the point of the actor (management).

Either different people are using different definitions of opportunity cost, or it is not as straightforward concept as it seems.

I suck at accounting, so

I suck at accounting, so forgive me if I sound like an idiot, but isn't the cost of issuing this option the decrease in value aggregated over all of the previously existing stock? And is this cost the same as the opportunity cost given up by not selling it to outside investors? If so, this would support the expensing argument, no?

Have you mentioned this post to Arnold Kling?

I've been trying to remember

I've been trying to remember the rationale all day too, Micha, and I think you're there. The opportunity cost for the company is the difference between the strike price and the exercise price (if I'm using the terms correctly). It is a cost that happens to get realized- the company faces that cost in giving out the option at the beginning, but unlike most people with opportunity costs, an exercised option tells the company exactly what its opportunity cost was.

Or, looking at it another way, you discount the price of the option from the date it was issued to the date it is exercised (time preference) and that is the loss (as you could have sold it for that price 5 years ago instead of now, for the same price, so you've lost 5 years worth of alternative uses of the cash.

I'm not an accountant either...

Micha, You are absolutely

Micha,

You are absolutely correct that the value of the existing shares would be diluted. The argument people often make is that this represents an expense and should be presented as such in the company report. However, this is not an operational expense like building a new gym for employees would be. It costs the company almost nothing to create new shares. The shareholders do lose out due to the existence of a greater number of share, but the cost of issuing new shares to the company is essentially nil.

However, my post was more about the 'opportunity cost' argument for expensing options, not the 'expense through dilution' argument.

Since the cost of issuing new shares is essentially nil, granting stock options as compensation does not in any way hinder the company selling new shares on the market.

Opporunity cost is basically a fork in the road; you take one path or the other. Not the case if scarcity is not an issue, as is true for a company issuing new shares.

From the Arnold Kling post

From the Arnold Kling post comments:

By Daniel Lam:
----------------
"It's a cost to you in your capacity as a shareholder. It's not a cost to the company as such; the company's assets and bank balances are unaffected. The ownership is redistributed, and that's all."

If this is the logic on which accounting principles are to be based, then indeed stock options, or, for that matter, stock grants should not be expensed.

But this would also imply that when a company issues shares or options for cash, it should book the proceeds as pure profit. After all, the company's bank balance has been boosted by this rearrangement of ownership.

Somehow there is something wrong with this.
-----------------------

If what Don Lloyd and Jonathan are saying is true, doesn't Daniel's point follow? And if so, is he right in that something is wrong with that?

I've been trying to remember

I've been trying to remember the rationale all day too, Micha, and I think you're there. The opportunity cost for the company is the difference between the strike price and the exercise price (if I'm using the terms correctly). It is a cost that happens to get realized- the company faces that cost in giving out the option at the beginning, but unlike most people with opportunity costs, an exercised option tells the company exactly what its opportunity cost was.

Or, looking at it another way, you discount the price of the option from the date it was issued to the date it is exercised (time preference) and that is the loss (as you could have sold it for that price 5 years ago instead of now, for the same price, so you've lost 5 years worth of alternative uses of the cash.

I'm not an accountant either...

This is not necessarily primarily an accounting issue but rather an economic issue. Let's simplify things a bit:

Instead of talking options, let's just talk plain ole' stock grants.

Scenario: Catallarchy, Inc. grants 500 shares of new stock to employee Brian Doss, increasing the number of outstanding shares by 500.

Does that action in any way prevent Catallarchy, Inc. from selling another 500 shares of new stock on the market?

If Catallarchy, Inc. does grant 500 shares to Brian Doss, how much does that cost the company?

At any given moment, though,

At any given moment, though, Catallarchy Inc. can generate X amount of money on the stock market by selling Y stock at Z price.

Just because Catallarchy can do this at any time, regardless of prior stock issues, it doesn't mean that there isn't a foregone opportunity when stock is issued now or later (due to an option). Because of the scenario in the first paragraph, there is always a stock opportunity available to Catallarchy- doing nothing or issuing an option means not issuing stock.

In all cases, time is scarce. Stock issuance is not done in a neoclassical timeless bubble, but in the context of time. Time has a subjective individual value as much as anything else, and a company is always constrained by the scarcity of time, if not by a pool of stock. This would lead me to believe that the economic argument is that scarcity holds and options are subject to opportunity costs, like all other actions.

However, the problem of

However, the problem of whether to expense or not expense an option remains, at its heart, an accounting problem, not an economics one. If one is to delve too far into questions of costs, you invariably run into benefits (to do Cost-Benefit Analysis to weigh options) and that logically collapses under the impossibility of interpersonal utility comparisons. AT some point, one must draw a line that you are accounting for real costs/expenses.

One of the reasons why one would invest in a company is a) the belief that the company will become more valuable in the future and that value will reflect in the price, and b) that the company is currently making money andyou want part of the current revenue stream.

By lowering wage costs through options, a company is boosting current revenue at the expense of future stockholder value. That state of affairs seems unbalanced (from my untrained accounting eye) over time. And by doing so, it paints a different picture to current investors about the future (and current) growth and revenue potential of the company, which strikes me as somewhat fraudulent.

At any given moment, though,

At any given moment, though, Catallarchy Inc. can generate X amount of money on the stock market by selling Y stock at Z price.

Just because Catallarchy can do this at any time, regardless of prior stock issues, it doesn't mean that there isn't a foregone opportunity when stock is issued now or later (due to an option). Because of the scenario in the first paragraph, there is always a stock opportunity available to Catallarchy- doing nothing or issuing an option means not issuing stock.

In all cases, time is scarce. Stock issuance is not done in a neoclassical timeless bubble, but in the context of time. Time has a subjective individual value as much as anything else, and a company is always constrained by the scarcity of time, if not by a pool of stock. This would lead me to believe that the economic argument is that scarcity holds and options are subject to opportunity costs, like all other actions.

Even if time was a limiting factor as you claim, this would only mean that there is an opportunity cost associated with the means called time because time is limited. However, from the point of view of the company, the number of additional shares that can be issued is not limited. Thus, the opportunity cost associated with the means called shares is non-existent.

But an even simpler objection: There is no reason why Catallarchy, Inc cannot issue X stock grants as compensation *and* sell X stock shares on the market at the same time.

Yes, but in any case,

Yes, but in any case, creating but not selling shares on the market (either through stock grants or options) is still... not selling shares on the market. That's always an opportunity cost, no matter how many shares a company can sell otherwise. It is an opportunity forgone.

In fact, the unlimited

In fact, the unlimited quantity of stock isn't required.

Ideally, every management decision is made to maximize shareholder value. Thus all stock sales and stock grants must each individually benefit the shareholders. Each of these categories is self-limiting. With enough stock sales, the cash raised cannot be applied to a sufficiently profitable internal investment. With enough stock grants, there isn't enough remaining salary to be substituted for. Thus both sales and grants will be finite. The total of both is all the stock that is needed.

Regards, Don

"Yes, but in any case,

"Yes, but in any case, creating but not selling shares on the market (either through stock grants or options) is still... not selling shares on the market. That's always an opportunity cost, no matter how many shares a company can sell otherwise. It is an opportunity forgone."

In fact, stock is not normally created until it is to be sold or granted. It has previously been authorized by shareholders. But even that doesn't matter as shares held by the company have no economic significance as a public stock company cannot meaningfully own a part of itself.

Remember, an opportunity cost must be a FORGONE opportunity, the second best option. At some point further stock sales or grants are not beneficial to the shareholders at all, so they can't be the value of an opportunity cost.

Regards, Don

Yes, but in any case,

Yes, but in any case, creating but not selling shares on the market (either through stock grants or options) is still... not selling shares on the market. That's always an opportunity cost, no matter how many shares a company can sell otherwise. It is an opportunity forgone.

This is why I said that this is an economic issue and that the definition of opportunity cost is very important.

Opportunity cost results from a fork in the road - you take the left path or the right path, not both. You use the evening to see an opera or watch the hokies, not both. You use the tree to make an axe or a fishing rod, not both. You use the glass of water to quench your thirst or drench your head, not both. Limitation of potential ends that can be reached due to a scarcity of means on the part of the actor is essential for opporunity cost to exist. The end not taken is the opportunity cost.

From the point of view of Catallarchy, Inc, there is nothing that stops the granting of additional shares. Yes, the shareholders lose out due to dilution, but the company does not undergo an opportunity cost. Whatever ends they potentially want to pursue with additional shares (future employee compensation, selling shares on the market, etc) are not removed from possibility in the future.

However, the problem of

However, the problem of whether to expense or not expense an option remains, at its heart, an accounting problem, not an economics one. If one is to delve too far into questions of costs, you invariably run into benefits (to do Cost-Benefit Analysis to weigh options) and that logically collapses under the impossibility of interpersonal utility comparisons. AT some point, one must draw a line that you are accounting for real costs/expenses.

Yes, but I still do not see it as a 'real' expense. A 'real' expense would be something like building a new factory or buying more expensive health care plans for employees. In the very basic relationship of earnings/share = (revenues - expenses)/# of shares, the granting of stock for compensation would affect the denominator, and also counting it as an expense would in fact be double counting it.

One of the reasons why one would invest in a company is a) the belief that the company will become more valuable in the future and that value will reflect in the price, and b) that the company is currently making money andyou want part of the current revenue stream.

By lowering wage costs through options, a company is boosting current revenue at the expense of future stockholder value. That state of affairs seems unbalanced (from my untrained accounting eye) over time. And by doing so, it paints a different picture to current investors about the future (and current) growth and revenue potential of the company, which strikes me as somewhat fraudulent.

This is essentially true, other than the 'fraudulent' bit since fraud has a precise definition. However, all this should be accounted for in the stock price, which is based on the already accounted for per share data.

Of course, this has nothing to do with the opportunity cost argument above.

Upon re-reading the original

Upon re-reading the original posts, I don't think either made the case that expensing is justified or based on opportunity cost theory.

Which ultimately means its kind of a red herring to argue whether or not it is an opportunity cost.

I still believe it is an economic cost, though. If you grant that you can lower current wages without changing physical inputs (labor and capital), and that exercising options in the future can lower shareholder value, then there are obviously economic costs involved.

That there is an 'equilibrium' point to the issuance of stock/options wherein no further issuance makes any money I think is somewhat beside the point of whether stock options or stock grants/sales are or are not economic costs.

With regards to fraud, I used the term precisely because to engage in an activity where the end result IS to dilute shareholder value (ceteris paribus) while boosting revenue in an accounting sense IS misrepresenting a corporation's finances, which is fraud. I don't believe in "rational expectations" or Homo economicus, so relying upon an assumption that such accounting chicanery as getting wage benefits from options but not expensing the dilution in future share value will always and everywhere be reflected in a discount in the stock price is incorrect. Rational irrationality (or rational ignorance) will preclude such an outcome from occurring quickly, if at all prior to the actual dilution (and may not even be noticed if the economy is doing well- regular growth of the company might mask stock dilutions, as was the case in the late 90s).

Just because one can get away with fraud doesn't mean it is OK...

Upon re-reading the original

Upon re-reading the original posts, I don't think either made the case that expensing is justified or based on opportunity cost theory.

Which ultimately means its kind of a red herring to argue whether or not it is an opportunity cost.

I may be misinterpreting this statement, but it sure sounds a lot like the authors are saying that options grants result in an opportunity cost:

When a company grants an option to an employee, it bears an economic cost equal to what an outside investor would pay for the option. But it bears no accounting charge and incurs no outlay of cash.

I still believe it is an economic cost, though. If you grant that you can lower current wages without changing physical inputs (labor and capital), and that exercising options in the future can lower shareholder value, then there are obviously economic costs involved.

If you look at what I have written so far, you will see that nowhere have I denied this. I have maintained that there are 'economic costs' involved. However, the key point is this: these costs are paid by the shareholders in the form of dilution; they are not operational *expenses* for the company.

With regards to fraud, I used the term precisely because to engage in an activity where the end result IS to dilute shareholder value (ceteris paribus) while boosting revenue in an accounting sense IS misrepresenting a corporation's finances, which is fraud.

Please explain how granting stock as compensation results in 'boosting revenue'.

Just because one can get away with fraud doesn't mean it is OK...

Fraud is intentional deception for personal gain. It is one thing to argue whether expensing options compensation should be required; it is another to claim fraud while the question is still being argued. You put the cart before the horse by proclaiming fraud when the two sides have yet to come to any sort of agreement as to what the proper standards should be in the first place.

Granting stock options

Granting stock options (which are not immediately exercises) in lieu of greater wage, will tend to reduce the labor expense of a company (depending on how widespread the practice is). Thus it is getting labor at a discount or saving money for use somewhere else. In either case, it is operating at a higher level of activity than it could if it did not offer such options.

Thus, offering options in the short term is equivalent to boosting a company's bottom line by allowing them to employ more individuals than their revenues would normally allow.

We say that fractional reserve banking is fraud, because it makes money out of thin air. Companies that use stock options to create wages out of thin air (essentially) are doing the same thing. Even if companies (like banks) don't "intend" to decieve for personal gain.

Granting stock options

Granting stock options (which are not immediately exercises) in lieu of greater wage, will tend to reduce the labor expense of a company (depending on how widespread the practice is). Thus it is getting labor at a discount or saving money for use somewhere else. In either case, it is operating at a higher level of activity than it could if it did not offer such options.

Thus, offering options in the short term is equivalent to boosting a company's bottom line by allowing them to employ more individuals than their revenues would normally allow.

And that's okay...

"You mean to tell me that the company can lower inputs while keeping output constant? That's great! But just pray you don't piss off the shareholders."

We say that fractional reserve banking is fraud, because it makes money out of thin air.

Not precisely. Fractional reserve banking is seen as fraud because the bank is violating its obligation to have every bit of deposited commodity in the bank *on demand*. It is fraud because it is saying, "We will not loan your property out" while loaning your property out. There is no such corollary for giving stock grants as compensation.

There is a very Austrian point underlying all this that I think other schools of economic thought don't really contribute to: in any voluntary exchange, the value to the receiver has little or nothing to do with the value giver. Just because the employee gains does not mean the company loses (although the other shareholders do lose).

By Daniel

By Daniel Lam:
----------------
"It's a cost to you in your capacity as a shareholder. It's not a cost to the company as such; the company's assets and bank balances are unaffected. The ownership is redistributed, and that's all."

If this is the logic on which accounting principles are to be based, then indeed stock options, or, for that matter, stock grants should not be expensed.

But this would also imply that when a company issues shares or options for cash, it should book the proceeds as pure profit. After all, the company's bank balance has been boosted by this rearrangement of ownership. [...]
-----------------------

As far as I can tell, this is a true statement. But remember that dilution occurs also here. Essentially, a new stock sale by the company redistributes cash from the existing shareholders to the company.

There is nothing inherently

There is nothing inherently fraudulent about stock or option grants to employees.

All we have, ideally, is a mutually beneficial, voluntary economic exchange between shareholders and employees, with management acting as an agent for the shareholders. Both employees and shareholders end up better off.

Assume an employee comes to management and says, 'I believe that the company stock will be worth ten times as much in ten years, but I need a raise to buy some.' Management replies by offering either $1000 worth of stock or $1200 in a cash bonus. It is clear why the company and its shareholders would be better off if the employee accepts the $1000 worth of stock rather than the $1200 cash, but why might the employee choose the stock?

Regards, Don