Plain Talk About Stock Options: An Outline Of A New Model (Part I)

Joseph W. Bartlett, Founder of VC

Ordinarily, it is a good idea to stay away from a controversial subject, particularly in the heat of ongoing SEC and criminal investigations, until the dust settles. However, it appears from published reports that there exist some profound misunderstandings about stock options, the rules governing the same and their function and utility in our tech-based, reward-for-risk, capitalist economy. Moreover, some fair minded observers are puzzled that so many boards and compensation committees were, in the `90s, cavalier about the strike price of stock options. Why weren't they scrupulously careful about making sure "fair market value" was determined using objective criteria applied in "good faith" (in line with Internal Revenue Code standards). Perhaps some perspective is in order.

1. The Stock Option Rationale

Stock options are about the only method many companies, including the high tech "gazelles," as rapidly growing, tech-centric firms are called, can use to attract the experienced and high quality management they need. Since this business began, tech investors, including venture capitalists, have recognized that 'you bet the jockey and not the horse.' However, in order to attract qualified jockeys, the parties have to find a way to pay the potential managers in a currency which is meaningful to the recruit, and which the issuer can afford. Inducing someone to take a new job (and leave, in many cases, a comfortable environment) often requires extraordinary potential rewards. Frequently, there is not enough spare cash around (cash being a scarce resource in a business dependent on R&D for growth) with which to motivate the jockeys to make a change; and growth companies need the best jockeys, in view of their growth ambitions. Equity-flavored compensation (a piece of the upside so to speak) is, therefore, an imperative.

The problem with many commentaries on the subject of stock options is that the writers have apparently failed to understand features which make options particularly attractive (prominently not, anymore, including the accounting treatment). First, options represent the principal pieces of paper which afford the executive a piece of the upside (at least the only type in current use) and which do not entail a tax as of the date of the award. To return again to the point with which we started this discussion, there may be little cash to spare by, among others, gazelles in their super-growth stage, certainly not enough to fund tax payments to the Treasury (whether the payor is the individual or the company). Stock options work because there is no tax involved as of the date of grant; restricted stock often does not do the job because tax is owed when the grant occurs, even though there are no cash profits from which to pay the I.R.S. (Tax can be postponed under Section 83(b) of the Code if the shares are subject to vesting, but that can be a bad idea all around.) Moreover, restricted stock, which makes the recipient an instant stockholder, is unlikely to be distributed democratically; [1] assuming the stock has value, only the top echelon- those who can afford to pay the tax- will be receiving restricted stock awards, an unlikely policy for the government and the SEC to adopt expressly.

Further, commentators should understand that, in many if not most instances, stock options and restricted stock grants amount, economically and legally, to substantially the same security from the executive's point of view, except that (absent a very expensive company benefit called a "gross up") the executive's motivation may well be more urgently driven towards short term company performance in the case of restricted stock grants . you may have to sell stock in the year of the grant in order to fund your tax obligation. Moreover, if there is a gross up, the "exercise price" of restricted stock is zero; and nobody has suggested that grossing up is a scandal.

The second virtue of stock options (often neglected as far as I have been able to see) is that the bonus compensation comes from the stock market rather than from the company. The company is able to use its cash internally; the market itself is the one that makes the jockey's trip worthwhile. Stock options may be an expense in the eye of FASB but they are of no concern to, for example, creditors.

To be sure, as Prof. Johnson of Texas Law School has been kind enough to point out, [2] options are not a free good. As he puts it:

There is of course no such thing as free stock. Management should not just leave it out on the bench for the passersby to pick up. Stock represents the NPV of a lot of future cash discounted at usurious rates. At least when you go to Bruno the loan shark for credit in advance he will give you a tax deduction for the discount (interest) rate.

Johnson suggests the use of cash bonuses and, if there is no cash, deferred compensation (today a vastly more complicated matter, courtesy of IRC õ409A). [3] The problem, however, with that suggestion (and he is by no means alone) is that, as followers of the "new" science (a.k.a. art) of behavioral economics point out, people behave the way they behave despite theoretical assumptions they will (because they 'logically' should) behave differently.

Assume for purposes of illustration, the investor and management are devising a compensation plan for a promising gazelle, and let's reference Apollo Computer founded by Bill Poduska. All hands knew that, if Apollo were to prosper, Poduska would give way to a new CEO, a professional manager. Further, Poduska and his experienced VC investors (including, a very minor key, yours truly) realized that an outstanding manager is tempted away from his or her current job (almost all sought-after candidates are currently employed somewhere else) and lured into a key position with, and only with, a promise of equity. Cash alone will not cut it, because you cannot make the bogey big enough to get the manager to switch. You cannot tell a Tom Vanderslice (who left IBM for Apollo) that the company will promise to pay him $50 million if Apollo were to work out to be a home run. As they say down South, 'that dog won't hunt.' But you can set aside, say, 18 percent of the equity (vesting over time) for a Vanderslice and he can entertain the thought that maybe he will make $50 million, and much of it at capital gains rates. An Apollo (like a lottery winner) comes along very infrequently; [4] but it can happen. And it is that hope which energizes talented and experienced managers to take the plunge, to leave a cushy job (at IBM in Vanderslice's case) and 'bet the farm' on a new startup.

My guess is that, given the failure rate, the odds (if full and fair survey data were available) are against the manager, any manager, realizing his or her bet. In fact, an academic, having the benefit of classical economics, would argue: "Don't do it." Prof. Hall would so argue: The NPV of $50 million is a lot of money. But, what if, without Vanderslice, there was no money for anyone. The NPV of zero is zero, but so what? Luckily for us, however, founders like Poduska (who left a good job at Prime Computer), and managers like Vanderslice are willing to buck the odds, believing in the power of their own talents to turn the odds around. But, they will not do it for a promise of future cash- or at least any amount of cash at all realistic. They want stock; they want the possibility (regardless of how "impossible" on paper) of an Apollo-type return; they want to feel they are equity partners in the enterprise, standing pari passu with the capitalists. [5] The critics of stock compensation will simply have to trust the voice of experience on this point; emerging growth finance needs stock options or their functional (in every respect) equivalent. [6]

In this connection, some of the commentators are fixated on the cost of stock buy backs, which are used by a number of companies to neutralize the dilution cost caused by the issuance of employee options. Their point is that a company pays more when it buys shares back than it receives when the employees exercise their options. For example, one persistent critic [7] states: "Last year, for example, Altera paid $18.58 on average to buy back 20 million shares. When employees exercised options in 2005, Altera received only roughly half that amount - $9.32 a share on average." Well, of course, Altera paid more. The shares went up in value, from $9.32 to $18.58. Otherwise, why would the employees have exercised the options in the first instance; and if employers hadn't exercised- let's say the options lapsed- there would be no reason to buy stock back.

The fact is that there is only one accurate way to understand the "cost" of a stock option program. What would it have cost the company had it had to use cash to attract, retain and motivate its employees versus a combination of cash and stock options? That is a number which is, obviously, very difficult, if not impossible, to calculate. Nonetheless, the board and the management have to make the judgment call on equity flavored incentives, including stock options and/or restricted stock. Thus, Microsoft made any number of its employees, up and down the line, Microsoft Millionaires. Could it have done equally as well if it paid everyone in cash? That is impossible to know. On the other hand, Microsoft seems to have done quite well. using stock options the way it did. The point is that, again, stock options are just another form of currency. There are questions on how the options are to be structured; whether the strike price is set at fair market value or at a significant discount from fair market value; whether options, once out of the money, are repriced; what the appropriate mix is between cash bonuses, restricted stock, liberal medical and pension benefits, straight cash. These are all the types of judgment calls the management of private and public companies have to make. There, as I recall, are studies out there tracking comparables (if comparables can be ascertained) amongst public companies and assessing which ones did better- those which liberally distributed stock options and those which did not. I will assume that the studies go both ways; "lies, damn lies, and statistics." My memory is the weight of authority favors, given the Microsofts and other high-tech examples, the companies which have been liberal in their use of stock options. And, that is about all that can be intelligently said on the "cost" aspect of the subject.

2. Generous Options In A Rising Market (1990-2006) . A Product of "Reforms"

Next, the current reformers ignore, or have forgotten the ultimate irony. The shift, among major public companies, from cash to equity-flavored compensation, mimicking the universal practice in the venture sector, was driven in large part, by bitter criticism in the 1980s from reformers! Today's relentless commitment to the pay-for-performance mantra is a response to the chants of critics in the 80's (whom the liberal press applauded as tribunes of the people) of what was then perceived to be entrenched, sedentary and risk averse managers. Much of that criticism was self serving, propaganda by wolves in sheep's clothing,i.e., the corporate raiders pretending to defend the moral high ground in aid of their pet greenmail and hostile takeover initiatives. But the notion stuck, tie the managers' pay to the shareholders' outcomes. If the company remains stodgy, its stock performance less than outstanding, fire the senior management, replace the same with entrepreneurs (or predators, if you like, to borrow Jim Stewart's label).

In short, ironically, the very option schemes which are now reviled were heralded as the solution, the way to a solid future for Corporate America in the `80's, the delight of the very 'reformers' who are in the vanguard of today's necktie parties.

As a consequence, I suggest, the board's view of the ideal CEO changed, often morphing a board's perception of the CEO to the equivalent of an asset manager, and in particular the manager of a private equity fund. I suggest the critics (the managers of LBO funds engaged in hostile takeovers) and the criticized CEOs began in terms of image and internal dynamics, to merge, to look, act and be regarded alike, a common phenomenon in social relations case studies, just as cops and robbers (husbands and wives, people and their dogs) tend to take on common characteristics because of their continually being in each other's company. Hence, the raiders (i.e., the general partners of LBO funds who were doing all the talking during the heyday of private equity investing) and their victims (i.e., the managers of the target companies) began to resemble identical twins. Please recall Abe Lincoln's story about the two gents who wrestled with each other so long, they wound up in the other's overcoat. If Harold Simmons, Boone Pickens, Carl Ichan et al., preached that Corporate America needed to be shook up, the CEOs to look and act like Simmons, Pickens and Ichan, the logical extension of that thesis is as follows: since Ichan, et al. normally took a 20 percent carried interest in the profits earned on their investors' capital, why shouldn't an outstanding CEO be paid in like vein?

The logic had, in fact, enormous surface appeal, as per the following scenario:

  • Superhero, on behalf of a private equity fund, criticizes management and seeks to take over Company X; the current team is too timid, too paranoid, too concerned about a regular paycheck vs. shareholder value; [8]
  • The fund takes control of Company X in order to unlock shareholder value, buying 50 percent of the stock for $1 billion, and installs Superhero as CEO;
  • Superhero cuts costs, boosts profits and Company X's market cap goes from $1 billion to $3 billion in a year's time. The fund makes $1,500,000.00 on its 50 percent interest. What should Superhero (and his team) make? Well, how about $300 million, a modest share (20 percent) of the new wealth created; the larger the company, the larger the award.

I further suggest this theme proved to be catching. [9] As the market boomed in the `90s, management boomed along with it. If the stock prices tripled on Superhero's watch, why shouldn't she get what amounts to a percentage deal, a carried interest in the appreciation in market cap? The directors were influenced by the fact that (a) good managers were and are scarce (and they are); and (b) everyone was making out, particularly (on paper) the very shareholders Boone Pickens said he cared so much about.

The huge awards, part stock (mainly options) and part cash, were not noteworthy as long as the music kept playing. The asset managers became super rich [10] but only because they "deserved" to; their pay was tied to profits. [11] And so with the CEOs, whether installed by Ichan or just mimicking his nominees- pay tied to profits, perfectly aligned with investors, whether the public shareholder or the limited partners of the LBO fund.

Well, the irony is that the reformers are now attacking stock options. First, the "reform" was to expense them, not a good idea in my view, but nonetheless respectable in the eyes of some critics, and now part of the canon. To the distress of the reformers, however, the market has shrugged off the impact of stock option expensing, as many of us thought it would. Thus, the economic effect of stock options was already built in to the financial statements, in the earnings per share calculation; [12] options are historically difficult to value accurately so the expense numbers are necessarily subjective, a change by Intel in its assumptions on Intel stock price volatility impacted option expense last year by $519 million; [13] options do not involve a cash outlay and, as the saying goes these days. "GAAP net income is an opinion; cash flow is a fact," meaning that many shrewd investors quite logically ignore the non-cash "expense" in calculating enterprise and shareholder value, just as creditors ignore it. Indeed, as indicated above, the one "reform" which has had a significant consequence is yet another example of the principle of unintended consequences. Companies expensing options and/or substituting restricted stock necessarily restrict the grants to a select few, a result Barry Diller and others predicted [14] when the reformers were in full cry. Reformers, in other words, are now hoist by their own petard, yet again validating one of the oldest stories in political lore: You are standing on a subway platform, are jostled, reach back and find your wallet gone. You wheel and immediately spot a man running up the steps and out of the station. Do you chase him? Heck no. He hasn't got your wallet. The guy who has is standing right behind you, yelling, "Stop, thief! Stop, thief."

3. The Backdating Issue

That said, the extraordinary compensation to managers has, in turn, led to the second jihad against the option structure .based the idea that back dating is a "scandal". In this section, I argue the perception of a "scandal" epidemic is, in large part, built on ignorance of the economic and tax consequences of options. and explains why (I strongly suspect), in a large majority of the cited cases, the odds are no scandals are involved.

The main problem is that the commentary I have read in the press suggests the writer starts with the assumption that, if a stock option is issued by a public (or private) company and the exercise price is pegged at a number which is less than the existing value of the underlying shares as of the date of grant, some form of civil or criminal malfeasance has occurred. I daresay that nine out of ten readers of these pieces assume that grants which set exercise prices below fair market value, so that the option is 'in the money' as of the date of the grant, are and were illegal and even perhaps criminal. The suggestion is that, according to one of the early civil complaints filed against a public company, awarding in the money options: "results in corporate waste because it serves no legitimate corporate purpose, but rather is a vehicle for looting the Company." [15] Few and far between are comments in the media which acknowledges that the grant of options 'in the money' as of the date of grant- and, in fact, deeply in the money- was (up until the enactment late last year of Internal Revenue Code Section 409A) perfectly proper, often advisable and, indeed, quite common.

The plain fact is that, in the time period we are talking about, there were two types of legal and customary employee options: incentive stock options, usually abbreviated as "ISOs," and non-qualified stock options, or "non-quals," as they are called. (Since the "scandals" all occurred prior to the enactment of õ409A, a section of the Code I deplore, I often use the present tense in describing option metrics since 409A. The grant of option to employees at discounts has come to a screeching halt since 409A was added in November of 2005) The incentive stock options did and do require that the exercise price be set at least at "fair market value;" indeed, for some employees- major stockholders of the company- the exercise price has to be 110 percent of fair market value. But for non-qualified stock options, exercise prices as low as 25 percent of fair market value (according to some prestigious experts) were perfectly legitimate as of the date of grant. Both ISOs and non-quals were commonly and openly used . in private and public companies. ISOs, at first blush, appear superior to non-quals in the tax consequences to the recipients; but in fact they generally are not from either the recipients' or the company's standpoint. If the holder exercises an ISO and then, as required, holds the option stock for the requisite holding period (generally a year), the gain, if any, when the stock is sold is capital gain. For a non-qual, the gain on the date of exercise (and in almost every case sale)is taxed at ordinary income rates; the spread on the date of grant, if not more than a 75 percent discount, is irrelevant for tax purposes, although not for financial reporting purposes.

A lot of options started out as ISOs. However, non-quals are, in the view of many commentators including me (and depending on specific facts, of course), a better security both for the company and the individual. First, if the company is taxable, the spread between the exercise price and the value of the non-qual as of the date of exercise, is a tax deduction to the company;[16] not so in the case of an ISO . no tax deduction to the issuer at any time.

Secondly, a non-qual is (or was at all the pertinent times) more flexible by virtue of the ability of the company to set the exercise price as low as 25 percent of fair market value. Management could grant options 'in the money' and that allowed management to attract employees and executives whom they otherwise would not have been able to pay competitively.

This point is critical and deserves some elaboration. First, one must understand that stock options, both ISOs and non-quals, are a form of currency. Secondly, as earlier indicated, the scarcest resource in Corporate America is top flight management. This country no longer enjoys a monopoly position in natural resources. We do have an educated and motivated work force on the factory floor; but labor arbitrage is eroding that advantage; in that regard, the world as Tom Friedman has put it, is flat. The trick then for a board of directors is to bet the jockey and not the horse. Even the largest public companies, General Motors, for example, have to reinvent themselves, bet the company, in other words, every few years or so. Studies have shown there are very few companies which remain in the S&P 500 list for decades. Corporate survival is Darwinian and the failure to innovate successfully is a ticket to a sale of the business, or, even worse, insolvency. It takes top talent to bring about what Schumpeter called creative destruction. and top talent does not come cheap.

In wrestling with the management issue the board and the CEO are obviously motivated to attract and retain managers at the lowest possible cost to the shareholders. The problem is that that cost can be a very high number whenever the candidate being recruited is, as she should be if she is a superior talent, comfortably and profitably employed by another company, or if the current executive is being recruited, in turn, by a competitor. And, to belabor this point a bit, a non-qualified option can be, under the right circumstances, a critical element of attracting top talent and yet minimizing the cost to the shareholder.[17]

Take a simple example: A company has 10 million shares outstanding and the trading price is $10 a share. If a candidate insists as part of her pay package 50,000 options exercisable at $10 a share, that is a price the board may be willing to pay because the candidate is deemed a prize by the board in its business judgment, which no judge, or, a fortiori, no newspaper columnist is equipped to second guess. The options can be incentive stock options if the strike price is $10 a share; no cash is involved, which is good for the shareholders but 50,000 options is 5 percent dilution . bad for the shareholders. If the board again in its business judgment sees the best forecast as a stock price in the next five years of, say, $15 a share (these are simply guesstimates; one needs, however, to make them if one is resourceful in this sector), then 50,000 ISOs at $10 a share maybe O.K. When the stock is selling for $15 a share, the spread is $250,000 (50,000 x $5) and the typical cashless exercise gives the option holder 16,667 shares of stock ($250,000 ö $15). If the stock goes to $100, however, the spread is $4,500,000 and the dilutive effect to the shareholders is the issuance of 45,00016 shares. Let's say the alternative is to issue non-quals, at an exercise price of, say, $7.50 a share. Assume that, by using non-quals, the negotiators on behalf of the company are able to reduce the number of options to 30,000. At $15 a share, the spread is $225,000 and the number of shares issued in a cashless exercise is 15,000. At $100 a share, the spread is $2,775,000 which, divided by $100 per share, equals 27,750 shares to the option holder. A better deal for the shareholders; 27,750 is a smaller number than 47,500.

The point is that, by being able to issue non-quals under the right circumstances and depending on the other elements of the package being offered to a critically needed employee, the non-qual option may wind up saving the shareholder a lot of dilution (and the company a lot of money if it buys shares back to cancel the dilution).[18] And, it can make the difference between success and failure in the recruitment process. I have been involved on frequent occasions where the company's willingness to issue a non-qualified option fit the screens of a given employee and induced her to favor our offer over one being presented a competitor. Indeed, once you analyze the situation correctly, it is difficult to understand the position of the "reformer," to take an alternative away from the board of directors, presumably a responsible board, so that they have fewer categories of benefits to offer a scarce resource and, therefore, a lower chance to win the contest for that resource.

Let me, at the cost of repeating myself, elaborate. Some of the commentators, see Morgenson, "Options Fiesta, And Investors Paid the Bill," NYTimes, Sunday, July 30, 2006, Sunday Business p. 1, are fixated on the cost of stock buy backs which are used by a number of companies to neutralize the dilution caused by the issuance of employee options. Their point is that a company pays more when it buys shares back than it receives when the employees exercise their options. For example, Morgenson states:

"Last year, for example Altera paid $18.58 on average to buy back 20 million shares when employees exercised options in 2005, Altera received only roughly half that amount - $9.32 a share on average."

Well, of course, Altera paid more; the shares went up in value from $9.32 to $18.58. Otherwise why would the employees have exercised the options in the first instance. The fact is that there is only one accurate way to understand the cost of a stock option program. What would it have cost the company had it had to use cash to attract, retain and motivate its employees versus a combination of cash and stock options? That is a number is, of course, very difficult (if not impossible) to calculate. Moreover, the board and the management has to make a judgment call on equity flavored incentives including stock options, Microsoft made any number of its employees, up and down the line, Microsoft millionaires. Could it have done equally as well if it paid everyone in cash? That is impossible to know. But Microsoft seems to have done quite well using stock options the way it did. The point again is that stock options are a form of currency. How they are structured- whether the strike price is set at fair market value, or at a significant discount from fair market value whether options once out of the money are repriced, what the appropriate mix is between the stock appreciation rights, cash bonuses, restricted stock, liberal medical and pension benefits, straight cash- these are all the types of judgment calls the management of private and public companies have to make. There may be a study out there tracking comparable public companies and assessing which ones did better- those which liberally distributed stock options and those which did not. If such a study exists, my guess is that it favors given the Microsoft and other high-tech companies which have been liberal in their use of stock options. And, that is about all that can be intelligently said on the subject.

Next, when ISO option stock is held for a year and sold, the spread enters into the very difficult (these days anyway) AMT calculation for the holder and so the difference between capital gain and ordinary income is partially nullified. And, finally, non-quals are far superior in terms of risk avoidance. Often the executives would (and still will) deliberately turn their incentive stock options into non-quals because no holding period is required between exercise and sale. From an economic standpoint, a stock option typically is exercised and sold according to a procedure called "cashless exercise;" in fact, an ISO turns into a non-qual when cashless exercise is the holder's intention. That is to say, the holder of a non-qual goes to a broker at a time when the fair market value of the stock exceeds the exercise price, sells the stock in the open market, and the broker advances the proceeds to the company to cover the exercise price. The remaining proceeds revert to the optionee. She then puts aside enough of her profits to pay the tax and pockets the rest.

The alternative is to call on one's own resources to come up with the exercise price; buy the stock; wait for a year in hopes that the stock will continue to advance, or at least hold its current value; and then to sell the stock at capital gains rates. The risk of holding the stock for a year with one's own money on the line made non-quals, typically, much more desirable.

If all this was aboveboard, well known and universally accepted at the time the so-called "scandals" occurred, what are we talking about? Options were issued at a price which was below fair market value as of the date of the grant? That system, as I have explained, was perfectly legal. One didn't have to backdate the grants to do it- simply issue a non-qual. The insiders were avoiding taxes due on the grant date? No. The immediate tax impact on the individual was zero for both incentive stock options and non-quals. If the option were back dated, perhaps it was not a valid incentive stock option, but, in most of these cases, so what? The holders typically, by taking advantage of the cashless exercise privilege, turned their incentive stock options into non-quals anyway. The non-qual spread was, prior to option expensing, generally an accounting expense as of the date of grant and the issuance of ISO's was not. But I daresay, in many of the "scandals" discussed, the impact of that deduction would not have been material.[19] Thus, in the Comverse case, the defendant's profit from alleged backdating was 4.5 percent of their overall option profits. The rub, I suggest, is that the overall profit was $138 million, a number deemed per se obscene by many entries. The backdating issues is a convenient hook on which to attack the underlying crime . "greed."[20]

On the subject of `one person committees', I say: "Let's get real." The chief executive officer of a well run and successful company generally controls, if only through the power of suggestion, the granting of stock options . and all the other compensation elements as well (whether or not there is a compensation committee made up of independent directors); the buck stops in her office and she is responsible for the company's results. Those results are the product of talented employees, the jockeys. The CEO has to hire them and needs the tools she can find with which to obtain and motivate talent, or else the company and the shareholders suffer. If the compensation committee overrides the CEO, the CEO better be replaced. Trust me. If the board, or "activist" shareholders, are running the company, sell the stock!

In fact, the best practice is often deliberately to backdate options to arrive at fair market value, taking the market price as of a given date is a clumsy way of figuring out the "fair market value" of a security. Using an average to calculate the fair market value (versus a particular day's trading price) is a perfectly acceptable way of looking at the world. Indeed, given the IRS's requirement that a "good faith" judgment be exercised, what about a situation in which a public stock is traded, say, $10 a share (give and take a few cents, for the past six months. Then, some euphoric news from, say, the Middle East (or some starkly depressing news) lifts or depresses the market to extraordinary highs or lows . a rising or falling tide which has significant effect on the stock of the company concerned, and all the other boats, on the day grants are awarded. The management is convinced that, as are a number of analysts that the effects of the instantaneous euphoria or depression will soon wear off. Again, if the management ignores the bump which it deems temporary in fixing fair market value does that show a lack of good faith? Indeed,

as Gordon Scott, a law school professor of mine, used to point out, the trading price on a given day is a reflection only of the price of interest to the most motivated seller of the security. The fact that .001 percent of Microsoft shareholders are willing to sell at x dollars a share on a given day does not mean that a Microsoft share is "worth" the price of the last trade on that day. It only means the trading price is what a small minority are willing to take for their stock. Thus, one widely accepted way of pricing the security, by "backdating" if you will, is to take the average trading price of the security for the previous, say, 30 days. If the stock has been rising in price, that will mean that the strike price is below the trading price on the day of the grant; but no one can argue that the method is off side.

Moreover, the date of the option grant is, as often as not, subject to interpretation. Assume, under the IRS Regulations, the plan itself is adopted by the shareholders on January 2. On February 1, the CEO hires X and promises her options on 10,000 shares; X is tendered a contract containing the promise on February 5; on March 1 the CEO and X shake hands and agree that the options are to be granted as of (a) the date X began to work, "subject to the paper work," or (b) as of the date of the handshake; on March 3, X signs and returns the contract and reports; on March 10, counsel to the company circulates a written consent to the Compensation Committee, asking approval of the option to X as of "[date not filled in]" . the Committee customarily authorizes the CEO to fill in the date; on March 15, all the consents are returned; on March 20, the written option agreement is issued to X and the date filled in by the secretary of the board is the date X reported for duty . March 3. This is a "forgery" . or the way the World works?[21]

The short of the matter is that the scandal is not 'backdating." As far as the law is concerned, the strike price of an option can be zero. The "scandal," when it exists, is the deliberate failure of the issuer to report its results fairly. In today's environment, this is an old, old story; see discussion in the next section. It only becomes 'new news' if the press report is colored with the seemingly sinister term "backdating," a first cousin of "backstabbing," "backbiting," "backbreaking," "backhanding," "backsliding." You get the picture.

[1] When mandatory expensing of stock options appeared imminent, Barry Diller announced that USA Interactive would (i) expense option grants and (ii) in the future give up the plan entirely in favor of restricted stock grants, because options are "far too democratic." Diller's forecast has been affirmed . companies typically use restricted stock for, and only for, "key" executives. No more "Microsoft millionaires" down to the secretary level.

[2] See Johnson, Stock Compensation: The Most Expensive Way To Pay Future Cash, Tax Notes 351 (Oct. 18, 1999). Johnson uses the following eye catching example to prove his point:

Assume a corporation that pays a secretary a $1,000 year-end stock bonus, Johnson says. Stock is long-term investment, so assume the stock remains outstanding for 73 years. Discount rates for large company stock have been running at 28 percent a year. After 73 years, the corporation must redeem the stock for $65 billion dollars. Since the $65 million is not deductible, they must make $100 billion to pay taxes to have $65 billion.

[3] Johnson argues against the "stock is free" psychology. Whatever the academic merit of his observation, it does not obtain in private equity. The dilutive impact of the stock option pool is a highly negotiated item in any of today's term sheets. I in fact have just finished a negotiation in which, as is the current practice in today's climate, the founders and the VCs negotiated intensely, to the point of deal impasse, over which category of owner should absorb the dilutive effect of the option pool. Nobody in private equity is insensitive to the three most important issues in venture finance . dilution, dilution and dilution.

[4] I don't know the exact number on what Vanderslice made but, given the Apollo story, $50 million is not far off.

[5] One has to understand the psychology of risk takers. The process can be financially rewarding but it is also fun. And to have fun in this business, one must legitimately feel one is a partner, not an employee. The partnership concept may be diluted when a Microsoft gets to the multi-thousand employee level but it is paramount in early stage. See Tracy Kidder, The Soul Of A Machine; Udayan Gupta, Done Deals. If economic science is built on the assumption people are solely rational in their economic chores, please explain why millions of people play the lottery.

[6] I daresay that in the last forty years, I have participated as a principal, an agent, and/or a service provider in (perhaps) a thousand venture-backed transactions, starting with the 'founder's round' (I have been on occasion a founder myself); the 'friends and family round;' the 'angel round;' and, as current nomenclature styles it, the 'Series A' round. These are the principal way stations whereby an entrepreneur grows his or her firm into a major (sometimes) multi-national . 'from the embryo to the IPO' (as I have put it in the past) or to company sale. And, I submit, if one were to dissect the fundamental elements of venture-backed deals (pick any number for the sample . say, a hundred thousand), in over 95 percent of those transactions the major compensation element, an element installed as early as the friends and family round, consists of stock options, which in turn leads to the obvious point: You had better be careful in fooling with stock options if you want to preserve the venture capital process and, to repeat, it is a process, I hope we have agreed, worth preserving . and in fact enhancing. Competitors in the world economy would almost literally kill to be able to duplicate the advantages our economy draws from venture capital.

[7] See Morgensen, "Options Fiesta, And Investors Paid the Bill," NY Times, Sunday, July 30, 2006, Sunday Business p. 1

[8] The average buyout partner made $1.2 million in 2005, according to the August 2006 Private Equity Analyst, p. 16

[9] Although all coincidences are viewed with suspicion in today's cynical environment, in fact my conclusions were arrived at independently in (and not borrowed from) a strikingly similar analysis (antedating mine) which appear in a paper authored by Harvard Business School Professor Brian J. Hall, Incentive Strategy: Executive Compensation and Ownership Structure (Part II) 4 (May, 2002).

[10] To appreciate some of the many ironies in the current scene, consider one of the "wins" achieved by the reformers . the forced resignation from United Health of Dr. McGuire, its CEO. According to The Wall Street Journal:

In the mid 1980s, Dr. McGuire quit clinical practice as a pulmonologist, or lung specialist, to hitch himself to the health insurance boom. He presided over stratospheric growth at UnitedHealth - the company's stock rose some 50 fold during his tenure. He is credited with savvy investments in technology, smart deal making and a visionary strategy that turned the company into a powerful force in American medicine.

Bandler & Forelle, "Embattled CEO to Step Down At UnitedHealth," The WSJ, Oct.16, 2006, p. A12. Just imagine what McGuire would have walked away with if he had been a private equity fund principal, the fun in turn owning UnitedHealth. The McGuire dispute will, without a doubt, pre-occupy the company for the next few years. Is it remotely in the best interests of UnitedHealth's shareholders that the CEO is fired and the company embroiled in investigations, probes, lawsuits . management attention diverted, etc., etc. The question answers itself.

[11] Pete Peterson likes to denigrate the amour propre of the managers of the '80s LBO funds, boasting of the double digit IRRs they delivered to their LPs, by pointing out that, if the Man From Mars could have leveraged the S&P index by 80% (vs. 50%) during that period, he would have delivered a compounded 35% IRR.

[12] .the charge that stock options involve sham accounting is simplistic. The dilutive effect of stock options are, in fact, accounted for in the all - important earnings per share number; in-the-money options are treated as outstanding for purposes of that calculation. On the tax issue, since today's executives either obtain non-qualified options initially or turn their incentive stock options into non-qualified options, the tax effect is neutral; the company gets a deduction because, and only because, the executive pays tax on the spread. If the company didn't get a deduction, then simple rules of tax equity require that the executive will be relieved of her tax burden. In either case, as far as the Treasury is concerned, it's a wash.

Bartlett, Innovation Review, Intelligence from the Berkley Center for Entrepreneurial Studies, "To Expense or not to Expense? Looking for a third option in the great stock option debate," Fall, 2002.

[13] "Ta Da: Cheaper Stock Options," Business Week, July 24, 2006.

[14] See n.2 supra.

[15] Complaint filed by Milberg, Weiss Bershad & Schulman, Sollins v. Alexander et al., p. 3, April 11, 2006, N.Y. Supreme Court.

[16] There is a potential diminishment of the tax advantage (to the company) of non-quals, as pointed out in a paper by William Mateja and Lezlie Willis of Fish & Richardson P.C.:

Section 162(m) imposes a $1,000,000 limit on the deduction that a public company can take arising from compensation paid to the Chief Executive Officer and the four highest paid officers other than the CEO, unless the compensation is, generally speaking, "performance-based." Under Section 162(m), stock options are exempted from this limit as long as the exercise price is equal to the fair market value of the stock on the day of the grant. In other words, if the compensation is performance-based, as stock option compensation is generally considered to be, the compensation arising from exercise of the options is excepted from the $1,000,000 limit and is fully deductible without regard to the Section 162(m) limit.

Note the point. The strike price must be at fair market value as of the grant date.

[17] This is a point which is missed in the paper on backdating by Erik Lie at the University of Iowa, "Backdating of Executive Stock Option (ESO) Grants." Assume the following hypothetical, Management needs to pay Jane Doe $1,000,000 a year to recruit her. She is desperately needed. The company can pay it all in cash, which drags down the EPS by, say . 10½ and costs, at a 20 multiple, the shareholders $2 per share. She will take half the compensation in stock. $500,000 in cash plus restricted stock worth $500,000. This entails a cash gross up of, say, $333,333 and drags down reported earnings by a factor close to the all cash result. However, she likes the company's prospects so she will take a minimum salary, say, $400,000 in cash, plus 20,000 options but only if the strike price is, say, $5, the price at which the stock traded three months previously, before a bubble, and reflects what she thinks the stock is actually worth. (It now trades at $7.) She agrees to vest over three years. Should management tank the deal because non-cash compensation expense is increased by $40,000? Should management insist on a strike price of $7, plus more options, and (maybe) lose Jane? Let's take a poll of people who have actually done deals.

[18] This point is made by Holman Jenkins, "How Backdating Is Like a 1980s 'Rocumentary'" WSJ A11 (Aug. 16, 2006) (hereinafter cited as "Jenkins"), citing an economic theory known as Prospect Theory, viz: "people overvalue a bird in the hand versus one in the bush," and leading to the following hypothetical:

Say your boss offers you a choice of two options packages, each with a three-year vesting period and 10-year expiration. One consists of 1,000 shares priced at $5 below par, the other 2,000 shares price at par.

The first shows a "paper" gain of $5,000, but you can't realize this gain and it may well have vanished before you're vested. Meanwhile, it would take only a $6 increase in the share price before the "at the money" package begins to pay off better than the "in the money" package.

Yet the same faulty thinking that led employees to overvalue "in the money" options now seems to influence the press coverage, which has often treated strike price as the sole determinant of an option package's value. The scandal arises, however, not because there's anything wrong with "in the money" options, but because of accounting contortions used to avoid expensing them.

[19] See Jenkins, n.15 supra for the columnist's typical, yet in this case perceptive, hyperbole:

For the deeper mystery here is why managements felt such a strong need to meet demand for "in the money" options and duck the pre-scribed accounting.

Yes, the then-regnant accounting rule was absurd, even imbecilic: It allowed companies to transfer infinite wealth to employees in the form of "at the money" options without recording an expense. Issue one option at a penny below the current stock price, however, and you had to expense it. Nonetheless, a rule is a rule.

Companies would likely have preferred not to issue any "in the money" options than account for them properly. Doing so would have meant not only dinging earnings every quarter for each new grant, but also endless backward-looking revisions as old option packages were canceled or modified in Silicon Valley's overheated scramble for talent.

[20] "Former Comverse Executives Confront Backdating Charges," NYLJ (Aug. 10, 2006).

[21] No less an authority than Commissioner Paul Atkins agrees. Thus, quoting from Alfieri & Raskin, "Backdating," N.Y.L.J. (8/31/2006):

"In a July 6, 2006, speech before the International Corporate Governance Network, SEC Commissioner Paul Atkins explained that 'there is no securities law issue if backdating results from an administrative, paperwork delay, 'such as board consent by telephone of options grants followed by collection of approval signatures due to the 'logistical practicalities of getting many geographically dispersed and busy, part-time people to sign a document."

In fact, the informality aspect of this issue has now been officially recognized. See Sept. 19th Letter of the SEC's Chief Accountant to Financial Executives International and the AICPA, stating inter alia that:

"a) Companies may have been awarding stock options by obtaining oral authorization from the board of directors (or compensation committee thereof) and subsequently completing the documents evidencing the award at a later date, or

b) Companies may have delegated the authority to award options to a member or committee of management. That member or committee of management determined option awards to be made to subordinates within specific parameters previously communicated by the board of directors (or compensation committee thereof) and obtained any appropriate approvals at a later date." .

. "We understand that some companies may have approved awards before the number of options to be granted to each individual employee was finalized. For example, the compensation committee may have approved an award by authorizing an aggregate number of options to be granted prior to the preparation of a final list of individual employee recipients. In these cases, the allocation of options to individual employees was completed by management after the award approval date, or the unallocated options were reserved for grants to future employees."