This article appeared in Upside (April 1993)
Trouble started last spring when FASB (pronounced fas-bee), proposed a new accounting rule that would require companies to deduct from current earnings the future value of the stock options granted to employees. For those unfamiliar with stock options, the change sounds like a minor tweak to an arcane rule. But FASB's proposal has profound implications for America's economic future, and has sparked a bitter political struggle whose outcome still hangs in the balance.
Leading the charge for the new rule is, of course, FASB itself. But the high priests of accounting are not alone. Oddly enough, they're allied with the capitalist-bashers in Congress. FASB had been mulling over its rule change since 1984, but it didn't actually propose the change until Senator Carl Levin (D-Michigan) threatened legislation if FASB didn't act. As Levin sees it, the current policy "encourages runaway executive pay by disguising the true cost of stock option compensation."
Their logic sounds eminently reasonable, particularly if you subscribe to zero-sum, "every benefit implies a cost" economics. After all, why should a company be able to compensate its employees without telling its shareholders about the costs incurred? Underreporting compensation expense allows companies to overstate earnings, deceive investors, inflate stock prices, and put giant corporations that don't hand out stock options at an unfair disadvantage when it comes to raising capital.
Since FASB's sole reason for existence is to assure investors that corporate financial statements accurately reflect the financial condition of American corporations, the failure to correct misleading accounting would amount to dereliction of duty. As Dennis Beresford, FASB's chairman makes clear, "Our principal mission is to establish accounting standards that lead to financial reports that are unbiased, that are neutral, and that don't favor one particular organization or type of company or industry over another."
But since Silicon Valley's ox is the one being gored, high-tech business leaders don't see things quite so dispassionately. They have mounted a feverish campaign to get FASB to abandon its proposal before it goes into effect, or failing that, to get Congress to override it. Dick Kramlich, head of the National Venture Capital Association called FASB's proposal, "a knife through the heart" of American high-technology.
A survey by ShareData, Inc. shows why. Nearly 90% of all high-tech firms with under a hundred employees distribute stock options to all their workers. With such heavy use of options, a Coopers & Lybrand projection shows that the typical high-tech firm's earnings will drop about 27%, if the new rule goes into effect. By contrast, large companies, which tend to restrict option grants to top executives, would only see a 3% hit to earnings.
FASB's opponents base their case on two arguments. First, they contend that stock options are the essential ingredient in attracting first-class talent to risky startups. If startups couldn't offer workers a realistic chance of getting rich, there'd simply be no way to recruit them from established firms or motivate them to put in the hundred hour weeks that propel "never heard of" firms like Microsoft into the top ranks of American business. Pulling the plug on stock options would kill off precisely the kind of entrepreneurial companies giving America an edge in the global battle for high-tech leadership.
FASB, quite properly, responds that it must let the cards fall where they may. Its mandate is accurate accounting, not industrial policy. If more accurate accounting reveals that high-tech startups aren't as profitable as previously believed, well, then, so be it. Underreporting employment costs should be no more privileged than any other subsidy or loophole.
Indeed, by waving the flags of job creation and U.S. competitiveness, the high-tech community demeans its unique economic role, and sounds like any other special interest group. "We need this special exemption to provide Americans with fill in the blank (more jobs, cheaper sugar, affordable subway fares). Take it away from us, and you'll hurt the whole country."
Implicitly recognizing this argument's weakness, the high-tech community also attacks FASB's rule on technical grounds. Since no one can tell what, if anything, a stock option is worth at the time of the grant, they claim it's ridiculous to expense a specific amount against the company's earnings.
For example, if StartUp, Inc. recruits the brilliant software designer Joe Bithead away from his high-salary job at MegaCorp by offering him the option to buy 10,000 shares of StartUp's stock at its current price of a penny a share, what's the value of Joe's grant? If StartUp goes belly up, as 80% of new high-tech firms do, the grant is worthless. More than once, jobless workers of bankrupted ventures have ceremoniously torched their option certificates in backyard barbeques.
But if, on the other hand, after five years of struggle, StartUp, Inc. manages to create a successful product and outperform its competitors, the company's stock might sell for, say, $10 a share on the public market. For a penny each, Joe can buy the 10,000 shares held in reserve in StartUp's treasury since the day of his grant. He immediately unloads them in the market for a $100,000 profit. Under FASB's new rule, how much should StartUp, Inc. charge against its earnings when it recruits Mr. Bithead, zero or $100,000?
Dennis Beresford, FASB's chairman, acknowledges that the mathematical formulas used to estimate the potential value of stock options are imperfect. But, he says, there's no way to avoid estimates in accounting. The future cost of pension benefits, insurance company reserves, and bank loan loss reserves are all calculated with the best available techniques. Even a flawed estimate is better than ignoring an expense altogether.
Amazingly, the whole debate misses the only point that matters: Does Joe Bithead's gain actually come at StartUp's cost? Does an employee's stock option profit flow from a company expense? Is it, to use Senator Levin's phrase, a "true cost" to the corporation?
Think about it. When Joe sells his shares, the cash he gets comes from outside investors who bought his shares in the open market. Not a penny comes from the company's coffers. All of Joe's gain comes out of the increase in StartUp's market valuation.
In short, stock option profits are bonuses paid directly by company owners to company employees. By granting Joe some options and keeping him on the payroll long enough to vest them, Startup merely validates to the shareholders that Joe helped raise the value of the company's stock.
As long as shareholders are aware that a certain number of reserved option shares may be sold on the public market -- and possibly drive down the stock's price -- no financial reporting problem exists. Accounting rules have long required companies to disclose how many shares they've reserved for employee options.
The zero-sum, double-entry mindset that controls the thinking of FASB's and Machine Age politicians simply cannot cope with the positive-sum, wealth-creating economics of Information Age capitalism. They simply cannot understand that new wealth comes out of no one's pocket; that there can indeed be benefit without cost, income without expense.
Stock options are powerful because they make possible the ultimate win-win deal, a true partnership between employees and owners, one that gives workers a share of the wealth they create. What more can we ask of capitalism?
If America's high-tech leaders fail to kill FASB's hare-brained scheme, it will be because they failed to attack it head on -- as stupid accounting. Rather than clutter the issue with a debate over the rule's economic impact or the technicalities of option valuation, FASB and its Congressional allies should be compelled to explain precisely how stock options generate any corporate expense at all. The silence will be deafening.