Commentary: Earth To Silicon Valley: You've Lost This Battle
Friday July 2, 3:58 pm ET
If anyone thought tech executives might finally give up their long fight against counting employee stock options as an expense, a rally on June 24 quashed that notion. More than 700 employees bused to Palo Alto, Calif., by Cisco Systems (NasdaqNM:CSCO - News), Intel (NasdaqNM:INTC - News), Sun Microsystems (NasdaqNM:SUNW - News), and other Silicon Valley companies staged a protest near a hearing by the Financial Accounting Standards Board, which wants options expensed by yearend. Jim Cunneen, chief executive of the San Jose Silicon Valley Chamber of Commerce, led a chant: "You are the face of employee stock options!" "Yes we are," they shouted back, cheering to Tom Petty's rock anthem I Won't Back Down.
It's too bad the tech industry refuses to read the writing on the wall, because its efforts are almost certainly doomed. True, a bill to block FASB's rule may soon go to the House of Representatives. But even if it passes there, it likely won't get past the Senate. And while FASB on June 29 raised the possibility of delaying expensing for a year because of the difficulty of implementation, it still seems like a sure thing. What's more, a majority of institutional shareholders -- the real corporate owners -- have spoken. In recent months, they have told Intel Corp., Apple Computer Inc. (NasdaqNM:AAPL - News), and others they want options expensed so they can compare companies consistently. Even some tech companies, from Microsoft Corp. (NasdaqNM:MSFT - News) to the online DVD rental service Netflix Inc. (NasdaqNM:NFLX - News), now support expensing.
An industry that rightly prides itself on creating innovative solutions to problems needs to ditch its shrill, unconvincing arguments and threats. Instead, execs should deal with the new reality at hand. To their credit, some recognize the need to move on. "At this point, it's unrealistic to protect this vehicle," says Eric Hahn, founder and chairman of Proofpoint Inc., an e-mail antispam startup in Cupertino, Calif. "If this is what the market wants, we should do it."
So why do so many people in tech continue to fight? Because options long ago became a religion in Silicon Valley. In the canon of the Church of Everlasting Options, these shares are the holy flame of innovation. Expensing them, goes the gospel, will douse the fire, make outfits look less profitable, and drive away investors. As a result, execs say, they will have to get rid of options for the rank and file, hurting innovation and slowing the economy further. "It could be a real problem for the country," says Rick White, CEO at tech lobbyist TechNet.
The industry's latest argument, in fact, is that expensing options will put U.S. companies at a competitive disadvantage to overseas rivals. China, India, and other countries do not require expensing, so tech leaders such as Cisco Systems Inc. CEO John T. Chambers contend that the best and brightest techies, many of them immigrants, will stay overseas and work for local companies. "I don't know how to compete with that without broad-based ownership," Chambers told BusinessWeek last December.
This, like most of the Valley's arguments, doesn't hold up. Many Indian and Chinese companies trade on U.S. stock markets, so they'll be obligated to expense options just like American companies. Besides, accounting's purpose is to protect investors, not to set industrial policy. Moreover, the most innovative U.S. companies -- small, private startups that account for most job growth -- wouldn't be bound by expensing rules because they don't report earnings. So expensing actually would give them the very advantage over large, publicly held rivals that expensing's opponents claim they would lose. That's why Vinod Khosla, a general partner at venture-capital firm Kleiner Perkins Caufield & Byers, backs expensing.
In the end, there's no logical justification for the current situation: Options, which clearly have value to employees, are left off the income statement while companies then take a tax break for the phantom expenses. If that isn't bad enough, firms routinely buy back stock to avoid dilution of share prices when employees exercise the options. But because such buybacks aren't counted as operating expenses, they don't show up as the real cash-flow drain that they are. It's no wonder that Reed Hastings, chief executive of Netflix, which voluntarily expenses options, calls the current setup "the immaculate compensation."
The industry is right about one thing: It's really tough to come up with a clear value for options. FASB's recommended formula, called the binomial lattice method, may well overvalue some options. It could even potentially allow execs to manipulate earnings by changing assumptions about stock movements and the timing of options exercises. "The biggest question is how to value stock options," says eBay Inc. (NasdaqNM:EBAY - News) CEO Margaret C. Whitman, whose shareholders on June 24 voted down a proposal to expense options.
But there are promising approaches. Sean Scrol, leader of the options practice at actuary services firm Chicago Consulting Actuaries, says it's no tougher for tech companies to make credible estimates of options exercises or stock volatility than it is for insurance firms to gauge life expectancies. Options assumptions may need to be adjusted over time as firms gain experience, he adds, but that's right up tech's alley: Startups always go for it, change direction as they learn, and ultimately the best solution prevails. Says Scrol: "Once people get over the hurdle of whether options will be expensed, they're going to look at other kinds of stock options."
Option Alternatives
Indeed, instead of following through on distasteful threats to eliminate options for rank and file, companies should look at expensing as an opportunity. Today's rules perversely encourage companies to avoid tying grants to how good a job an employee is doing because performance-based options already must be expensed. If all options will have to be expensed anyway, companies might as well seize the chance to tie them to specific performance goals. That way, options could be transformed from a lottery ticket into a steadier, more targeted motivator.
At the least, employers should consider other forms of equity compensation. Microsoft, Amazon.com Inc. (NasdaqNM:AMZN - News), and others have moved to restricted shares, which vest over several years. They also must be expensed, but, unlike options, they always have some value. In contrast, when the company's stock price falls below an option's strike price, the options are worthless, and their motivational power vanishes. Because employees sensibly value restricted shares more highly, companies can give out far fewer -- in Amazon's case, less than one-third as many as options. So although restricted stock is likely a similar motivator, the earnings impact is far less.
Let's face it: The war is over. It's time for the tech industry to quit wasting time, money, and energy, and get back to what it does best: Inventing the next big things that will produce real wealth for us all.
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