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The traders who help set prices on option exchanges are, of course, pragmatic, profit-motivated creatures who respond to supply and demand. But usually they also bear in mind the valuations that Black-Scholes would predict. And though option valuation formulas have at times failed spectacularly, they are good approximations for how most options trade most of the time.

However, Silicon Valley executives say the formulas overstate the value of employee options. Interestingly, dozens of corporations, most of them outside tech (Microsoft is a big exception), have started to expense options voluntarily, and none of them seems to have a problem with using a standard formula.

But the bean counters in Silicon Valley have a point. Black-Scholes was developed for plain vanilla options that trade on exchanges. Employee options cannot be bought or sold, and under certain conditions (if the employee quits or is fired, for instance) they are cancelable. Therefore, it is reasonable to suppose that such options are worth less than vanilla. But how much less?

Cisco’s solution would delight Adam Smith. Instead of using a formula to derive a value, the company plans to issue new derivatives, similar to the options granted to its employees, and to sell these derivatives to willing buyers. The price that the buyers pay would represent the true “cost” of the employee options.

Morgan Stanley, Cisco’s investment banker, has been peddling the plan to scores of other companies in the Valley and elsewhere, so it’s likely that Cisco will not be alone. But first, it will have to get a green light from the SEC, which has been studying the proposal since late spring, and whose decision is being eagerly awaited in the Valley.

At least in theory, the SEC is amenable to a free-market approach, and so is the Financial Accounting Standards Board (FASB), a private-sector body that sets the accounting rules that the SEC enforces. A FASB bulletin on options notes, “observable market prices…in active markets are the best evidence of fair value and, if available, should be used as the basis for measurement.” The key phrases are in active markets and if available: no “active market” for employee-like stock options has ever existed. But the idea of creating one had occurred to Buffett, who sits on the board of Coca-Cola, which has expensed options since 2003. As Buffett told me, “That was our original idea at Coke. It’s the most rational approach, as long as it isn’t gamed.”

Coca-Cola went with Black-Scholes, perhaps because the stakes were not so large. But the stakes at Cisco are very large. Last year, Cisco granted 195 million options, far more than any other single corporation in the S&P 500 (Coke granted 31 million). Also, according to Ciesielski, Cisco’s unwillingness to expense inflated its earnings 38 percent last year. By contrast, options reduced Coke’s earnings by only 5 percent.

The difference reflects the chasm that has separated mainstream America from Silicon Valley ever since the late 1960s, when a group of underpaid engineering whizzes broke away from Fairchild Semiconductor. Their disenchantment stemmed, in part, from Fairchild’s resistance to the idea of granting employees stock options; in the company they created, Intel, options would become as much a part of employee culture as the union shop steward is at General Motors. Even today, high-tech companies, which need a means of luring and retaining ambitious employees, rely on options much more than other sorts of companies.

In the 1990s, the theory that options drove corporate returns gained wide currency and – coupled with the realization of what they could do for CEO pocketbooks – led to a boom in option grants. FASB proposed a rule that options should be expensed, but VIPs in the Valley, led by venture capitalist John Doerr, kicked up a furious protest. In 1994, Arthur Levitt, then chairman of the SEC, bowed to political pressure and urged FASB to back down. He would later call that decision his worst mistake.

Levitt’s surrender has been portrayed by people on both sides of the debate as the defining moment of the Roaring ’90s. In the view of critics such as Joseph Stiglitz (and me), indulging the fiction that options were “free” led to grossly excessive grants. This distorted proper incentives, leading to mismanagement and scandal. On the other hand, many executives have argued that without the ability to recruit top talent that options engendered, the high-tech boom might never have occurred. In this view, presumably, the bust was a small price to pay – even though it deflated the Nasdaq by close to 80 percent.

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