Kling on stock-based compensation

Arnold Kling has responded to my wanting to hear an argument in favor of expensing options on his blog. I appreciate his post which gave me a lot to think about. I was planning to respond last week to his post, but due to the technical difficulties we encountered, I did not have a chance to do so.

Arnold gives a reason why employers might use stock-based compensation.

As an ordinary employee, some of my effort is observable by management and some of my effort is not observable. The observable component can be rewarded with wages and bonuses. The rationale for stock-based compensation is to increase the unobservable component.

However, as an ordinary employee, I have little influence on the company's aggregate value. Moreover, most of what influence I have comes from the observable component of my effort. If the value of the company is only infinitesimally correlated with my unobservable effort, then my stock options will not provide much incentive for me to increase my unobservable effort.

Providing incentive to increase the employee?s unobservable effort may be one rationale for using stock-based compensation, but it is not the only one, and likely not even the major rationale in most cases. Rather, stock-based compensation is a way the company can conserve cash by entering into a mutually beneficial exchange between the shareholders and the employee, with management acting as an agent of the shareholders. If management is true to its mission of maximizing shareholder value, stock-based compensation can be a means to increase the net present value of future returns of the shares.

The stock options that you as the entrepreneur grant to me as an employee necessarily reduce your wealth and increase my wealth. If you could obtain another employee for the same wage without granting options, then it would be rational for you to do so. Therefore, the only reason I am getting stock options is because I am willing to take a lower wage.

Stock-based compensation does not necessarily reduce the wealth of the employee or increase the wealth of the company. As all economic exchanges come with the expectation of mutual benefit, it is very possible that stock-based compensation can benefit both the employee and the shareholders. The shareholders can benefit if the cash saved is employed in such a way that the net present value of future returns of their shares increases. The employee can benefit for various reasons including tax implications.

The last part of Arnold?s post, and the main thrust of his argument seems to be agreement with Warren Buffet's statement, "As Warren Buffett says, if stock options are not compensation, then what are they? And if compensation is not an expense, what is it?"

Suppose that the market wage is $40,000. If you pay me $30,000 plus stock options, then unless I am a fool those stock options have to be worth at least $10,000. From this perspective, my stock options have to be viewed as a form of compensation. That is why they must be expensed.
[emphasis mine]

To the employee, the stock options may very well be worth more than $10,000. But it does not imply that the same is true for the company or the shareholders. Prices are poor measures of value.

The part in bold implies that the fact that stock options are compensation for the employee, they must be an expense for the company. Or to put it in the starkest of terms: compensation implies expense.

I agree that stock options are a form of compensation; it is very clear that they are. But is the next step where I disagree. It does not necessarily follow that the company suffers an operational expense. Rather, it is the shareholders who pay for the compensation through dilution of their existing shares. Stock options cannot both be an expense to the company and a dilution of shareholders? stock; that would be double-counting.
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Stock options compensation and opportunity cost
Employee compensation: cash vs. stock
Candy bars and movie tickets
Stock options compensation and opportunity cost II

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This type of discussion is

This type of discussion is what is so great about blogging. And this is really good blogging because you guys write about a subject I know nothing about and it make sense to me. good stuff!

Matt, Thanks for the

Matt,
Thanks for the compliment. I was afraid that this topic was too 'dry' to have any appeal.

Very good. But I still have

Very good. But I still have a question. What difference does it make? If Warren Buffet wants companies he invests in to report stock grants as expenses then he should avoid Cisco (CSCO) stock, and instead pick up, say, Microsoft(MSFT), or buy enough Cisco to make noise about Cisco stock options and back up that noise with share votes. As long as a company is consistent about how they report stock grants (and do so), then the investor can easily determine how the stock grants affects his valuation of the shares.

David, One reason that it

David,

One reason that it matters is that the expensing of stock and options grossly distorts the net earnings and net earnings per share lines. These are the lines that should quickly distinguish a company with a profitable business from one without.

It shouldn't require more than a minimal understanding of logic and arithmetic to realize that if a profitable company simply increases its share count by 2%, its earnings per share shouldn't be affected by more than about 2%. But if the company were to subtract the Black-Scholes-Merton calculation of the value of the options granted, the effect can be much larger, even turning a profit into an apparent loss. It is simply absurd to apply an addition/subtraction process to an event which is clearly a multiplication/division process. The range of results of the two processes simply cannot be made congruent.

The supporters of stock and option expensing apparently have little interest in the accuracy and appropriateness of an accounting report for a given company, but insist that every company report must be directly comparable to every other company report. This is a lazy investor's viewpoint, not the viewpoint of an existing shareholder who is actually paying for the accounting.

In effect, insisting on stock and option expensing is somewhat like insisting that an airline report its coal fuel costs so that it can be easily compared to a railroad. Companies that can and do grant stock and options to their employees are qualitatively different from companies that cannot or do not. A square peg cannot be pounded into a round hole without significant distortion.

Regards, Don

Right, no disagreements

Right, no disagreements there. I personally do not like expensing stock options, but I also realize I'm drinking John Chamber's (thus Cisco's) Kool-aid, so I am biased.

It seems that the debate is over what a law or regulation should be (or at least that is the debate that I am hearing most often). This then brings up a matter of who should be butting into the conversation. As I see it it is between the shareholders and corporate management, no one else.

Still, quite interesting.

It seems that the debate is

It seems that the debate is over what a law or regulation should be (or at least that is the debate that I am hearing most often). This then brings up a matter of who should be butting into the conversation. As I see it it is between the shareholders and corporate management, no one else.

Exactly. That is what this whole debate is about for me. Sure, I can't see how increasing the number of shares is an 'expense' rather than a 'dilution', but what really bothers me is the calls for 'regulation' to make a one-size-fits-all solution for that would count options as an expense.

Instead of options, simply

Instead of options, simply grant stock. Simple, easy, and obvious. Restrict sale of that stock if necessary, but grant actual, honest-to-glub ownership in the company instead of an ephemeral chance to cash in "if and when."

I believe this would be a better motivator than options. Even if the employee leaves, he or she will be a more effective advocate for the company as one of its owners than as a former option-holder.

If you grant stock instead

If you grant stock instead of options, the employee might leave earlier than he otherwise would.