Democratic Underground  

Options, Options
July 30, 2002
By Joseph Arrieta

I am a walking labor market accident. When a technology is truly new and obviously being rushed to mass adoption there's always a very brief window when the tinkerers and the hobbyists, just by their stated ability to work with it, are seized upon by wretched HR types desperate to find anybody. Know html? Go.

Another reason I'm not super-sizing that order is the contracting racket. For all the righteous bitching I vehemently spewed over the years for being just a disposable cog in the corporate machine, contracting did give me a chance when no company would have dreamed of offering me a permanent slot.

Spare me the swelling violins. Until my last contract I was sure the whole fling was a dismal failure, a knife-edge existence of brutal learning in classically Dilbert environments. I'm sure a few of my bosses wouldn't have kind things to say about me either.

But then I got a contract working for one of the best humans I know in a dream company. My boss is so good I'd die of shame if I let her down. I freakishly fell into a corporate fit that's perfect for me. Seven years after graduating with a political science degree, a Ford Escort and an Apple IIe I was actually offered a job.

I got home and held that offer letter like a woman holding her first grandchild. At will, salary, benefits, bonus, sick and holiday pay - and options. Options? Me? Options are what those rich people in McMansions get. What those crooked CEO's abuse. What John McCain is on his latest righteousness jag about. How the hell did I end up with them?

Our Merino senators uttered nary a bleat when that felon Jeff Skilling says it's just too complicated to explain, but lack of or not sharing knowledge has never been my style. If you know the crux of the options controversy, by all means click on. John McCain is still wrong about Vietnam, but probably - probably - right this time.

Alright. Company A has been in business six years with an exciting product with 20% market share. They've demonstrated solid 35% growth every year in revenue, have negligible debt, experienced management and very clean books. Unfortunately they're up against global competitors, and without the necessary infrastructure investments to reach global markets they'll never go beyond 30% market share. They're too small and young for a bank to loan them the necessary cash, but they're determined to go global. How to get the money? Go public. Slice the ownership into tiny pieces'shares'and sell them for what the market will bear. In return for giving up ownership, the founders get a big chunk of cash. [1]

There are as many ways to set this up as there are people in the world, but generally the founders divvy up the shares so they keep a controlling interest. The rules for taking a company public dictate a board of directors, which is supposed to have oversight and authority of the officers of the company. Board members are often major shareholders. The founders often end up as officers of the public company, appointed by the Board and doing the same jobs they had before.

Investors buy these shares because they have faith. Faith that the company will make money, become more valuable and thus their shares increase in value. It used to be that almost all public companies paid a dividend: profit sharing (many still do). Investors would have faith that the company would make money every quarter and then give a portion of that profit back the owners, the shareholders. A dividend is usually stated at so many cents per share, say, 10 cents. If you owned 1,000 shares you'd get a dividend check for $100.

Now, when the Company A was made public lets say they split it up into 10,000 shares. There's nothing that says Company A has to sell all those shares right away, so they squirrel away 1,000. They sell 9,000 at $100 apiece and get to play with $900,000 that investors forked over on faith.

Joe Schmoe me comes along and the officers decide they want a hedge on their employment investment. If I stick around for 48 months they grant me an option to buy 100 shares at $10 with a portion they'd saved from the IPO. [2]  If the market price for those shares is magically $20 four years later, why, I'll take that option, thank you very much, purchase the shares for $10 and instantly turn around and sell them on the market for $20. 100 x 10 = $1,000 in my pocket. A retention bonus. Nice.

If Company A had paid me a retention bonus of $1,000 at 48 months with their cash on hand they'd have to expense it'state it as a cost that would ultimately subtract from their profit for that reporting period. The rules currently say granting options don't have to be expensed as a cost. Free money for Company A - $1,000 worth of hedge that doesn't subtract from their profit like paying for electricity does. Sweet.

The con in options occurs in two facets. Of course not counting the bonus as an expense is rank dishonesty. Money that had been spent on a perfectly legitimate reason (damn straight!) was not being reflected in the reported ability of the business to generate cash. Company A lies to itself and its shareholders by not expensing that retention bonus.

Potentially more egregious is the abuse of the market faith the options con initiates. Investors purchase shares in the faith that they're investing in the company, not solely compensation cash. In theory the cash put on the table by the investors should build the optimum cash machine, not compensation schemes so easily abused that ultimately give back a funny number in profitability.

Liars! Cheats! Crooks! "You have a point, you have a point," my accountant kept saying.  [3] He refused to definitively take a stand, all because of one of the most magical words in the American vocabulary: cash.

That $1,000 Company A paid me didn't come out of cash on hand. There have been so many cons in accounting that many investors only look at cash flow - how much comes in, what's left on hand when all is said and done. The market and investors magically supplied the cash for that $1,000 bonus, not the cash flow of Company A. A business is incorporated to create cash. Period.

If the rules are set up for a business to legally generate and protect cash then that's what it'll naturally do. My new employers aren't lying, cheating crooks. Ultimately, investors are responsible for endorsing such a system every time they back it up with their money. No one forces them to play.

A company can grant options in perfectly good faith that what they're doing is in the best interest of shareholders. A company can also abuse that faith and have their share price wiped out by betrayed, hurt investors. Anybody seen the NASDAQ lately?

Unfortunately there's still two more wrinkles to the story. The first is that although Company A didn't have to expense my bonus, they did get to deduct the option amount from their taxable income. Jesus, Mary and Joseph - is there any element to doing business the Republicans cannot turn into a cheesy tax break? Free money that gets you a deduction - I hear Walmart employees are getting that perk soon. Right.

The other outrage is the horrendous CEO compensation packages that pay out options. The con elements are still the same, but the huge numbers - tens of millions of dollars - 'is just an incredibly rank display of dishonesty, greed and abuse. We don't allow a system to rip off investors with false trades, and we shouldn't have a system that compensates people with the result of horribly skewed profit numbers. My Joe Schmoe chump change bonus won't harm much in reported profitability, but the $70 million Larry Ellison took home in options sure will. [4]

I am no longer surprised, revolted and outraged that Bush, Daschle and Hastert didn't include options expensing in the current reform bill. They, too, are just responding to a system where money rules, not democracy. What else can one expect?

My new 401k is 100% bond funds, and all of my modest cash is in a 36 month CD. The nice thing about following this issue is that after listening to all the bullshit about a reform bill with no options rules I can finally do something about it. My money walks.


[1] This is greatly simplified, and all the dollar amounts stated in integers of 10 for further simplicity. BACK

[2] Of course, if there are no shares, why, they can just print more. It's sorta like the US govt. printing money when it needs it; it doesn't solve much and eventually gives you a fresh problem. BACK

[3] Anyone who wants to question the bona fides of a liberal with an accountant, go right ahead. You try to figure out a 1099 contracting for Crisco Systems. I've been a defiant rebel all my life, but even I won't mess with the IRS. BACK

[4] Silicon Valley companies, desperate to hold onto employees, have really abused the options con. No one really knows, but it's been estimated that forcing the Valley to expense option would reduce profits 5-15% across the board. BACK

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