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
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.
What is ‘Backdating’? Simple. Assume today is 6
Aug 2006. A company’s stock price as oftoday is Rs.120. It decides to grant ESOs dated 1
Jan 2006, although today’s date is 6
is ‘Backdating’. Why would someone do that? Assume that the price on 1
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
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’!
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.