Wayne and All -
As you may be aware, I have been making a (truly) random series of posts that, despite a widespread belief to the contrary, argue that the granting of employee stock options is NOT an expense to the company as a whole, but rather simply a dilution of existing stockholders than can and should be captured and encapsulated in a more aggressive diluted share count. Up to this point, the arguments have been based on underappreciated fundamental economic theory, in particular the Subjective Theory of Value from the Austrian School of Economics, and on certain analogies from other circumstances. Now I am prepared to directly prove, beyond a reasonable doubt, without needing any economic theory or any analogy, that even if we take the worst case for options, there is NO non-trivial company cost or expense involved.
Since there is always the possibility of my overlooking a key unwarranted and/or unrecognized assumption (or just being flat out wrong -g-), I am requesting any argument or combination of arguments that convinces me that my arguments or conclusions are flawed in any significant way and that options DO indeed NECESSARILY represent an expense to the granting company as a whole.
Background -
To make the option grant worst case to the company, drop the exercise price to zero, eliminate any vesting period, and eliminate any possible tax deduction. This is essentially equivalent to giving out free, unrestricted stock, and eliminates any real cash flow to the company, except for the elimination of the phantom salary increase that would otherwise be needed to produce the same levels of successful employee recruitment and retention. In accordance with the above, the proof below will deal with actual stock, and not the options that may indirectly lead to shares that result from option exercises.
Proof -
1. The company, with shareholder approval, declares a 5% stock dividend, in other words, a 1.05 to 1 stock split, with each existing shareholder receiving 5 new shares in the mail for each 100 shares owned. As with all stock splits, this has no cost or benefit to either the company or the shareholders, as the value of each share will be 1/1.05 of its original pre-split value.
2. Instead of merely depositing the newly received shares to their brokerage accounts, the shareholders have agreed to re-mail their new shares directly to a number of company executives and employees in varying amounts. In making this agreement, the shareholders have determined that this particular distribution of their new shares will sufficiently improve company employee recruitment, retention and morale to such a degree that, over time, the resulting improved business and financial performance of the company will lead to an increase in market value that more than offsets the loss of the new shares to each shareholder.
3. After all the new shares have been re-mailed and received, the original shareholders now have exactly the same number of shares that they had pre-split, but their value has been diluted by a factor of 1/1.05. The executives and employees now have the new shares, to hold or dispose of at will.
4. It is clear that nothing in 1,2,3 above in any way represents any non-trivial cost or expense to the company. The executives and employees have received the new shares from the original shareholders which otherwise would have prevented shareholder dilution if they had been retained.
5. If we assume that every executive and employee has received the exact same number of new shares that he would have received from the company in a direct stock grant program, then it must be true that the stock grant program is also free of non-trivial cost or expense to the company. Since the stock grant program was designed to be a worst case equivalent of an option grant program with respect to the company, any option grant program must also be cost and expense free to the company. After the fact, the executives, the employees, the shareholders and the company all find themselves in an identical state no matter whether it was the stock grant program or the stock split program which was executed.
Regards, Don
Note: To forestall questions, none of the above establish any requirement for the company to sterilize the stock dilution by buying back shares. The buying back of shares is inherently a separate investment decision in its own right whose actual rate of return will depend on the prices paid for the shares. The buybacks are clearly costs and expenses for the company, but these are only the result of the buybacks themselves, not the preceding stock or option grants.
None of the above makes any claim that option grant programs may not be pursued inappropriately in practice. Both option grants and stock buybacks can easily be executed at abusive levels to the detriment of the shareholders. |
