Cisco's Options Play

If you were working in Silicon Valley in the 1990s, you probably have employee stock options to thank for your Porsche, your second home, and the gratitude of your spouse. If, more recently, you lost your job, you can thank stock options for that, too.

The long debate over whether companies should be forced to account for options is really a debate about what sort of high-tech industry one wants. Will honest bookkeeping tame the goblins of extreme greed that bring bubbles and busts? Or as the ardent champions of options have long maintained, will accounting for options so flatten entrepreneurial zeal as to snuff out serious investment in the Valley?

Cisco Systems’ newly proposed plan for valuing its employee stock options has at least introduced a novel idea into a debate that has flared since the early 1990s. Corporate watchdogs have insisted that employee options represent a cost to the public companies that issue them – and that the cost should be properly expensed in financial statements. Those on the other side – who come mostly from the high-tech industry – have argued that the obligation to account for options would discourage companies from granting them and thus diminish a primary method by which the industry attracts talented employees.

This dispute would seem unimportant, if only the stakes were not so high. According to Jack Ciesielski, publisher of The Analyst’s Accounting Observer, by failing to book the costs of options, high-tech companies in the S&P 500 inflated their profits last year by 31 percent. The U.S. Securities and Exchange Commission recently ruled that companies must begin accounting for options in their first fiscal year after June 15, 2005.

That hasn’t quelled the controversy. A bill before the U.S. Congress would reverse the SEC mandate, and William Donaldson, the SEC chairman who pushed for the expensing rule, resigned in June. His proposed replacement, Christopher Cox, a congressman from Newport Beach, CA, has been a fervent opponent of expensing. (Hearings to confirm Representative Cox are expected soon.)

What Cisco is proposing has the appearance of a compromise. To understand this, you need to think a little about how options work – in particular, the options that companies such as Cisco grant to their executives and their ordinary employees.

From the point of view of the recipients, options are free. But as Alan Greenspan and Warren Buffett have observed, they aren’t “free” in an economic sense. Like other forms of compensation, options bear a cost to the corporation. But what is that cost?

An option conveys the right to purchase a given number of shares at some specified price (called the strike price) within a specified time frame. If the stock rises above the strike price, the option’s owner can exercise the option – that is, purchase shares from the corporation – at a price that is now below-market, and thus turn a profit. Frequently, to restrain dilution, the issuer will go into the marketplace and buy back shares – paying, of course, the market price. In the 1990s, corporations such as Microsoft and Cisco spent hundreds of millions of dollars on such buybacks.

On the other hand, if the stock price does not rise, then the option will expire worthless. Since every future stock price represents a different potential outcome, the number of such potential outcomes is limitless. And since we can’t know in advance what the stock will do, the value of the option at the time it’s granted must take into account the full range of possibilities.

Academics have been devising formulas to value stock options for decades; the creators of the Black-Scholes formula, the first such attempt to be widely adopted, won a Nobel Prize. Under Black-Scholes, the value of an option varies with the price of the stock, its volatility, the duration of the option, the dividend rate, and interest rates. But a good rule of thumb is that a 10-year option to buy stock at $100 is worth about $30 or $40 today.

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.

Given how much the Valley has at stake, we should at least be circumspect about accounting “compromises” emanating from the left coast. Cisco, in particular, has been a self-interested advocate. In the 1990s, John Chambers, the company’s CEO, lobbied vociferously against expensing. And no one at Cisco stood to lose more from it. During the last four years of the boom (1996 to 1999), Chambers received option grants of, successively, 1.6 million shares, 1.8 million, 1.4 million, and 2.5 million. No one can say for sure whether the potential lucre that such options represented was a factor in Cisco’s decision to try to grow so rapidly – too rapidly, as it turned out. All we know is that the options existed, that Cisco’s managers stood to make millions on each increment of stock price appreciation, that during the late 1990s Cisco placed huge equipment orders, and that in 2001 it was forced to write off $2.25 billion worth of that equipment. Its stock collapsed, too – from $80 in 2000 to $8 in 2002.

However, it is also possible to see Cisco as an options success story. Even its post-bubble low of $8 a share was 100 times the going-public price of 1990. By any fair reckoning, the net result of the boom and bust of the tech industry was also strongly positive.

Chambers has not lost his ardor for options. In both 2002 and 2003, he received an enormous new grant of four million shares. Then, in 2004, when it became clear that expensing was coming, Cisco, along with Qualcomm and Genentech, proposed a valuation formula that seemed absurdly lax. As FASB noted, “the proposed method can be easily designed to produce a value of zero.”

This is when Cisco turned to Morgan Stanley to design an option look-alike to sell to investors. What has Morgan wrought?

The instrument is a “warrant” that would be sold to investors. Suppose that in June 2006 Cisco granted a new batch of employee options. It would also sell to investors warrants that had the same terms as the options – including that they be nontradable.

In theory, the holders of the warrants would get the same return as the employees. So whatever investors bid for the warrants would determine the value of the options.

Cisco intends to sell the warrants in an auction, but the auction would probably be open only to a dozen or so institutional bidders, which Cisco (or perhaps Morgan Stanley) would preselect. This has raised concerns. Since when did limiting the number of potential bidders lead to the most accurate price?

What’s more, the fact that the warrants could not be traded will presumably greatly limit the demand for them. “You are talking about a very idiosyncratic contract,” notes Myron Scholes, one of Black-Scholes’s Nobel laureate creators. “The Cisco management team must know a lot more about HR [human resources] at Cisco than the outside investors. Due to that, [investors] would probably insist on a large discount.” (Knowing, for instance, whether an executive who had been granted a lot of options was planning to leave the company before being able to exercise those options would matter; if her options expired worthless, so too would a proportionate amount of warrants.) Scholes says the new instrument would likely produce an artificially low value. This would fulfill the apparent aim of Cisco’s executives, since the lower the assessed cost of the stock options it grants, the smaller the effect on its reported earnings.

That the SEC has similar concerns became evident in June, when Chester Spatt, the agency’s chief economist, worried aloud in a speech at Carnegie Mellon University that “barriers to transferability” might unduly depress the estimated values of stock options. Corporations have disputed this, noting that employee options cannot be traded either. The SEC has yet to decide, and the hope of high-tech executives is that the incoming SEC chairman will be faithful to his constituency.

Investors should hope, more neutrally, that the SEC sticks to the decision to require expensing and then quickly embraces some market instrument that attaches to options a reasonable cost. That will result in some expense on Cisco’s books, one that a free market has validated, and in some penalty against its earnings the next time it decides to award its CEO four million options. Ultimately, the existence of a financial deterrent is more important than its precise amount. And the option issue needs to be put to rest.

Roger Lowenstein contributes to the New York Times and other publications. His most recent book is Origins of the Crash.