...Even if no cash changes hands, issuing stock options to employees incurs a sacrifice of cash, an opportunity cost that needs to be accounted for. If a company were to grant stock, rather than options, to employees, everyone would agree that the company's cost for this transaction would be the cash it otherwise would have received if it had sold the shares at the current market price to investors....
Here, Merton and friends go off the rails almost immediately. I do not agree, and it is NOT true in general that stock grants are a company expense, and it is in fact only true for one specific case. The fact that stock grants ARE currently and improperly expensed is one of several reasons why option grants have turned into such a gigantic mess.
If a company like Intel sends an executive secretary out with petty cash to buy the CEO a dress shirt, the cash expended IS an expense.
If Intel's executive secretary wires cash to a broker to buy shares of MICROSOFT on the market for delivery directly to the Intel CEO, the price paid for the shares, including any fees or commissions, IS an expense. Under the EXACT same conditions, if the shares purchased were INTEL shares instead, it STILL would be an expense. In neither case above would ANY shareholders see their holdings diluted, as shares already on the market would have simply changed hands.
However, this is not the case at all when new shares are created and presented to the CEO. In this case existing shareholders DO suffer dilution of their company ownership positions, but no shareholder cash escapes the imaginary film bubble that surrounds the company and encloses what it is that the shareholders actually own.
If the company expends shareholder cash to purchase stock on the market for the CEO, or if the same number of new shares are issued to the CEO and dilute the shareholders, the result is a reduction in the liquidation value of the shareholder holdings that is EXACTLY the same in either case at the instant of the transaction. This would no longer be true if the company were charged an extra phantom expense of even a penny for the grant of new shares.
It is Merton's argument that the company, and presumably the shareholders, suffer an 'opportunity cost' when shares are granted to the CEO because those shares can no longer be sold for cash on the market. This is obviously true, but meaningless. To see why we need to have more than a superficial concept of just what an opportunity cost is, and more importantly, what it isn't.
If you are walking in a city and come to a fork in the road, you can't just take it. You have to decide whether to take the left branch or the right branch. Your plane leaves in one hour and you don't have enough time to take both, one after the other. If you take the left branch, you can grab lunch from a fast food restaurant and take it along to the airport. If you take the right branch, you can stop at your bank and exchange a dollar bill for two rolls of pennies.
If you decide to take the left branch and get lunch, the opportunity cost of so doing is the inability to stop by the bank and exchange the dollar for penny rolls, and vice versa if you make the other choice.
If you had the ability to stop and reset time, you could sequentially take both branches and there would be NO opportunity cost because time is effectively no longer scarce.
This is the exactly the situation that results if a company creates new shares. These new shares can effectively be created out of thin air with neither significant limit nor expense, IF there is a good reason for doing so. If it makes sense to create new shares for the CEO AND to sell new shares on the market, then both can be done repeatedly, in any order, in any quantity, UNTIL it no longer makes sense to do so. If the CEO feels that it will ALWAYS make sense to give HIM new shares, the resulting problem is NOT the result of not expensing share grants, but rather a general compensation methodology issue that would exist for every form of compensation.
Assuming now that time is scarce, and that an opportunity cost DOES exist, it needs to be quantified. What we are prevented from doing is exchanging a one dollar bill for a total of 100 pennies. Merton claims that the opportunity cost of not being able to sell shares on the market is the full market value of the shares. In the case of the fork in the road, he would logically claim that the opportunity cost is $1. Hopefully, it isn't necessary to explain how nonsensical this claim would be. In general, a precluded opportunity cost must be evaluated on a net, not a gross, basis. Just for completeness, if there were more than two streets, the opportunity cost of getting lunch would be the highest of the costs associated with the other precluded streets.
Summary -- Granting stock fails to be an opportunity cost both coming and going. New shares have no scarcity value to the company itself, and even if they had, not being able to sell the shares on the market effectively has a net value of zero at the time of the transaction.
Regards, Don
There is more that can be said about ALL of the possible company transactions that involve stock alone, but it will have to wait. |
