Home' Technology Review : September 2005 Contents 78
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 mil-
lion). Also, according to Ciesielski, Cisco's unwillingness to ex-
pense in ated its earnings 38 percent last year. By contrast,
options reduced Coke's earnings by only 5 percent.
The di erence re ects the chasm that has separated main-
stream 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 em-
ployees 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 to-
day, 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 re-
tur ns gained wide currency and---coupled with the realiza-
tion 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 pres-
sure and urged FASB to back down. He would later call that deci-
sion his worst mistake.
Levitt's surrender has been portrayed by people on both sides
of the debate as the de ning moment of the Roaring '90s. In the
view of critics such as Joseph Stiglitz (and me), indulging the c-
tion 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, pre-
sumably, the bust was a small price to pay---even though it de-
ated 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 advo-
cate. 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 mil-
lion shares, 1.8 million, 1.4 million, and 2.5 million. No one can
say for sure whether the potential lucre that such options repre-
sented 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 in-
crement of stock price appreciation, that during the late 1990s
Cisco placed huge equipment orders, and that in 2001 it was
forced to write o $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 valua-
tion formula that seemed absurdly lax. As FASB noted, "the pro-
posed method can be easily designed to produce a value of zero."
This is when Cisco turned to Morgan Stanley to design an op-
tion look-alike to sell to investors. What has Morgan wrought?
The instr ument is a "war rant" 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
ter ms 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 auc-
tion, 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 poten-
tial 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 war-
rants.) Scholes says the new instrument would likely produce an
arti cially low value. This would ful ll the apparent aim of
Cisco's executives, since the lower the assessed cost of the stock
options it grants, the smaller the e ect 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 trans-
ferability" 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 chair-
man 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 nancial 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.
Given how much
the Valley has at
stake in the way
accounted for, we
should at least be
the left coast.
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