Stock Options Should Not be Expensed

One proposal on Intel's 2003 Annual Stockholders' Meeting (held in May) was to request the company to begin expensing stock options. This proposal was defeated, but not by a robust margin.

The supporting statement for that proposal quoted Alan Greenspan as saying The failure to expense stock option grants has introduced a significant distortion in reported earnings and also quoted an op-ed in the New York Times on July 24, 2003 by Warren Buffett :

Options are a huge cost for many corporations and a huge benefit to executives. No wonder, then, that they have fought ferociously to avoid making a charge against their earnings. Without blushing, almost all CEOs have told their shareholders that options are cost-free...

When a company gives something of value to its employees in return for their services, it is clearly a compensation expense. And if expenses don't belong in the earnings statement, where in the world do they belong?

With all respect due to Messrs. Greenspan and Buffett, stock options are not an expense because their cost is borne by the stockholders, not by the company. The company and its owners are separate entities, and this fact must be kept firmly in mind. The response to the proposal by Intel's board of directors is explicit about how stock options work:

The economic cost of a stock option grant is borne by the stockholders through the potential dilution of their ownership interest. There is no outflow of corporate assets (such as cash) that results from a stock option grant. In fact, there is an inflow of cash, because the employee must pay the option exercise price to [the company]. The value of stock to employees is value that is transferred from the existing stockholders to the employee, and this value transfer is already transparently reported to investors in our diluted earnings per share calculation and other quantitative and qualitative disclosures included in [the company]'s financial reports.

Specific scenarios help to clarify the issue.

Imagine a company with 1 employee who is 100% owner, holding 1000 shares. (However, this company is not a sole proprietorship, viz., the company and its owner are understood to be separate legal entities.) Let us assume the company grants this employee 50 stock options at an option price of $7. After some time passes the employee exercises these options. What happens to the company and the employee?

1. The employee pays $7 × 50 = $350 cash to exercise the options.
2. The company acquires the $350 cash.
3. There are now 1000 (original) + 50 (new) = 1050 shares of the company.
4. The employee holds all 1050 shares of the company.

The net result of exercising these options is to move $350 from the employee into the company. The employee remains 100% owner. This case is deliberately simple, but there is clearly no expense to the company involved. (I have omitted any mention of what happens if the employee sells the stock, because it has no impact on the financial state of the company.)

Imagine a company with 2 employees (Alice and Bob) and 1000 shares, all initially owned by Alice. Let us assume the company grants Bob 50 stock options at an option price of $7. What happens to the company and both employees when these options are exercised?

1. Bob pays $7 × 50 = $350 cash to exercise the options.
2. The company acquires the $350 cash.
3. There are now 1000 (original) + 50 (new) = 1050 shares of the company.
4. Alice holds 1000 shares (95%) and Bob holds 50 shares (5%).

The net result of exercising these options is to move $350 from Bob into the company and for 5% ownership to transfer from Alice to Bob. There is an expense involved in this case, but the expense is Alice's, not the company's. (Remember that Alice owns the company, the company doesn't own itself.) Indeed the company has acquired $350, its assets have risen. How can stock options be an expense to the company when their exercise causes its assets to rise, not fall?

(Just as the increase in company assets does not represent an expense, it also does not represent a profit. It has nothing to do with the sales or costs of the business, it is simply a cash infusion from an owner.)

What happens if the company issues stock options below the market price? If they were issued at a price of $0 — essentially giving them to the employee — the only effect upon their exercise would be the dilution of existing shares. The ownership pie would be divided into more and smaller pieces, but there is no impact to the company's assets or liabilities or ability to conduct business.

I must state clearly that I believe stock options are a form of compensation. However, it does not follow merely from that fact that they ought to be expensed. Only compensation paid by the company should be expensed by the company.

Stock options that cause dilution are paid for by existing stockholders, not by the company. Stock dilution is analogous to monetary inflation: A growing quantity of money transfers purchasing power to those who first spend the new money, paid for by a falling purchasing power of money. Stock dilution transfers ownership to those who acquire the new shares, but causes the overall value of each share to fall.

Stockholders experience the cost of dilution through lower stock prices and decreased voting influence as the number of shares increase. The cost is real and is reflected in the stock price. To demand stock option expensing in addition is to demand this compensation be double-counted.

UPDATE 2003-10-02 05:51:22 UTC: Fixed a typo, added the below.

If stock options are awarded by the company, but are an expense to the owners, doesn't this mean that companies are in a position to give away other peoples' money? Yes, it does. There's nothing inherently sinister in this, because stockholders have the power to modify a company's options policy — for example, by setting limits on the number of options that can be awarded — or upset stockholders could sell their holdings and invest elsewhere.

UPDATE 2003-11-10 23:19:51 UTC: Added link to further discussion.

Also see this related blog article where I relate this argument to the idea of opportunity cost.