Employee compensation: cash vs. stock

Don Lloyd asks the following question about the employee
compensation.

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?

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I don't disagree with your

I don't disagree with your statement- there isn't anything inherently fraudulent about giving an employee stock or options in lieu of cash.

However, from an accounting perspective, a company has to book how much stock it has outstanding- it should also take into account the stock it "may have issued" in the form of options ("may have issued", since if the stock goes into the toilet, the options are worthless and no stock will then be issued), and IMO should do that immediately (either at current value or at some discount). If the stock isn't issued after an expiration date, credit the company's account back to make things balance.

A company that does not do that (via "expensing" or some other accounting tool) is deliberately avoiding the responsibility to come clean on its future stock situation. THat, and not the original exchange, would be the source of fraud.

A company that does not do

A company that does not do that (via "expensing" or some other accounting tool) is deliberately avoiding the responsibility to come clean on its future stock situation. THat, and not the original exchange, would be the source of fraud.

As I have said before on the prior thread, the dilution is reflected in the denominator - the # of shares outstanding.

Yes, and that needs to be

Yes, and that needs to be reflected on the company's bottom line.

Yes, and that needs to be

Yes, and that needs to be reflected on the company's bottom line.

It is - in the earnings per share.

It is clear why the company

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?

Depends on the specifics of the situation. Minimizing taxes is the most obvious, avoiding brokerage fees and the vagaries of the market may also contribute. Also a company might grant shares for less than market price, so the company might grant 100 shares at $10/share when NASDAQ is trading the company at $12/share.

Don, I believe the answer is

Don,

I believe the answer is dependent on the effects of dilution - a point that seems to be repeatedly missed when this topic comes up. I am not completely sure how that will play out, but what follows is the best I can come up with.

When the company pays the employee with cash, this is a true operational expense for the company.

When the company pays the employee with new stock, there is no expense for the company. Rather, the value of the new stock is essentially obtained from redistribution from the already existing stock of the already existing shareholders.

When faced with the choice of how to be paid, the employee in this scenarios has two options:

1) Receive payment in cash. With this cash bonus, he can immediately buy stock, but that stock will have a lower bottom line as the issuance of the cash bonus itself represents an expense. Thus, the earnings per share will be lower than before the cash bonus is issued as a result of increased expenses.

2) Receive payment in stock. This stock does not hurt the company's bottom line as its value comes from redistribution of already existing stock. Thus, the earnings per share will also be lower than before the new stock is granted, but for a different reason - more outstanding shares.

As a result, the pre-existing stockholders will see the value of their stock drop no matter how the payment is made.

For the employee, he is faced with the choice of either buying pre-existing stock with a lesser amount of cash but hurting the bottom line of the company...

...vs receiving new stock that represents a greater cash equivalent but not hurting the bottom line of the company.

The total 'bottom-line value' (i.e., the his ownership of the earnings of the company, as calculated by # of shares owned multiplied by earnings per share) of his shares under the two scenarios will vary with the amounts he receives either of cash or stock. It could very well be that he would receive a greater 'bottom-line value' even with the stock grant.

I spoke with one of my econ

I spoke with one of my econ professors about this issue today. She advises the FASB, so I assume she knows what she is talking about. She said that it doesn't really matter how these transactions are recorded, as it is all arbitrary anyway. The important thing is that the raw data is recorded and available to investors and other consumers of financial documents, but the specific calculations could just as easily be left to the consumers to do for themselves.

The arguments in favor of disclosing stock options granted to employees are based upon the belief that too many of these options are being granted, and that a change in accounting standards would serve as a disincentive and thus reduce this practice. But this has little to do with the arbitrary standards themselves, and more to do with the desired policy result.

The issue of fraud is important here, as the managers have an obligation to provide the investors with accurate information. But rather than using these standards as a way to influence compensation behavior, it might be best to move away from questions involving calculations and instead just require the raw data, allowing the readers to decide for themselves.

The employee wants to buy

The employee wants to buy stock, but can't afford it.

THe company offers to give him the stock ($1000 worth, which to him has a much higher NPV) or $1200 in cash to buy stock now ($1200 worth, I presume).

If the employee took the cash to buy the stock that will increase 10x, he's adding one extra step that he can avoid if he just takes the stock grant straightaway. Adding a step pushes the realization of his final goal a little bit further into the future, which discounts the value more than if he were to get the stock today (things present today are always valued more than those tomorrow).

So, as long as the NPV of the stock is higher than $1200, he should take the stock offer.

Jonathon, On first glance,

Jonathon,

On first glance, your answer seems to be possible, but unlikely unless we are talking about a CEO and a large amount of stock.

As a hint, my answer doesn't involve the employee paying any attention to the effect on the company, can be expressed in a single sentence, and is obvious on retrospect. -g-

Regards, Don

The employee is putting her

The employee is putting her money where her mouth is. By accepting stock instead of cash, she's revealing her actual beliefs to management about the future stock price by her actions. Accepting cash might reveal to management that she's simply pulling a fake negotiation tactic to obtain a raise. And that probably would imply a pink slip in her future.

Don, If it is that

Don,

If it is that straightforward, perhaps Brian's post has the answer you're looking for.

Jonathan, Not quite, the

Jonathan,

Not quite, the likely time difference between grant and purchase isn't likely to be near long enough to make a difference in the NPV for any reasonable interest rate. However Brian's post DOES bring up a related answer in that the stock price can simply fluctuate before the purchase occurs and the share purchase price may be higher or lower.

Further hint -- David's post comes closest to what I had in mind, although it's not his primary concentration.

Regards, Don

Don, In receiving a cash

Don,

In receiving a cash bonus and subsequently buying stock, there is a tax involved. In receiving stock directly, there is no tax involved.

This difference could very well be more than $200.

Micha, I spoke with one of

Micha,

I spoke with one of my econ professors about this issue today. She advises the FASB, so I assume she knows what she is talking about. She said that it doesn't really matter how these transactions are recorded, as it is all arbitrary anyway. The important thing is that the raw data is recorded and available to investors and other consumers of financial documents, but the specific calculations could just as easily be left to the consumers to do for themselves.

I would have to humbly disagree with your professor. Yes, there are some issues with accounting that deal with the 'details' in which the questions are what column to record what, and when to record it, etc; I agree that these issues are largely arbitrary.

However, stock compensation expensing is not primarily an accounting issue IMO; it is an economic issue. There is a significant difference between dilution and expense, and the question of how to record the effect of stock compensation depends on the nature of value.

The arguments in favor of disclosing stock options granted to employees are based upon the belief that too many of these options are being granted, and that a change in accounting standards would serve as a disincentive and thus reduce this practice. But this has little to do with the arbitrary standards themselves, and more to do with the desired policy result.

As this example showed, there is no 'right' way to pay employees. As long as both sides agree to the exchange, it comes with the expectation of mutual benefit. The onus is on the shareholders to effect policy change when they disagree with the actions of management.

Jonathan, Yes. Someone with

Jonathan,

Yes.

Someone with a combined marginal income tax rate of 50% can only buy $600 worth of stock with the $1200 in cash and must finance $600 worth of unwanted government activity.

Regards, Don

Don, So the moral of the

Don,

So the moral of the story is that both the employee and the company can benefit from stock compensation as opposed to cash compensation in certain situations, one of which is when taxes come into play.