A primer on stock options, why the tax code is much of the problem, and what Rush missed yesterday

Much has been written, and babbled, about executive stock options as the root cause of much of the recent financial shenanigans. Yet what is more remarkable is what isn't being said about them. Most congresscritters, tripping over themselves to get to a microphone, know not of what they speak. Even Larry Kudlow, on Rush's show yesterday, got several things wrong. And surprisingly, it may well be that the income tax code ( no real surprise here,) is a major cause of much of this financial manipulation. So, if you'd like to learn a little more, read on...

You just haven't thought about this issue sufficiently. Let me ask you, again, to address a specific question.

Three companies A, B & C have identical operations. Each generates $1 billion in revenue; each has non-salary expense of $400 million(IOW, they all have gross earnings of $600 million before salaries). Company A pays $550 million in salaries; Company B pays $50 million in salaries and grants options to buy 100 million shares at it's current price of $10 at any time in the next 2 years; Company C pays no salary but grants options to purchase 100 million shares at a price of $3 any time in the next 5 years. Is it your opinion that the best reflection of earnings is that A earned $50 million; B earned $550 million; and C earned $600 million? If so, our differences have nothing to do with my lack of understanding of options but rather your lack of understanding of what earnings purport to measure.

Options on 100 Million shares at $10 are worth about $0.00 if the price of the stock is $2.

If the price of the stock rises to $12, then those options are worth at least $200 Million.

If the price of the stock rises to $14, then those options are worth at least $400 Million.

Stock prices rise and fall every day. Some people will exercise their options at the right time. Other people will wait and the stock will drop down below $10 making their options worthless again (generally). Timing is everything. You won't know what those options cost the company until they are all exercised or expired.

In the history of investing, some 80% of all options expire worthlessly.

If you force a company to guess at what the options will be worth when they are exercised, then you will be forcing companies to engage in pretend accounting. That company's books will no longer reflect the actual cash on hand, but will reflect a guess of what its cash should be if option-holders behave a certain way and the stock price moves a certain way.

That's not accounting. That's fantasy-land. Alice is through the looking glass once corporations start making guesses as to how much cash they "should" have on hand under certain market conditions.

No, the better solution is to do what we are doing today: counting the actual revenue and the actual expenses paid, when those expenses are finally paid. At least this method tells us accurately where we are financially today.

Changing over to this new "expensing options" craze will destroy even that last tidbit of worthy justification for accounting. Might as well save your money by not doing any accounting as to force companies to write such guesses on future option-values into the books.

You keep on repeating the same silly mantra as if it meaningfully addresses the issue. It doesn't. You also refuse to answer the specific question I ask which might allow even you to see the lunacy of your position (even if the options get expensed at time of exercise which you (incorrectly) assert is done currently).

Addressing my example in post #78, you GUESS that the values of all options are zero at the time they are granted for purposes of computing earnings. You, therefore, come to the ludicrous conclusion that earnings of companies A, B, and C are $50 mil, $550 mil, and $600 mil, respectively. Based on reasonable option pricing (about $5 each for Company B and $8.50 each for Company C) the true earnings for A, B, and C are VERY different: $50 mil, $50 mil, and -$250 mil, respectively.

Lest anyone think this issue is minor, let me repeat: If Microsoft expensed its compensation stock options, it has been losing money for 7 years.

"you GUESS that the values of all options are zero at the time they are granted for purposes of computing earnings. You, therefore, come to the ludicrous conclusion that earnings of companies A, B, and C are $50 mil, $550 mil, and $600 mil, respectively. Based on reasonable option pricing (about $5 each for Company B and $8.50 each for Company C) the true earnings for A, B, and C are VERY different: $50 mil, $50 mil, and -$250 mil, respectively."

That's incorrect.

The information in your example left no way to calculate what the options were worth at the time that they were issued (much less when they finally get exercised).

To do that, you must have:
1. The price of the stock at the moment that the option is issued,
2. The "strike price" of the option, and
3. The length of time that the option is valid.

Combining all of the above with the historical volitility of the stock as well as the supply/demand for options contracts will permit you to know what the option is worth for that first moment that the option is issued.

After that first moment, the value of the option will begin to decline unless the price of the stock increases.

If the option is never exercised (e.g. it isn't "in the money"), then it will expire worthlessly.

The final value of the option will only be known when/if it is exercised or allowed to expire.

Knowing all of the above, a corrupt company that "expenses options" in advance, as you relentlessly champion, will wait until the day before their fiscal tax year end to issue options. Those options, which cost nothing to issue, will then be treated as if they were real expenses at the value computed by the formula that I list above. Those "expenses" will then be written off their accounting books and often written off of their taxes, too (i.e. they are printing their own tax deductions).

But since the corrupt company wasn't actually out any real initial expense to issue those options, the accounting books, which have now been written down, will show that the company has LESS cash on hand than it really has in possession.

Hmmm... I wonder how a crook would act if she saw that her firm had more actual cash on hand than what her accounting books showed...

Now later, as options either expire or are exercised, those companies that "expense options" are going to have to revise their books to reflect what the options finally cost.

Funny, but we're already doing that today.

That's how we already "expense options", at the tail end of the transaction.

And that's the same as how we will "expense options" if the corporate world is forced to make your change, except that in the meantime your change will have created a hidden cash bubble inside every large American company that will be ripe for explotation and embezzelment by any corrupt insider.

That's what you and Mr. Keating-Cheating-S&L-McCain are advocating whenever you cry out to change our accounting books to "expense options".

Figuring the value of options is indeed very simple. There are at least 60 acceptable price models. Categorizing the issue of out-of-the-money options as an expense is ludricrous, though. Why?

Take a company. On July 15th, it has no outstanding executive options. Its share price is $20. On July 16th, it issues EOs to the extent of 100,000 shares, exercisable at $40 within five years. Using a popular option model (modified B-S-M, if you care) and observing the 5-year volatility of the share price to be 30%, we compute the theoretical fair value of the options, which turns out to be $1.80/share.

Are you claiming that the company has, in one day, incurred an 'expense' of $180,000? At the moment, the company's expense is entirely the cost of entering the options onto their books, call it 1 man-hour.

This is every bit as silly a viewpoint as when the Clintonoids tried to tax homeowners on non-existent 'imputed rent'. How have earnings changed? They haven't, not by a penny. There are already far too many bookkeeping fictions floating around, let's not add one more.

N.B. Now, if the options issued were IN-the-money, that's an entirely different matter.

Inversely, if the options turn out to be worthless, it's like a successful short sale, but the tax benefits would still have been realized during the year that the options were issued. Issue enough stock this way, and the likelihood is greater that the options will end up being worthless.

Take a company. On July 15th, it has no outstanding executive options. Its share price is $20. On July 16th, it issues EOs to the extent of 100,000 shares, exercisable at $40 within five years.

This is not the way ISO's or NQSO's are granted or work.

There is no 'exercise price' written into the grant. The exercise price is whatever the stock trades at on the day the option is exercised, as per the vesting schedule and the holder's decision to exercise. Depending on the option type, the exercise price affects the companies tax position. Also, depending on option type, both the exercise price and the sale price (if and only if stock is also sold) affects the individuals tax position.

Other 'performance clauses' may exist in employment contracts that peg compensation to stock price, e.g. 'bonus of additional 1M shares when stock price exceeds $40 for a 1 year period'...but again that is not part of a stock option.

ISO's and NQSO's have a only grant price which must be within 85% of the FMV on the day the option is granted. The exercise price floats with the market but years into the future as per the vesting schedule. That's why they can't be reliably estimated.

If the future FMV of a stock could be reliably estimated for accounting purposes, we'd all get rich 'knowing' what the future price of any given stock would be. But it can't and we won't.

It is my experience that ISO's, Incentive Stock Options, are issued to the lower level employees and Non-Qualified Stock Options are issued to the senior people. Just the opposite of what you have indicated. As for expensing stock options, that is really just nonsense put forth by people who should know better. If an option is issued for $20 when the stock is selling for $20 (the usual case) nothing changes hands. If later the option is exercised at a market price of $50 the employee pays the company $20, the option price, and the company issues the stock. Beyond the $20, no money has changed hands, no asset has been decreased or liability increased, so there is absolutely no basis to deduct an expense on the books. Any such "expense" is a pure fiction. Shareholders' Equity remains unchanged. There is certainly "value" to the option but it is not something that the company has parted with because the books never reflected that "value".

Thanks for the clarification. I'd erroneously assumed that NQs were functionally identical to 'standard' securities options. One statement is puzzling, though.

The exercise price is whatever the stock trades at on the day the option is exercised, as per the vesting schedule and the holder's decision to exercise.

If this is so, how can a granted option ever be 'wnderwater'? Why would repricing ever be an issue, if the exercise price floats?

Also, if the exercise price (once the option has vested, of course) is indeed the market price on the day the holder exercises, the holder who intended to own the stock, as opposed to flipping it, would in fact be rooting for the share price to FALL while he held the option(s). A rather perverse incentive, wouldn't yuo say? Would you please clarify here, because something doesn't smell quite right.

If this is so, how can a granted option ever be 'wnderwater'? Why would repricing ever be an issue, if the exercise price floats?

We'll, I should have been more careful in my choice of terminology.

There are 3 prices involved:
- The grant price which is written into the option grant and is what the holder pays to the company to exercise the option and take possession of the shares.
- The exercise price, or the FMV of the shares on the day of exercise
- The sale price, if any shares are actually sold (either on the same day of exercise, or later.

The difference between the grant price and the FMV share price on the day of exercise ('exercise price') is what the holder is taxed on. This can go two ways:
1) When the exercise price is higher than the grant price (because over the years since granting, the stock has gone up) there is a gain which is taxed and the exercise price becomes the new basis (note ISO's and NQSO's are treated differently under the AMT)
2) When the exercise price is below the grant price. This is 'underwater' (because the stock has lost value since the option was granted) and the holder pays more to exercise and take possession of the shares than the shares are worth on the market....consequently there is a loss which is not taxed, but can be carried forward to offset future gains (if any). Because employees don't want to pay to hold something worth less value (they'd be betting it'll exceed the grant price in the future) and thus they might not stick around, then companies sometimes re-price the options, but usually with a new extended vesting period. Obviously, no one does a same day sale ('flip') on underwater options, though there are reasons to exercise and hold underwater options.

If a stock has lost a little or not gained a lot, then the tax liability upon exercise is none or small and if one believes the future for the stock is very good, then holding all the shares ('exercise and hold' or 'cashless exercise' because the employee receives no cash) and selling later might be wise. ISO shares must be held for 1 year following exercise. To exercise and hold the employee must come up with cash to pay the grant price. This can be done either out of pocket, or margin the exercised shares. Many people did this over the last few years. No one typically does it for options that are way under water (e.g. grant price $50, exercise price $5)

Hopefully the above clarified some of this. But no, when exercising and holding, the holder is wanting the stock price to rise further. Assuming of course the grant price was less than the exercise price, so the employee pays the grant price to the company and takes possession of the shares (holds) and also pays taxes on the gain (FMV on day of exercise - grant price). Money for the grant price and taxes came from elsewhere (2nd mortgage, savings, margin) and to recoup it requires the stock price rise appreciably for some future sale.

I think the point is that options are a benefit to the company in the form of savings on labor. This is more like a used line of credit, if the stock price rises and the options are exercised by the employees. Or look at it as an unsuccessful attempt at a short sale of stock, albeit with payroll and corporate tax benefits that could not be realized by the typical Wall Street trader out to make a quick buck by shorting stock.

Options are an unrealized liability, ergo they are like an unused line of credit. It is true that options are to the benefit of the company and employees, but they are also very often of benefit to the shareholders as they are a means of attracting necessar talent that otherwise might be too expensive to afford.

Also, unlike a line of credit where the liability is the face value (plus interest) of the amount borrowed, options are at par when at face value and have no value. Therefore, the liability of options are limited to anything above par value. Historically, it is the people holding options for a lengthy amount of time that reap the most benefit from them. Also the U.S. tax codes discourage options flipping.

Inversely, if the options turn out to be worthless, it's like a successful short sale, but the tax benefits would still have been realized during the year that the options were issued. Issue enough stock this way, and the likelihood is greater that the options will end up being worthless.

No, options are promissary notes which can be paid out in a number of ways. The stock already exists. Options do not create new stock. The company, when redeeming options, does so from existing stock.

I appreciate your efforts at explaining, but the explanation does not hold water, no offense intended.

This 'grant' price business is nonsense. If one owns an option, whether he bought it or a company granted it to him, then he can buy shares at a KNOWN price within some period of time if he wishes to do so. What you call the 'grant' price SEEMS (and your explanation is needlessly prolix) to be simply a striking price, i.e. the price of exercise on demand.

What you call the 'exercise price, the FMV of the shares on the day of exercise' is no such thing. If your 'grant' price is 30, and the shares rise to 50, you would have it that the 'exercise price' is 50. It is not, it is exactly 30.

I'm not concerned, not ever have been during this discussion, with tax consequences. Obviously, the IRS impute tax liability on the day and at the market price of the shares when the option is exercised, and clearly, as everyone on this thread (with any sense) has stated, when someone exercises a privately granted option, they're idiots if they don't at least sell as many shares as necessary to pay the tax bill, that day. What they do with the remaining shares is irrelevant to this discussion.

BTW, and merely for your convenience, and not waving a red flag at you, I bought my first membership on CBOE in April 1974, and have traded options there since. This notion of 'three prices' is bizarre, to say the least. A call option, ANY call option, any flavour, allows the owner to buy a specific amount of something at a specific price, on or before a specific date, subject to any conditions that may be specified by the grantor. If the grantor is a company, obviously they can include any restrictions they like, but, no matter the conditions, the definition of 'option' does not change. Perhaps, in support of your argument, these companies are actually granting something else, a non-recourse warrant, say, but if they are in fact granting options, then the definition of the instrument is inarguable.

If you disagree, fine, I've no quarrel, and I certainly hope you trade listed stock and futures options. If not, please distinguish SHARPLY between this mystical 'grant' price and the equally curious notion of 'exercise' price.

A fascinating thread, I've learned some things (not necessarily those you might think, btw).

FRegards!

You seem to have assumed an 'option' on the CBOE and an ISO or NQSO 'otpion' are the same. They are not. They have nothing in common, except for the underlyling common-class shares. Don't read into the name 'option' and assume public trading practices apply to ISO's and NQSO's. They don't.

False. The ISO or NQSO option is not owned. It can not be traded or assigned. It is only a right to exercise as per a future vesting schedule subject to additional T's & C's. You can not buy or sell shares (under the option) when you wish at any price. You can only buy those shares which have vested and only at the fixed grant price written into the 'option' agreement when the 'option' was granted to the employee (usually within 1-3 months after being hired).

False. The grant price is the price the employee must pay to exercise the option and own the vested shares ($30 in your example). This is the way ISO's and NQSO's work. This is not a CBOE option. The employee cares aout the FMV on the day of exercise because the spread bewteen the grant price and the exercise price determines the tax liability and withholding in the case of an NQSO. Yes! taxes are withheld immediately and concurrently with the exercise for the NQSO, or gain recognized for an ISO.

when someone exercises a privately granted option, they're idiots if they don't at least sell as many shares as necessary to pay the tax bill, that day.

You assume taxes are due. In the case of ISO's, they are not. In the case of underwater ISO's or NQSO's they are not. Only in the case NQSO's with a gain are taxes withheld, and whether one chooses to pay the taxes with cash or sell shares is a another analysis.

This notion of 'three prices' is bizarre, to say the least. A call option, ANY call option, any flavour, allows the owner to buy a specific amount of something at a specific price, on or before a specific date, subject to any conditions that may be specified by the grantor. If the grantor is a company, obviously they can include any restrictions they like, but, no matter the conditions, the definition of 'option' does not change. Perhaps, in support of your argument, these companies are actually granting something else, a non-recourse warrant, say, but if they are in fact granting options, then the definition of the instrument is inarguable.

Irrelevent to ISO and NQSO's. They are not traded on the CBOE and the are not public traded options. ISO's and NQSO's are entirely different.

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