After my Med Scape AMT debacle, I wrote an article about it.

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

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.

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