Insiders calls the tune

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Treating the value of share options as a cost makes a dramatic difference to the reported profits of many technology companies. And it points to a broader issue. In the knowledge economy, the distinction between employee remuneration and shareholder return is fundamentally changed

What was the issue that prompted America’s bosses to take to the streets, man picket lines, and even hire a band to drown the speeches of their opponents? Was it the threat from North Korea? The abuse of power in the Oval office? The failure to build enough plant to supply the electricity needed for Silicon Valley servers and Paolo Alto swimming pools?

The menace to American capitalism that provoked such outrage was none of these things. It was the possibility that the Financial Accounting Standards Board might require that the cost of share options to employees and executives be recorded in the profit and loss account of companies. With the aid of the band, the threat was beaten off and the party went on. Sir David Tweedie is now pursuing the issue through the new International Accounting Standards Board. Tweedie is a tough man but this is the most difficult issue he has taken on.

And yet the issue is essentially simple. Warren Buffett famously got to the heart of the matter: employee share options are remuneration, remuneration is an expense, and expenses reduce profits. What do they say in response? That diluting the equity of a business is a cost to the shareholders, not to the company. And that reporting the true cost of options would make it harder for new companies to raise money. With no better arguments than these, you can see why they needed the band.

The only question is what the charge should be. The IASB proposal would be based on the fair value of options under the Black-Scholes formula. This mathematics is not simple – Scholes won the Nobel Prize for working it out. But you can buy programs to calculate Black-Scholes values. Since banks use these programs, the values that emerge are a good indication of what it would cost companies to ask someone to take over their liabilities for stock options.

The effects of making proper allowance for option values is huge. Andrew Smithers has kept a careful eye on this for the largest US corporations. He computed Black-Scholes values. But he also noted that very few companies actually did immunise their liabilities in this way. If they haven’t, and their share price goes up, they need to make still further provision against the future cost of options.

Smithers found that in the heady days of the US bull market, these adjustments halved the profits of an average US company. For many high technology companies, it eliminated them altogether. Once again, the detail is complex but the essence is simple. The amounts which companies were promising to their employees, year by year, were greater than the net revenues from their operations. Do you really want to say that a company in that position is making a profit? Warren Buffett knows the answer to that, so does Sir David Tweedie, and so do you and I

And yet there is something not quite right about this analysis. In the heady days of the bull market, no-one thought of their options in terms of Black-Scholes valuations. The point of options was the expectation that share prices would go up. And year after year, they did. That was why shareholders were not worried about abstruse techniques of option measurement. Who cared about fundamentals when everyone was making so much money?

The real crunch comes when share prices go down. At first sight, options should provide some consolation for depressed shareholders. Companies can reduce – even write back – their provisions against future liabilities.

But then the blunt truth – that share options were always employee remuneration – finally dawns. In a bull market, people are happy to be paid in options close to the current market price. In a bear market, they still need to be paid. At best, you can reprice your options. At worst you will need to pay employees the old-fashioned way, through their salary cheques.

We really do live in a knowledge economy, and that means that the boundaries between the capabilities of employees and the assets of the business are hard to draw. It is common enough to hear companies say that one is the other. If that assertion is even partly true, the boundaries between employee remuneration and shareholder return are hard to draw too.

In the old days, shareholders owned the equipment and workers operated it: shareholders received dividends on their capital and employees were paid for their labour. Today, dividends are old hat and shares and share options are an important element of pay. The key distinction is no longer the distinction between capital and labour, but between insiders and outsiders.

Insiders acquire a share of the company’s revenue through their involvement in the business: outsiders acquire a share of the company’s revenue by buying it in the market place (generally from insiders). The value of the business to outsiders is equal to the amount of cash generated by operations which can be transferred, now or in the future, from insiders to outsiders. If insiders own a substantial proportion of the stock, and options are being issued at a rate faster than the company’s ability to generate cash to buy back its own shares, the date at which such a transfer is even theoretically possible may be far in the future – if it exists at all. That is why the insiders needed to disrupt the debate. The band played on….. but if Sir David gets his way, the last waltz is approaching.

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