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Observations - Employee Stock Options

Observations - Employee Stock Options

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Published by abhimails

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Published by: abhimails on Oct 08, 2008
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07/28/2010

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 This piece comes after a rather long sabbatical. It’s been somewhat due to lack of ideas & largely due to lethargy. I am very finicky about shareholder friendliness & admire corporations whose actions conform to this objective. In this piece, I will write on the subject of Employee Stock Options (ESO) & my views on it. Most employees love it, some corporations, I’ll try to be a little euphemistic here, ‘use’ (mis?) it for their benefit. Rather than rewarding the exceptional performers proportionately to their performance, which is what should ideally happen, most Stock Options have a Socialistic feel about them. While there are lots of corporations that use ESOs  judiciously, I will write on why I think they may not be very shareholder friendly in lot of cases. In fact, in some cases they are not ‘employee friendly’ as well! 
The most common reasons corporations cite for issuing Employee Stock Options (ESO), is that itmotivates the employees to strive towards a common goal, & that it aligns shareholder &employee interests etc. etc. Indeed, for a lot of them, ESO’s are a way to attract & retain toptalent. The Internet companies not so long ago used (misused?) it to rather good effect,seemingly achieving
their 
objective in the process. But did they achieve the commonly ranted ‘weare shareholder oriented’ baritone as well?Some of the abuses that strike me as utterly un-shareholder oriented, & in cases un-employeeoriented, includes Backdating of ESOs, non-expensing of option grants, & finally the Pricing &Repricing of ESOs. Each demands some ‘piece-space’ here & so I’ll dive directly into each ofthem. The shareholders perspective is mostly the same under all these cases.
BACKDATING
What is ‘Backdating’? Simple. Assume today is 6
th
Aug 2006. A company’s stock price as oftoday is Rs.120. It decides to grant ESOs dated 1
st
Jan 2006, although today’s date is 6
th
Aug2006.
This 
is ‘Backdating’. Why would someone do that? Assume that the price on 1
st
Jan 2006was Rs.100. This act achieves the purpose of taking advantage of a lower stock price as on theprevious date compared to the prevailing market price.This gives the employees; including the Top Brass, an immediate paper profit (Rs.20 in thiscase)…& the poor shareholder is the one who is the sufferer. In hindsight, this may seem veryprofitable for the employees, but it’s not always the case. This is why.‘Non Qualified’ Stock Options as they are called, attract a tax treatment that is slightly differentfrom ‘Incentive Stock Options’. For employees, ‘Non Qualified’ Stock Options attract tax paymentat the ordinary Income Tax Rate (which is about 30% under US Tax code), while the ‘IncentiveStock Options’ attract a
lower 
Capital Gains Tax Rate (about 15%).Now if the unfortunate employee was unaware whether the Options granted to him are ‘NonQualified’ or ‘Incentive based’ he will get into a shit hole later when the taxman comes knockingon this doorstep. That’s because he would have paid the lower Capital Gains Tax assuming theOptions to be ‘Incentive based’, while in reality,
he should have paid the full ordinary Income Tax Rate as the Options were ‘Non Qualified’! 
Employee friendly?
EXPENSING (OR LACK OF IT)
This is a no-brainer. When Stock Options are included as Compensation when HR works out yourpackage, I think it’s pretty straightforward to record it as an Expense on the Financial Statements.But most don’t do this! The US code has now made it mandatory to expense all granted StockOptions, but corporations continue to abuse this rule.
 
 
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A recent example that springs in my mind is that or Brocade, which has been accused of regularlybackdating options, without expensing them! Once this is taken as correct, a cascade of chargeshit the company. Misrepresentations to auditors, botching books, misrepresentation by the CEO &CFO thereby violating the Sarbanes-Oxley Act & finally, the big one Misrepresentation ofFinancial Statements to Investors! Whew! I wonder who benefits from all this pain, for a rathersmall gain (in the form of paper profit)!!!! Certainly not the corporation & most certainly not thenaïve Investor who commits his money oblivious of this hanky panky.
PRICING & RE-PRICING
This to me is one of the extreme examples of selfish human thinking!When a corporation receives a take-over bid from a competitor, it quickly & vehemently points outhow the price offered, which in most cases is slightly
higher 
than the prevailing market price, istoo low (Think Arcelor-Mittal). But when the same corporation grants Stock Options to itself, theyare invariably at a juicy discount to the current market price! I don’t see any further room forexpanding selfishness & stupidity than this!As an example of the latter case, the Indian Bauxite/Bentonite company Ashapura Minechem hasan outstanding Employee Stock Option grant that is exercisable at Rs.65 / share. The Prevailingprice is about Rs.200 / share. Why on earth should a company ‘take’ the right to buy an additionalstake at 1/3
rd
the prevailing price?I can’t fathom & digest the fact that managers are unwilling to sell themselves to an ‘outsider’ atthe prevailing market price, but gleefully sell to ‘themselves’ a stake in their company at a superdiscount to the same prevailing market price! Shareholder friendly or plain stupid? I think both.When an unwitting pay-off occurs to employees due to extraneous factors & they have an optionto exercise, one can’t find anybody complaining, but if the same pay-off were to occur to an‘outsider’ (including investors) you can rest assured there will be a huge hue & cry over it!Chrysler being a striking example.When the US Government, which had an option on Chrysler during its near-bankruptcy days, gotan unintended pay-off, Chrysler cried like hell over the ‘injustice’ but if the same pay-off hadoccurred to themselves, I wonder how many would have cried hoarse…The subject of Pricing & Repricing of Stock Options seem inherently un-shareholder friendly.Ideally, the Exercise Price should be around the Fair Value of the company, but this is seldom thecase. Employees can readily & at times at a substantial discount, exercise their Options, make aneat profit & dilute Equity.Equity Dilution has the effect of reducing EPS (Earning Per Share) & who suffers? Shareholders.The scene goes on something like this.

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