Stock Options

After my MedScape AMT debacle, I wrote an [article](http://webseitz.fluxent.com/articles/Stock OptionsAMT.html) about it.

Note: I Am Not An Investment Banker - everything you read here could be wrong - send me email with corrections!

Jan'2016: Grellas writes: *

  • A brief observation: when stock options first became widely useful in the startup world in the 1980s, ISOs conferred a huge benefit to employees because you could be assured that you could exercise them when they vested without any practical tax risk whatever. Over the years, however, AMT, though first enacted in the 1960s as a "millionaire's tax" to ensure that the wealthy could not easily manipulate tax deductions to avoid paying any tax whatever, evolved into a general catch-all tax that is now used to fill serious deficiencies in the U.S. tax code and that now ensnares many people making pretty average incomes. Once that happened, it effectively killed many of the once-very-special tax advantages of ISOs for employees and turned ISOs into a form of equity compensation that is only slightly more favorable for employees and is often a real disadvantage (for example, the notorious 90-day tail for exercising vested options on termination of employment derives directly from tax-code rules imposed as special restrictions on ISOs alone but today functions to entrap many employees into having to stay in undesirable employment situations far beyond what they intended on pain of losing their vested options altogether if they quit).
  • A final theoretical observation on best types of grants in order of preference: first, unrestricted grants (here, you own it all and can't theoretically ever lose it and you usually have zero tax risk while trying to hold for long-term capital gains); second, restricted stock at a cheap price with a timely 83(b) election (while it vests, and you can forfeit it, the tax picture is near-ideal in giving you a path to long-term capital gains tax treatment with no landmines along the way); third, ISOs with a low strike price and an early exercise privilege (with these, you exercise early, file an 83(b) election, and in effect get the equivalent of a restricted stock grant); fourth, ISOs or NQOs without a 90-day tail on termination (these give you maximum flexibility to trying to work around or at least postpone potentially detrimental tax events while being able to wait as long as 10 years before being at risk of losing vested options); fifth, and worst of all from a tax standpoint, RSUs (which really are a super-high-value startup's way of granting very nice bonuses to employees in situations where the very high price of its stock makes it tax-prohibitive to use any other more favorable equity compensation vehicle). Of course, this is theoretical only and you get what you get in the real world depending on whether you are a founder, an early-stage employee, or a later-stage employee and depending as well on what is negotiated with investors concerning any restrictions they may insist upon as conditions to their investments.

A more current controversy involves the treatment of Stock Options by companies in their financial reporting. When options are issued, should they be expensed?

Note that we're generally talking about expensing the difference between the option exercise price and the value of the underlying shares.

  • So, if you have a public company, you typically issue options with an exercise price matching the current public stock value, and the future value of that option to the employee is only the difference between the value of the stock and the exercise price (e.g. today the stock is worth $20/share, company issues options with exercise price of $20/share; in a year if stock is worth $25/share then each option has a net value of $5 at that time, vs if the stock is only worth $19/share then each option is worth $0.

It's a huge mistake for everyone to keep treating all options the same.

  1. I think the options that get expensed are usually the Non-Qualified programs at public companies. Their stock is liquid and has a public value; a reasonable estimate of option value can be made.

  2. Companies that are within a year of (planned) public offering often already have bankers trying to make "reasonable" estimates of the ultimate public price, so that any new (Qualified) options issued are set at a reasonable price (because I think the SEC gets pissed when options are issued at a $0.01 exercise price when a year later they become worth $10). You could take those estimates and pretend to assign a cash value to them, though it would be rather make-believe (e.g. not very predictive - if you took actual values a year later there would be a giant variance).

  3. Any company at an earlier stage than that has a completely make-believe valuation.

A meta-rule is that financial statements should be verifiable/provable:

  • Note that Sarbanes Oxley rules put execs at risk of going to jail for bogus financial statements.

  • Note that lots of shareholder suits involve dubious calculations of asset values, recognition of revenue, etc.

  • Note that we don't attempt to assign values, and book changes in value to, brand value, reputation, employee satisfaction, etc.

So, given these different categories of companies, what's the real problem we're trying to solve?

I think the biggest one is where a company is newly-public, and maybe even has a little bit of earnings. But the number of outstanding options, if all exercised, would significantly increase the number of liquid shares, thus reducing the net earnings per share. So this puts us basically with case #2.

Or is all this really just window dressing to appease people who bought stock in WebVan? Because they deserved to lose everything.


Edited: |

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