Home' Technology Review : September 2005 Contents 76
I 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 de-
bate about what sort of high-tech industry one wants. Will hon-
est 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 atten entrepre-
neurial zeal as to snu 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 ared since the early 1990s. Corporate watchdogs have
insisted that employee options represent a cost to the public com-
panies that issue them---and that the cost should be properly ex-
pensed in nancial 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 Ana-
lyst's Accounting Obser ver, by failing to book the costs of options,
high-tech companies in the S&P 500 in ated their pro ts last
year by 31 percent. The U.S. Securities and Exchange Commis-
sion recently ruled that companies must begin accounting for op-
tions in their rst scal year after June 15, 2005. That hasn't
quelled the controversy. A bill before the U.S. Congress would re-
verse the SEC mandate, and William Donaldson, the SEC chair-
man who pushed for the expensing rule, resigned in June. His
proposed replacement, Christopher Cox, a congressman from
Newport Beach, CA, has been a fer vent opponent of expensing.
(Hearings to con rm 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 Bu ett have obser ved, 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 speci ed price (called the strike price) within a
speci ed 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 pro t. 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 op-
tion will expire worthless. Since every future stock price repre-
sents a di erent 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 for mula, the rst
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 r ule of thumb is that a 10-year op-
tion 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, pro t-motivated creatures who respond to
supply and demand. But usually they also bear in mind the valua-
tions that Black-Scholes would predict. And though option valua-
tion 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 for mulas overstate
the value of employee options. Interestingly, dozens of corpora-
Cisco's Options Play
The company's proposed method for accounting for
employee stock options would a ect all of Silicon Valley.
BY ROGER LOWENSTEIN
Our reviews use any artifact---a book, a product, a government report,
a movie, a research paper---as the occasion for a contemplative essay
on some technological controversy.
79 GPS phones
81 New book about Google by John Battelle
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