Hi Steven J Emmerich; Re the company that pays its bills with options.
Lets do a practical example... Suppose a company sells books on the internet. Each book sells for $20, and costs the company $12 for the goods, and $8 for the labor to ship it, if it paid its labor in cash. Instead it pays its labor in options, and books $8 in cash flow per book. I think this would satisfy everybody's need for an example. of a company that makes no money as a going concern, but is highly cashflow positive, due to the options reducing its labor costs.
We might as well suppose that they sell 1 million books per year, and do our accounting on that basis. That would mean that their sales are $20 million per year, COGS is $12 million, and they give out $8 million in options.
A company that sells $20 million per year on the internet might have a valuation of $200 million. (I know this seems ridiculous to both the conservative and go-go investors, but at least it seems like a ridiculous valuation in different directions to them...)
Employees value options at about their strike price multiplied by their share size. (I know this from seeing many engineers analyze many stock option plans. It is just the simplest, stupidest, easiest thing to do.) Given that the labor costs are $8 million per year, this means that the employees have to be vesting options at a rate of about $8 million per year. Assuming that options are struck at the current market price, this means that the company's market cap has to increase by about $8 million per year (in the absence of a buy back). Since the market cap is $200 million, this means that the company is leaking shares at the rate of 4% per year.
As long as the growth rate of the company is well above 4% per year, the stock holders will not have a problem with the above arrangement. The selling of options will hide the company's high labor costs, and the stockholders will all be happy. But what is going on is that the company is dumping shares onto the market in order to pay its labor costs. Lets reanalyze the same numbers but with a more realistic market cap.
While a go-go internet book seller might have a market cap of 10x annual sales, this is kind of number doesn't stick around for long. Lets take the case of Barnes & Noble.Com, BNBN:
For the three months ended 3/31/00, net sales totaled $78.2 million. up from $32.3 million.
...
Price/Sales (ttm) 2.09
biz.yahoo.com
This is a company that is growing like hot potatoes, but still its P/Sales is only 2. And that is a trailing figure. The P/S for annualized most recent quarter sales is more like 1 1/2.
For such a company, the cost of converting all their compensation costs to options would be horrendous to the shareholders. With a P/S of 1.5, the market cap would only be $30 million instead of $200 million, and the labor costs of $8 million per year will inflate the shares by 27% per year.
As soon as the ratio of labor to the market cap gets above the growth rate of the company, the increase in shares due to employee costs will exceed the increase in sales, and the sales per share will decline instead of grow.
So my conclusion is that paying employees with options is a good idea only for companies that are growing at extremely high rates and/or that have an extremely high market cap, compared to their labor costs.
The whole purpose of this was to support my contention that paying employees with options will disappear when this bull market finally breaths its last. (Probably already has, with regard to BNBN.) But the problem with options is that they hide the true expenses of companies. Compensation is an expense, and must be included as an expense. The way it is currently done, options are taken out of the expense items and hidden on the balance sheet. This is not reasonable accounting. Expenses are expenses. How anyone could use Austrian economic theory (which I revere) to argue anything else is beyond me. The value of options given to employees must be included as a business expense because it is something the business must do in order to get the employee to kiss his boss' butts (which seems to me to be the primary use of employees, but that is another story completely). Options are a cost of doing business. They are an expense. They belong on the expense line, not hidden somewhere in the balance sheet. They are a cost. The one thing that the Austrian economists will stress over and over is that there is no free lunch. Making money costs money (expense). Making a complex transaction (like an option grant) to hide the expense doesn't make it go away. There is still an expense. Expenses belong on the Income/Outgo sheets, not the balance sheet.
Any elementary book on Accounting will explain how complex transactions are split into parts that hit both the balance sheet and the income sheet. Companies do this all the time. It is not a question of the correct way of accounting for expenses. Double entry book keeping with profit and loss statements date to the 15th century. This is not some sort of complicated new theory, it is ancient. The problem is that neither the SEC laws on income reporting nor our tax laws follow standard accounting principles (GAAP). The accounts asked for GAAP to be applied to stock options and congress declared that it would not happen. This was done because of the influence of politics, not because the accounting principles of the current situation are valid.
-- Carl |
