To all the pundits looking for scapegoats amid the Enron fallout: Do right by our economy and back off employee stock options. Lawmakers such as Senators Carl Levin (D-Mich.) and John McCain (R-Ariz.), who support the mandatory expensing of these employee options, should look closely at the unintended consequences of such a proposal, including the extinction of a key driver of economic growth.
Stock options are critical in fostering innovation and entrepreneurship, rewarding employees for strong performance at all levels of all organizations. The mandatory expensing of these options would make them too expensive to issue for most organizations, turning them into an entitlement for only the corporate elite. This path does not represent a direction in which anyone wants to go.
When a new company is formed, attracting the brightest talent to grow the organization is paramount. Employee stock options have served young companies well as their use allows startups to affordably compete for talent by offering a larger reward for the risk taken. By requiring that options be expensed, we are tying the hands of entrepreneurs, since the consequential hit to earnings could negatively affect a company’s attractiveness to investors.
The use of employee stock options is not limited to startups. Large, publicly traded organizations have recognized the value of employee ownership during the last decade. More than 10 million employees received stock options in 2001, according to the National Center for Employee Ownership (NCEO). Further, stock options are not limited to the executive office but are offered to the rank-and-file employees, motivated by financial independence through employee ownership. The NCEO also found that the average broad-based option plan makes the following categories of employees eligible: 90% of middle management, 82% of salaried technical workers, 79% of salaried non-technical workers, 82% of sales personnel, and 48% of hourly workers. Additionally, the NCEO study supported the premise that employee stock options improve corporate productivity and return on assets.
If employee stock options are so successfully utilized in our country, then why all the fuss? It appears that well-intentioned individuals believe that expensing employee stock options will paint a more accurate fiscal picture for investors. Unfortunately, just the opposite is true.
There is currently no means to value employee stock options. Even the Nobel Prize-winning option-pricing model developed by Black and Scholes deals only with freely tradable options, not employee stock options. Therefore, to value employee options with Black Scholes, one would have to make many assumptions regarding market and organizational conditions at the time of exercise, assuming the options ever get exercised. Under proposed legislation, accountants and investors will need crystal balls.
The current approach for employee stock option accounting works. The Financial Accounting Standards Board (FASB) successfully issued its current disclosure policy in 1995, after various proposals were subjected to vigorous debate and rejected. The current rule permits, but does not require, stock options to be expensed. If the non-expensing approach is selected, extensive disclosure relating to the options must be made in the footnotes to the financial statements. This disclosure-based approach was widely hailed by shareholder advocates and investor groups. It is a time-tested standard that should be maintained.
The noise being made about employee stock options is Enron-creep at its worst. Proposals such as the Levin-McCain bill would undermine the best incentive this country (or any other) has found for promoting entrepreneurship and performance. If you truly want to place a value on employee stock options, look at what they have done to make the U.S. economy the strongest in the world. Don’t trigger their extinction by assigning them an arbitrary number for the sake of capturing their existence on a different page of the financial statement. American workers deserve better. t
Craig A.T. Jones is president of Ticonderoga Capital and is managing partner of the general partner of Ticonderoga’s funds. He co-founded the Wellesley, Mass.-based firm, which was formerly known as Dillon Read Venture Capital, in 1997. He has spent 19 years in the private equity business at such firms as Advent International and Centennial Ventures. He is a member of the National Venture Capital Association and is chairman of its membership committee.