Pros and cons of employee stock options as compensation

Let me talk about the conclusion first: the company grants employee stock options as compensation, which is beneficial to employees, but damages the rights and interests of investors.

Buffett vehemently opposed

In his 1985 shareholder letter, Buffett disclosed in detail that he strongly opposed the issue of corporate stock options as rewards for employee performance.

Managers actually apply a double standard to options. Leaving aside warrants (which deliver the issuing corporation immediate and substantial compensation), I believe it is fair to say that nowhere in the business world are ten-year fixed-price options on all or a portion of a business granted to outsiders. Ten months, in fact, would be regarded as extreme. It would be particularly unthinkable for managers to grant a long-term option on a business that was regularly adding to its capital. Any outsider wanting to secure such an option would be required to pay fully for capital added during the option period.

Despite their shortcomings, options can be appropriate under some circumstances. My criticism relates to their indiscriminate use and, in that connection, I would like to emphasize three points:

  • First, stock options are inevitably tied to the overall performance of a corporation. Logically, therefore, they should be awarded only to those managers with overall responsibility. Managers with limited areas of responsibility should have incentives that pay off in relation to results under their control. The .350 hitter expects, and also deserves, a big payoff for his performance – even if he plays for a cellar-dwelling team. And the .150 hitter should get no reward – even if he plays for a pennant winner. Only those with overall responsibility for the team should have their rewards tied to its results.
  • Second, options should be structured carefully. Absent special factors, they should have built into them a retained-earnings or carrying-cost factor. Equally important, they should be priced realistically. When managers are faced with offers for their companies, they unfailingly point out how unrealistic market prices can be as an index of real value. But why, then, should these same depressed prices be the valuations at which managers sell portions of their businesses to themselves? (They may go further: officers and directors sometimes consult the Tax Code to determine the lowest prices at which they can, in effect, sell part of the business to insiders. While they’re at it, they often elect plans that produce the worst tax result for the company.) Except in highly unusual cases, owners are not well served by the sale of part of their business at a bargain price – whether the sale is to outsiders or to insiders. The obvious conclusion: options should be priced at true business value.
  • Third, I want to emphasize that some managers whom I admire enormously – and whose operating records are far better than mine – disagree with me regarding fixed-price options. They have built corporate cultures that work, and fixed-price options have been a tool that helped them. By their leadership and example, and by the use of options as incentives, these managers have taught their colleagues to think like owners. Such a Culture is rare and when it exists should perhaps be left intact – despite inefficiencies and inequities that may infest the option program. “If it ain’t broke, don’t fix it” is preferable to “purity at any price”.

Not regularly reviewed

In Buffett’s 1994 shareholder letter, he even pointed out that there is a shortcoming of stock options that few people pay attention to: A common form of misalignment occurs in the typical stock option arrangement, which does not periodically increase the option price to compensate for the fact that retained earnings are building up the wealth of the company.

Indeed, the combination of a ten-year option, a low dividend payout, and compound interest can provide lush gains to a manager who has done no more than tread water in his job. A cynic might even note that when payments to owners are held down, the profit to the option-holding manager increases. I have yet to see this vital point spelled out in a proxy statement asking shareholders to approve an option plan.

Where is the point?

Ironically, the rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An
owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I’ll be happy to accept a lottery ticket as a gift – but I’ll never buy one.)

Buffett said in his 1998 shareholder letter: “This Alice-in-Wonderland outcome occurs because existing accounting principles ignore the cost of stock options when earnings are being calculated, even though options are a huge and increasing expense at a great many corporations.” “In effect, accounting principles offer management a choice: Pay employees in one form and count the cost, or pay them in another form and ignore the cost.”

There are many reasons why a company may ask investors to ignore stock-based compensation. For one, stock-based compensation does not represent an immediate cash outflow from operations in the way that a salary or hourly wage will. And for options, it can be very difficult to estimate what the ultimate cost of this compensation may be since there’s no telling where the stock price will go and when the employee may exercise.

The sector most commonly associated with stock-based compensation and liberal non-GAAP based earnings is probably tech, where pay at young companies skews heavily toward options as managers are usually working with limited piles of cash. 

In short, this is an unreasonable act of generosity to shareholders, diluting the equity of existing shareholders, and sacrificing the rights and interests of investors.

Companies do pay for it

In Buffett’s 1998 letter to shareholders, he wrote: “

 Readers who disagree with me about options will by this time be mentally quarreling with my equating the cost of options issued to employees with those that might theoretically be sold and traded publicly. It is true, to state one of these arguments, that employee options are sometimes forfeited — that lessens the damage done to shareholders — whereas publicly-offered options would not be.

It is true, also, that companies receive a tax deduction when employee options are exercised; publicly-traded options deliver no such benefit. But there’s an offset to these points: Options issued to employees are often repriced, a transformation that makes them much more costly than the public variety.

         It’s sometimes argued that a non-transferable option given to an employee is less valuable to him than would be a publicly-traded option that he could freely sell. That fact, however, does not reduce the cost of the non-transferable option Giving an employee a company car that can only be used for certain purposes diminishes its value to the employee, but does not in the least diminish its cost to the employer.”

Relevant regulations have been amended

Because more than 20 years ago, more and more companies listed on the US stock market competed to issue employee stock options as rewards for employee performance, which damaged the rights and interests of investors.

The competent authorities are forced to amend relevant laws and regulations, requiring companies to recognize the stock options issued to employees as “expenses” in the company’s financial reports, that is, companies must actually amortize this cost, rather than generously generous to shareholders, diluting Existing shareholders’ rights and interests damage the rights and interests of investors.

Since the fraud broke out in American companies such as Enron and WorldCom in 2002, well-known companies such as Coca-Cola (ticker: KO), General Electric (ticker: GE) and Procter & Gamble (ticker: PG) have first Announced that stock options will be publicly listed as expenses, and the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASC) have also clearly regulated that companies must treat stock options as expenses. Options are no longer just a footnote on financial statements, with a growing number of companies treating stock options as an expense, like rent or employee salaries.

Closing words

Buffett’s 1998 letter to shareholders best concludes with the words: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

employee stock options

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