Cisco’s latest idea for reducing the reported cost
of employee stock option grants sounds as if it depends on a poorly performing derivative instrument (see B5 of the WSJ for a better description). How else describe a security that institutional investors could buy but not sell, making them wait as long as five years to convert it to common stock?
Yes, the price of the derivative may suffer as a result of these limitations. And in doing so, that could conceivably establish a market value for the underlying securities—the option grants—that is lower than what might be recorded under the option pricing models that are acceptable to the FASB.
But if the security is such a lousy deal, why would anyone buy it? And if it’s not so lousy, wouldn’t the resulting dilution to EPS offset the benefits?
It seems to me that Silicon Valley’s time and efforts would be better spent on producing new technology instead of methods of limiting the impact of an accounting rule. After all, investors may simply ignore the hit to earnings and focus on cash flow instead. Or is that what really concerns the tech lobby?
I can understand your frustration; however, Cisco is wise to pursue a market-based derivative pricing solution. Clearly, if you read the literature, an ESO is worth less than a theoretical model price. You can refer to Hull and White's paper on "How to Value Employee Stock Options" (Sept-02) or John Finnerty's recent paper entitled "Extending the BSM Model to Value ESOs". I guess the moral of those legitimate research papers is that ESOs are, as you point out, worth less than exchange traded or OTC derivatives due to the lower level of liquidity, vesting restrictions, etc. The point is that the value assigned - whether a pure BSM value or some other value - is a theoretical value and capable of being "gamed". Using a market-based approach would be the most transparent method one could take; however there are some concerns about using such an approach such as trading frequency, liquidity of the contracts, market depth, et cetera. I am not certain the detail of Cisco's proposal, but unless the market grows and they get more companies to issue these restricted options, I don't think anyone at the SEC would be wise to give the green light.
You note that these are securities that the street can buy but can't sell....who would do this? I would like that same question to be asked about Mortgage Servicing Rights, I/O residuals, and FAS 140. What FASB doesn't seem to understanding is that there is a vast difference between theoretical value (i.e., MSRs and ESOs) and "realizeable" value. If a value is attributed but cannot be realized - whether it is a revenue or expense - it is more "mark-to-myth" than it is "mark-to-market". Unfortunately someone at FASB, in their pursuit of fair value measurement, has forgotten that in order to mark to market, you need a market. Another good example = deposits at banks. How is it that FASB will allow mark-to-myth for ESOs and MSRs, but not deposits? They want their cake and they want to eat it too.
Posted by Ted Dia | May 19, 2005 03:31pm
Mr. Fink,
I respect your right to post an opinion about the proposed option valuation mechanism, but you are misinformed about the new method and I believe that you are doing your readers a disservice on this issue.
Unfortunately the media, CFO.com included, has yet to correctly interpret the new market valuation mechanism. This is partly due to the lack of disclosure about the specifics of the mechanism. Further complicating things is that Cisco?s lack of credibility on the issue seems to have soured even the most objective observers on the proposal.
In fact, the mechanism has nothing to do with poorly performing securities. Performance is contingent upon the value that an investor pays for an asset. Is an employee stock option a poorly performing instrument? No. But it is worth far less than that estimated by Black-Scholes. The fact that you view the characteristics of employee stock options so negatively, such as the inability to sell the asset, is exactly the criticism of Black-Scholes and why the proposed valuation mechanism represents the first method that is capable of accurately valuing ESOs.
The fact is the newly proposed valuation securities are simply being equipped with similar value inhibiting characteristics as the employee stock option grants that the transactions are attempting to value.
Black-Scholes does a reasonably good job of valuing exchange-traded options, but the rigid formula ignores value inhibiting characteristics such as non-transferability, vesting and forfeitability endemic to ESOs. The beauty of the proposed solution is that it brings market forces to bear on the valuation exercise. Unlike formulas, markets are capable of capturing all the value characteristics of an asset.
In reference to your comments, it is not a lousy deal. It is an asset with value restrictive characteristics, just like the employee stock options. As to why anyone would buy such a security, why wouldn?t they? This is a viable security. Institutional investors spend their time evaluating securities, assessing risk and attempting to accurately value those securities. By selling these securities in a competitively executed transaction, such as a Dutch Auction, participants will determine what the securities are worth, which is why they will participate. They will bid what they believe the securities are worth, and if their bids are high enough they will receive an allocation.
Accurately valuing employee stock options is indeed likely to reduce compensation expense and increase reported earnings because there is a consensus that Black-Scholes vastly overstates the value of ESOs.
The net effect of the emergence of an accurate valuation mechanism will be a restoration of the ability to use employee stock options, but at efficient levels based on accurate prices. These concepts underpin a free market economy and should be embraced.
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