<<< Re: Using options as compensation>>>
<<<There's nothing magical that forces a company to issue stock options. Wind River can hire an engineer with 10 years experience for $100,000 cash or $90,000 cash plus $10,000 worth of stock options. If LEAPs were available for Wind River, it wouldn't make any difference to the engineer which method was used. In fact, he'd probably choose 100% cash because he could invest the $10,000 in LEAPs or stocks in any one of thousands of companies, rather than have his fate tied to the market's opinion of Wind River. Or, he might enjoy the freedom to invest in a mutual fund or even to refrain from speculating in the stock market at all.>>>
There might not be any magic, but there are powerful incentives to both the employee and the company to use options as part of a compensation package.
To use your example, assume that the engineer needs the first $90,000 to meet his living expenses. If he receives the extra $10,000 in salary, he pays about $4,000 of it in taxes, leaving him only $6,000 to invest. Lets further assume that he needs the money in four years, when his son goes to college, that he invested the entire $6,000 in company stock, and that the company stock price doubles in the four years. After four years, the employee has $12,000, less about $1,400 in capital gains tax, or $10,600 net.
The company has paid out $10,000 in salary, plus they have medicare taxes to pay of $145, for a total out of pocket outlay, before taxes of $10,145, or $6,087 after tax savings, using a 40% combined federal and state tax rate.
Now lets look at what happens if the company instead pays him with stock options for the extra $10,000, and does a stock buyback to prevent dilution. Assume that the company grants this engineer an option to buy $20,000(current FMV) of company stock for $20,000, and that the Black-Shoals formula says that this option is worth $10,000 (I am not an expert on Black-Shoals, but my guess is that this option would be valued at way less than $10,000. Help anyone?). The company buys $20,000 of stock at market prices to prevent dilution, meaning they are $13,913 behind on day one (after tax, as compared with paying straight salary). Reported EPS should be marginally improved, since they have the same number of fully diluted shares outstanding, but have lowered payroll expense by $10,145 ($6,087 after tax).
After four years, the engineer exercises his options and sells right away, because he needs the cash. His options are worth $40,000, less his $20,000 exercise price, or $20,000 before taxes. All of the $20,000 is taxed to him as ordinary income, costing him about $8,000 in taxes, assuming his marginal tax rate (federal plus state plus medicare) is 40%. He ends up with $12,000 after tax, or about 13% better than if he had received cash up front and bought company stock.
For the company, they have no expense to report on their financial statements, but they get to deduct the $20,000 in compensation on their tax return. They pay medicare tax of $290 on the compensation, but save about $8,000 in corporate income taxes at 40%. Plus, they get the $20,000 option price, so they end up with cash of $27,710 after tax. Not bad for an investment of $13,913. The tax savings is reported on their financial statements as paid in capital; it increases their book value, but not their reported earnings.
In the above scenario, everyone wins except the IRS. The employee controlled more stock, so he benefited more by the increase in price. The company benefited financially, had an employee with extra motivation to keep driving the stock price higher, and probably made it harder for the employee to leave the company (because he probably got similar grants in other years, and the options probably vested over time). The shareholders benefited by both of the above. In fact, the only time everyone doesn't win is if the stock price goes down or fails to appreciate, in which case everyone loses.
The great thing about options is that everyone wins if the stock price goes higher, and no one wins if it doesn't. As a shareholder, I would love nothing better than to see WIND continue to avoid dilution by repurchasing shares granted through options (Sorry Allen, but I don't think it has that much to do with qualifying for pooling of interests), and seeing lots of WIND billionaires that got that way from their options. (How many people who have owned MSFT for the last ten years are complaining about the stock option packages?)
If I was a great software engineer, I wouldn't even consider working for a company that didn't have a generous option package. As a shareholder, I would much rather see an employee have stock options that only have value if the stock price goes up than an investment in any one of thousands of companies. I would rather see his fate tied to the market's opinion of Wind River than have him enjoy the freedom to invest in a mutual fund or even to refrain from speculating in the stock market at all. |
