Case for discussion Value of stock options. (The text does not give an explicit answer to this question but provides a sufficient basis to enable students to discuss the question.) Below is an excerpt from an article from the San Francisco Examiner, a leading Silicon Valley newspaper, which appeared at the height of the controversy over the accounting for employee stock options. For example, if StartUp Inc. recruits the brilliant software designer Joe Bithead ….. by offering him the option to buy 10,000 shares of StartUp’s stock at its current price of a penny a share, what’s the value of Joe’s grant? If StartUp goes belly up, as 80% of new high-tech firms do, the grant is worthless... If, on the other hand, after live years of struggle, StartUp manages to create a successful product and Out-performs its competitors, the company’s stock might sell for $10 a share on the public market. For a penny each, Joe can buy the 10,000 shares.... . He unloads them in the market for a $100,000 profit.
The accounting question is, What cost, if any, does StartUp incur on Day 1 of the grant to Joe Bithead of an option to acquire 10,000 shares five years hence for $0.01 per share? StartUp shares trade in public stock markets on the date of grant at $0.01 per share. Because the word cost has so many meanings (see cost terminology in the Glossary. make the question operational and specific by considering the following.
Imagine that you are the financial executive of StartUp and that Goldman Sachs offers to relieve you of the obligation to deliver the shares to Joe Bithead. That is, Goldman will take a payment from you today and will deliver the shares to Bithead if he exercises the options but will do nothing otherwise, except keep your cash. How much are you willing to pay Goldman today to relieve you of your obligation to Bithead? That is you pay Goldman now and they later deliver shares to Bithead if he exercises his options.
No one can be sure of the exact answer, given the sketchy data, but which of the following ranges do you think most likely?
a. $0 to $l0.
b. $l0 to $100.
c. $l00 to $1,000.
d. $1.000 to $10,000.
e. $10,000 to $100,000.
f. Some other answer (indicate answer).
SOLUTION
(Case for discussion: value of stock options.)
The answer must be either a. or b. The cost per option cannot exceed one penny per share, for otherwise StartUp would merely buy the shares on the open market, rather than pay Goldman Sachs to relieve StartUp of the burden. The total cost of the options awarded to Bithead, then, cannot exceed $100 (= 10,000 shares X $.01 per share). We think the answer is likely to be in the range of $15–$40 for those shares, so we would answer b.
Within the last two decades, no subject has caused more controversy in accounting than the accounting for the cost of employee stock options. When it issued SFAS No. 119 in 1995, FASB said that this issue threatened to end standard setting in the private sector and that the debate had ceased to be rational.
Some firms, such as GE, grant to employees the right to buy a specified number of shares of the firm’s stock at a fixed price, called the exercise price, usually the price on the day the firm awards the options to the employee, say $10 per share. The employee, typically, has several years to decide whether to exercise the option—that is, give up the option and cash in return for the shares. If the stock price rises above the exercise price, say to $18 per share, then the employee can give up the option and $10 in return for a share with current market value of $18.
Such options have value to employees who receive them and many companies, particularly the high-tech Silicon Valley companies, award such options as part of their compensation in hopes that the employer’s shares will skyrocket in value, enriching the employee.
The accounting issue has been: how much should the employer firm, such as GE, charge to expense in the period when it awards an option to its employees. The FASB’s Exposure Draft outlines an approach for computing such amounts of expense and requiring that firms report such amounts as expense.
William H. Scott, Jr. of Scientific Applications International Corporation of San Diego, has studied the costs to the issuing firm. He found that under a wide variety of conditions, the cost to the firm issuing an option exercisable at the market price on the date of grant is, for most firms, about 10%–20% of the market value of the shares on the date of the grant. The cost to the firm of awarding the option can never exceed the market value of the share itself on the date of the award. This is true because the firm can always, on that day, go out into the market to buy a share for the current market price, building that share until the employee exercises the option.
At the height of the debate, chief financial officers (CFOs) from Silicon Valley lobbied against the FASB proposal. We believed that many of those CFOs did not understand the FASB proposal, nor its consequences. Consequently, at a private seminar on the subject at which one of us taught, we administered the question in the text to the Silicon Valley CFOs.
The Silicon Valley CFOs answered as follows: a. = 3, b. =3, c. = 6, d. = 8, e. = 5, and f. = 1. That is, only six of the 26 participating got the answer right, which means that 20 of the 26 got it wrong. In the discussion following, we pointed out that these officers should probably understand the cost of options better than they did before arguing so hard against the proposed accounting. It’s no wonder that a CFO would dislike the proposed accounting for options which the CFO thinks cost $10,000 when they actually cost no more than $100. About 25% of the Silicon Valley CFOs had beliefs that much in error.