A possible threat to stock options

Nation's Business, August, 1994 by Michael Barrier

Many small companies see their growth imperiled by a proposed change in accounting rules.

Cheryl Breetwor knows something about employee stock options. Not only does her 10-year-old Sunnyvale, Calif., company, ShareData, offer a stock-option plan to its 40 employees, it also produces software that other companies use to manage their own plans. ShareData's 1,300 customers range in size from "little start-ups," Breetwor says, to such corporate giants as AT&T and Microsoft.

"I think we have a very keen insight into how companies use stock options," she says, and she believes that in most cases, particularly at small, young firms, they're a tremendously effective tool for attracting talent, building employee loyalty, and aligning employees' interests with those of the shareholders.

That's the reason Breetwor is so strongly opposed to a proposed change in accounting rules that could make it much more expensive for small businesses like hers to offer stock options to their employees.

The rule change would require corporations to calculate a charge against earnings for employee stock options as soon as they are granted. (The charge might be spread over several years, if a vesting period was involved.)

Under current rules, so-called fixed stock options--which are granted at a fixed price and for a fixed term, to be exercised when the recipient chooses--are never charged against earnings. Instead, they are disclosed in footnotes to reports on company earnings; they also show up in calculations of how much stockholders' equity will be diluted if the options are exercised.

The rule change was proposed last year by the Financial Accounting Standards Board, a private, seven-member organization based in Norwalk, Conn., that draws up the rules for the accounting profession. These rules are designed to achieve a uniformity that permits meaningful comparisons, so that when someone is buying a company, for example, there is no question what the figures in a financial statement mean.

But FASB's reach extends well beyond the accounting profession: Ordinarily, for example, the Securities and Exchange Commission requires that corporate financial reports be written in accord with FASB's rules so that investors can be sure they are comparing apples with apples.

Only rarely, however, do FASB's operations draw much attention from anyone besides accountants. But the proposed stock-option rule is different: FASB has received 1,500 letters commenting on it since the rule was proposed. "About 900 of them are form letters," says FASB Chairman Dennis R. Beresford, "so they don't really give us much new information. But there have been about 600 substantive letters." FASB also heard from about 60 witnesses in six days of public hearings last March.

The response to the proposed rule has been overwhelmingly negative. It has drawn withering fire from critics--including some in Congress--who claim it is not just bad accounting but bad public policy.

The accounting argument centers on whether it is possible to attach a reasonable value to stock options at the time they are granted. Says George Sollman, president and CEO of Centigram Communications Corp., a San Jose, Calif., telecommunications firm: "The people who seem to think they can do this are the academicians. The people who actually have to do it, the accountants and business people, have thrown up their hands and said, 'You just don't understand.'"

There is widespread agreement that if stock options can be valued accurately, they should be charged against earnings. Options can be considered a form of compensation, just like a salary, and, as Beresford points out, accounting rules already require that most transactions involving an equity instrument be charged against earnings. If, for example, a company exchanges some of its stock for a tangible asset like a truck, or for an attorney's services, he says, "no one really questions those being reported as accountable events."

But what is the value, at the time it is granted, of a stock option that an employee might exercise in five or 10 years--or never? (An option most likely would not be exercised if the employee left the company or the stock's price fell below the option price and stayed there.)

If really accurate measurement of an option's worth were possible, Breetwor says, "I don't think you would have the hue and cry that you have today."

When FASB proposed the rule change, it suggested that there were mathematical models for valuation of options that could adequately take into account such things as the volatility of the market price of a stock.

Centigram's Sollman, for one, is skeptical. He points out that Centigram's stock has gone through terrific gyrations since the company went public in October 1991, dropping to just a few dollars a share and then rising into the 40s. "Given the roller-coaster ride we've been through," he says, "how do you put a value" on an option to buy Centigram stock?

Last April, FASB brought together 10 experts on valuing stock options-including both academic researchers and investment bankers--who had submitted papers on that subject. "They all thought we could make adjustments," Beresford says, and all but one thought that the adjustments should be in the direction of lowering the value assigned to options.