A Thought Experiment

Looking for Evidence of Stock Grant Opportunity Costs

One of the things that spontaneously emerged from the chaos of the arguments over the expensing of employee stock option grants is the claim that the granting of stock itself represents an opportunity cost to the company that is equal to the sale proceeds that otherwise would have been received from the sale of stock on the market.

This not only sounds quite sensible, but would seem to identify a contender for the title of 'The Greatest Thing Since Sliced Bread', as well as a source of an entire free lunch as well.

Given that selling stock on the market is such a universal boon, it would seem to be easy to predict the results of the following possible, but hypothetical, experiment --

Take a list of public companies, say the 30 Dow Jones Industrials, or the NASDAQ 100, and search the financial newswires over the past three months for notifications of secondary market offering stock sales. Record the percentage of companies which have sold stock in the previous three months.

Why wouldn't the percentage be close to 100%? Are company managements too lazy to bend over and pick up $100 bills lying in the street?

One reason could be all the stock and stock option grants that have been made to employees that have used up all the available stock to grant. Maybe there really is an opportunity cost. Even in the unlikely case that no authorized stock remains to issue and sell, surely the shareholders will authorize the management to issue more if merely asked nicely.

As a result of the experiment, it seems to me far more likely that the companies will have made notification of their intent to BUY BACK stock, than to sell it. Why are the companies regurgitating their free lunch and throwing $100 bills on the street?

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I don't understand your

I don't understand your point at all. The argument is that giving stock options to employees is no different from selling them on the open market. As long as the options are being distributed, the opportunity cost of giving them as compensation to employees is what they would have been worth on the open market.

That doesn't mean that selling them on the open market is free money. That money is only available after the decision has been made to grant the option to somebody. Granting the option is a cost to the corporation. Taking an option that would otherwise go to an employee and selling it on the open market is not.

The argument that you are parodying is correct. It does not lead to the free lunch paradox that you are suggesting.

X, Sorry I wasn't clear. The

X,

Sorry I wasn't clear. The free lunch being considered is the selling of stock on the market even in the case where no grants of any kind are made.

Regards, Don

Then you're distorting the

Then you're distorting the argument. When we say that the opportunity cost of granting an option to an employee is the price it would receive on the open market, it's already assumed that the option is going somewhere.

Try replacing stock options with bonds in your example. A company chooses to compensate employees by granting them bonds. The company is of questionable stability, so the bonds may be difficult to value. It would be reasonable to say that the value of those bonds should be whatever they would be worth on the open market. That certainly doesn't imply that issuing debt on the open market is a free lunch.

X, Note that I am talking

X,

Note that I am talking about the expensing of STOCK, not options. Supporters of option expensing have used the fact that stock is currently expensed as an argument for option expensing, and justify the expensing of stock by the opportunity cost argument. This is the problem.

Regards, Don

I guess we agree that there

I guess we agree that there is no logicial reason to expense stock, but not options. I think both should be expensed. You seem to think neither should be expensed.

I was a little sloppy with the distinction between stock and options, but that's only because I don't see any real difference. Options could be sold on the open market too. If you replaced "option" with "stock" in my above post, it still works.

If you assume that issuing stock (or options) is a real cost to the company (as supporters of expensing would) then the free lunch you're talking about disappears. That's the point I was trying to make. I'm sorry if I confused the issue by talking about options instead of stock.

If you assume that issuing

If you assume that issuing stock (or options) is a real cost to the company (as supporters of expensing would) then the free lunch you?re talking about disappears.

How is it real cost to the company? Real costs to the company include things paying employees with cash it already has. Stock grants/options are compensating employees with existing shareholders' ownership of the company. Expensing this would be non-sensical, as it is a dilution of existing shares of the company - a cost borne by the existing shareholders.

Aren't all costs to the

Aren't all costs to the company borne by the shareholders?

Jonathan: That's a point on

Jonathan: That's a point on which reasonable people can disagree. But the important thing to note is that Don's disagreement with the opportunity cost argument all boils down to a disagreement over whether issuing equity is a cost to the company.

Don said that opportunity cost argument degenerates into a free lunch paradox. That's only true if you assume that issuing equity is not a cost to the company. The people making the opportunity cost argument were obviously using the opposite assumption.

I'm not trying to argue here that stock and options should be expensed. I'm just suggesting that Don's attack on the opportunity cost argument is unpersuasive.

Actually, I think I can make

Actually, I think I can make my point a bit better.

Don takes the argument that granting stock to employees is an opportunity cost. He then assumes that granting stock is not a cost to the company. The conclusion is that granting stock and selling it on the open market is free money, which is absurd. Don takes this as a refutation of the first premise.

The first premise is obviously true. If the company is choosing to grant stock, then the cost of granting it to an employee is the price that it would have fetched on the open market. The problem is the second premise: that granting stock is not a cost to the company.

If anything, Don has produced an argument that granting stock to employees should be expensed. I don't think that was his intent.

My argument for expensing stock grants is that debt and equity are essentially equivalent. It makes no sense to expense one and not the other.

Aren?t all costs to the

Aren?t all costs to the company borne by the shareholders?

Yes, but some costs borne by shareholders are not borne by the company. An increase in the # of outstanding shares dilutes the %ownership of each share, but does not affect the revenues or expenses of the company.

All, I have to take

All,

I have to take responsibility for creating a post so unclear that it can't even be determined just what target it was that I was shooting at. For the record, the target was the sale of stock itself, used to quantify a theorized opportunity cost. I believe that the degree and the scope of the benefits that may result from the sale of stock are widely misunderstood.

If the newswires are investigated, it is a near certainty that notifications of stock sales are far outnumbered by notifications of stock buybacks, their precise opposite. If stock sales were the universal benefit that most people likely believe, this is, at least superficially, a peculiar result.

I promise (threaten??) to create a new post containing an argument that examines stock sales on their own.

On the subject of opportunity cost, there are a number of subtle qualifications that are required to produce a valid opportunity cost. The following simple example may illustrate one of these --

If you choose to take a vacation cruise from Boston to Miami, this choice has an opportunity cost of not being able to take a vacation cruise from Boston to Bermuda, your second choice, during the same vacation period.

However, if your second choice were a vacation cruise from Boston to Anchorage, this could not be an opportunity cost for the Miami cruise because no such cruise exists. Any valid opportunity cost for the Miami cruise must be both realizable and unblocked by anything other than the first choice Miami cruise itself.

Regards, Don