September 2005

Cisco's Options Play

The company's proposed method for accounting for employee stock options would affect all of Silicon Valley.

By Roger Lowenstein

If you were working in Silicon Valley in the 1990s, you probably have employee stock options to thank for your Porsche, your second home, and the gratitude of your spouse. If, more recently, you lost your job, you can thank stock options for that, too.

The long debate over whether companies should be forced to account for options is really a debate about what sort of high-tech industry one wants. Will honest bookkeeping tame the goblins of extreme greed that bring bubbles and busts? Or as the ardent champions of options have long maintained, will accounting for options so flatten entrepreneurial zeal as to snuff out serious investment in the Valley?

Cisco Systems' newly proposed plan for valuing its employee stock options has at least introduced a novel idea into a debate that has flared since the early 1990s. Corporate watchdogs have insisted that employee options represent a cost to the public companies that issue them -- and that the cost should be properly expensed in financial statements. Those on the other side -- who come mostly from the high-tech industry -- have argued that the obligation to account for options would discourage companies from granting them and thus diminish a primary method by which the industry attracts talented employees.

This dispute would seem unimportant, if only the stakes were not so high. According to Jack Ciesielski, publisher of The Analyst's Accounting Observer, by failing to book the costs of options, high-tech companies in the S&P 500 inflated their profits last year by 31 percent. The U.S. Securities and Exchange Commission recently ruled that companies must begin accounting for options in their first fiscal year after June 15, 2005.

That hasn't quelled the controversy. A bill before the U.S. Congress would reverse the SEC mandate, and William Donaldson, the SEC chairman who pushed for the expensing rule, resigned in June. His proposed replacement, Christopher Cox, a congressman from Newport Beach, CA, has been a fervent opponent of expensing. (Hearings to confirm Representative Cox are expected soon.)

What Cisco is proposing has the appearance of a compromise. To understand this, you need to think a little about how options work -- in particular, the options that companies such as Cisco grant to their executives and their ordinary employees.

From the point of view of the recipients, options are free. But as Alan Greenspan and Warren Buffett have observed, they aren't "free" in an economic sense. Like other forms of compensation, options bear a cost to the corporation. But what is that cost?

An option conveys the right to purchase a given number of shares at some specified price (called the strike price) within a specified time frame. If the stock rises above the strike price, the option's owner can exercise the option -- that is, purchase shares from the corporation -- at a price that is now below-market, and thus turn a profit. Frequently, to restrain dilution, the issuer will go into the marketplace and buy back shares -- paying, of course, the market price. In the 1990s, corporations such as Microsoft and Cisco spent hundreds of millions of dollars on such buybacks.

On the other hand, if the stock price does not rise, then the option will expire worthless. Since every future stock price represents a different potential outcome, the number of such potential outcomes is limitless. And since we can't know in advance what the stock will do, the value of the option at the time it's granted must take into account the full range of possibilities.

Academics have been devising formulas to value stock options for decades; the creators of the Black-Scholes formula, the first such attempt to be widely adopted, won a Nobel Prize. Under Black-Scholes, the value of an option varies with the price of the stock, its volatility, the duration of the option, the dividend rate, and interest rates. But a good rule of thumb is that a 10-year option to buy stock at $100 is worth about $30 or $40 today.