Even more on stock options and opportunity cost

Don Lloyd responds to Kyle Markley's entry on stock options and opportunity cost.

I think that opportunity costs can, in some cases, be accounted for, but in the case of stock and options, there is no opportunity cost.

If the CEO of Ford gives his wife a Ford Explorer, Ford has forgone the opportunity to sell it to a dealer. This seems to me to be an opportunity cost that should be accounted for, but the appropriate value to be assigned is the replacement cost, not the wholesale or retail price. This replacement cost perspective is also one way to look at why stock and options have an opportunity cost of zero.

Currently, stock grants are expensed and option grants are not, even though they are transitional forms of the same thing. In fact, neither should be expensed.

The supporters of expensing correctly perceive that a logical fault exists and want to enter an expense so that companies cannot use equity compensation without any visible penalty. However, their purported solution is simply wrong and extremely counter productive.

It is not the granting of stock or options that is a real expense, but rather the repurchasing of shares to mask dilution of shareholder ownership.

As an example -

CASE I

The company buys $10K worth of its stock on the market and has it delivered directly to an employee without taking ownership itself.

Result -- The company incurs a $10K compensation expense. The shareholders do not suffer a dilution of ownership as no new shares have been created, and suffer only indirectly as the company that they own has expended $10K.

CASE II

Part 1 -- The company creates and grants $10K worth of new shares to an employee.

Result of Part 1 -- The shareholders suffer a direct cost due to the ownership dilution of their shares. This dilution can be quantified by the fact the shareholders would have to expend $10K collectively to restore their original ownership positions in the company by buying shares on the market from either willing sellers or from the employee himself. The company itself suffers no cost or expense.

Part 2 -- The company subsequently repurchases the newly created shares from the market for $10K, assuming that the market price has not yet changed.

Result of Part 2 -- When a company buys its own stock, this is equivalent to destroying the shares and reduces the outstanding share count as any company shares owned by the company itself are really owned by the external shareholders.

The shareholders have now had their direct cost removed and their ownership of the company has been restored to the original levels. They now suffer the indirect cost of the $10K expended by the company to repurchase the shares.

Summary

At the end of CASE I and at the end of CASE II, part 2, both the company and the shareholders end up in exactly the same place. The number and distribution of shares is the same and the company is out $10K.

The question is why these two cases end up with different accounting treatments when only the order of actions is different between them. The answer is that the treatment should NOT be different. The only way to treat the two cases the same is to record a company compensation expense of $10K when the company repurchases shares to reverse the ownership dilution of the shareholders as a result of employee grants of new shares. This is complicated by the fact that shares can be repurchased for other reasons, primarily when shares are thought to be undervalued and worthy of investment and when repurchasing shares represents a tax-advantaged alternative to distributing unneeded cash to shareholders instead of taxable cash dividends. This complication should not be fatal.

By following the above procedure, the employee compensation expense is either borne directly by shareholders in ownership dilution or indirectly by a reduction of company value. It is an equivalent expense of $10K in either case, and must not be recorded as both a direct and an indirect cost at the same time. Until the company actually repurchases shares, if it chooses to do so, the company itself cannot be charged with a compensation expense.

Follow-on

Actually, the expense is not being deferred at all. All the repurchase does is move the expense from the shareholders directly back to the company. The problem now is that companies can start with the expense falling directly on the shareholders and then move it back to the company without recording it. If the companies actually had to record repurchases for this purpose as expenses, they would become extremely reluctant to do so. This in turn would mean that the extent of dilution over time would not be able to be disguised by ongoing 'free' repurchases.

Related Catallarchy posts:
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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
Kling on stock-based compensation

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I responded on my blog.

I responded on my blog. Thanks Don, it's good to spread the word that the issue is with repurchasing, not with grants or options.