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Tuesday, Jul 23, 2002

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Silicon Valley in a fix over Coke move

Pratap Ravindran

MUMBAI, July 22

COKE'S recent move to expense stock options — mimicked by other US corporates frantic to clean up their financials, regain credibility and, by extension, pump up the value of their stocks — has caused consternation in Silicon Valley.

Actually, not all of Silicon Valley. It is basically the venture capitalists, the tech outfits that they have got a stake in and the politicians who receive money from these ventures who are aghast at the prospect of expensing options. As for the others — investors, analysts and regulators — they are refusing to buy into the argument that expensing options will bring to a grinding halt innovation in an ideas-driven industry. They dismiss the innovation scare with the argument that a revised accounting of options will, in no way, blunt Silicon Valley's edge. All that it will do is put Silicon Valley outfits, which tend to make non-cash charges vanish in their so-called pro forma disclosures, on a level-playing ground with other enterprises that use cash or restricted stock, which are expensed, to compensate employees.

By now, just about everybody who is vaguely numerate has figured out pro forma (boosted) results enrich only venture capitalists and employees — at the cost of the investor.

None other than Mr Alan Greenspan, head of the US Federal Reserve, has put his stamp of approval on this perception with the observation: "If investors are dissuaded by lower reported earnings as a result of expensing, it only means that they were less informed than they should have been. Capital employed on the basis of misinformation is likely to be capital misused."

And so the investors are inclined to go along with Mr Warren Buffett's much-quoted position: "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"

Several technology majors, including Microsoft and Verizon Wireless, had, last calendar, successfully scuttled a move by the Securities and Exchange Commission (SEC) requiring companies to enhance disclosures relating to their stock option plans for employees. SEC had mooted more extensive disclosures in this regard on the basis of the argument that, under the existing regulations, it was difficult for investors to evaluate the impact of stock options on a company's future earnings growth.

Microsoft and Verizon had argued that further explication was not necessary as the accounting standards in place required companies to disclose stock-option plans.

Microsoft, at that point of time, had written to SEC: "We are opposed to the proposed rule and believe it would result in increased administrative burden to companies with little, if any, benefit to investors.''

The current head of SEC, Mr Harvey Pitt, who was then under nomination to the post, had maintained a studied silence on the subject.

He may not continue to be able to do so this time around because, the continuing opposition from tech outfits to the expensing of options notwithstanding, John and Jane Doe have worked out the data blackouts caused by the manner in which they are not accounted for.

Going by informed comment in the US media, investors have now learnt to see through the overstatement of earnings by tech companies enabled by the fact that the "cost'' of options at grant is zilch, even though they have very real economic value to the recipients — mirrored as a cost to the issuing company's equity holders. The company's balance sheet is beefed up by the cash flow benefits — and the strike price proceeds collected when the options are exercised. Options, therefore, are basically evergreen equity offerings at below-market prices.

Further, contrary to orthodoxy, there is absolutely no evidence to suggest that options align the interests of management with shareholders. It is now clear that options, much like lottery tickets, have an asymmetric returns profile and can make for imprudent risk-taking, especially when combined with short vesting periods. Stock grants with short vesting periods, of course, tend to be the norm in the US tech sector as restricted grants with long vesting periods (which do create a higher level of management-shareholders interests) have to be expensed.

Finally, the American tech industry's contention that options help develop a direct ownership stake now stands trashed. The anecdotal evidence is that employees of companies that grant them stock options annually sell their stock shortly after exercising their options. Obviously, the US tech industry should have paid heed to Abe Lincoln: You can't fool all the people all the time....'' If they had, they may not have found it so difficult to replace pro forms earnings with real ones now. ''

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