Business or stock play?

Last week we argued that stock-based compensation did a poor job of aligning management’s interests with those of the shareholders. The question of accounting for the cost of option plans, while it is not the whole issue, is an important thing to consider.

It is a general complaint now among market-watchers that corporate financial statements do not give a clear accounting of this cost. Two solutions have been advanced: to consider options to be an expense, and put this cost (however calculated) on the balance sheet, or (as suggested by McGill University economist Reuven Brenner) to consider options to have offsetting asset and liability components at the time they are granted, and to revalue those assets and liabilities as they evolve.

Both ways, to the accounting layman, show merits and disadvantages, but there seems to be a consensus building that those costs should show up somewhere; the old argument that options have no cost because they have no cash component is thoroughly discredited. The expense approach has been criticized for requiring complex calculations of option value (such as statistical pricing methods, the best-known being the Black-Scholes formula). The balance-sheet approach has the drawback of leaving an asset on the books that may or may not exist, depending on whether the employee stays with the company.

It is not just to make quarterly financials a better measure of reality that accounting for stock-based compensation is a necessary step. Paying people in stock or options — touted for years as the way to make management perfectly sensitive to the interests of shareholders — has not lived up to its billing, and in some spheres may be an idea whose time is past.

So along with the question of how to account for options, the more fundamental question — whether they are good for a business in the first place — needs examining.

None of this is in conflict with the idea that stock options can be a useful and even necessary means of paying people in high-risk ventures. The point was made quite effectively for the junior mining industry by Grayme Anthony, president of Houston Lake Mining. In a letter to Canadian Mining Journal, Anthony pointed out that the salaries junior exploration companies can pay are often limited not only by the need to conserve the company’s cash resources, but also by regulation. Clearly, in a situation like that, stock options represent the best way to offer a financial reward to the people who will or will not make the company successful.

Move, though, from a junior’s core shack to the boardroom of a major corporation, and you find options and other share-based compensation programs are strategies that have had only mixed success at making shareholders rich, but have been quite reliable at making management rich, whether or not management has performed well.

Striking examples come from the market bubbles in internet and telecommunications stocks that ended the 1990s. Let it first be said that investors fell in love with a lot of stories in those days: this is not a defence of their foolishness or avarice, nor a plea for the investor to be free of any duty of care about where he puts his money.

And in the first of the bubbles, the dot-com craze, the investor was like the rustic on the Manhattan subway that thinks he knows how to beat the house at 3-card Monte; and the dot-com promoter was the dealer. The one may have slightly better morals than the other, but he has no room to complain about having been taken.

That was not the case in the telecoms bubble. Consider that large companies form the bulk of most investors’ pension funds, most mutual funds, and most stock indices; that most people with any sense carry the bulk of their equity exposure in vehicles like that; and that the structure of the equity markets make it exceptionally difficult to diversify a personal investment portfolio in any other way.

Thus it was out of prudence, not out of a taste for the big score, that a great many private investors held significant positions in the large telecommunications utilities and telecom-hardware makers, which were leaders in every developed country’s private sector. And it was largely the case that they were captives of their pension funds, or small investors diversifying their holdings the only economical way they could. And their dollar was owed no less attention than any other dollar in the company’s capitalization.

For telecom executives to have adopted a strategy that depended on continuous and unsustainable expansion of markets points to one of two things: either they were taken in by the mythology of unlimited growth, in which case they were singularly foolish with other peoples’ money; or they were hoping to ride the wave of a peaking stock market to riches for themselves and for their shareholders, which amounts to having taken shareholders on a tiger ride for which shareholders had not necessarily signed up. The collapse of the telecoms meant that too many of those investors became tiger food when most top management in the telecoms business were doing perfectly well through exercising stock options and selling stock. The money made by management, which represented only a fraction of the loss suffered by shareholders, is not so much the problem; the problem is that stock-based compensation let management enrich itself even when business faltered, and that became management’s goal.

That’s a bad thing for several reasons. It shifts risk from the people running the business to the ordinary shareholder: in Leona Helmsley’s world, only the “little people” paid taxes; in the world of Joseph Nacchio and others who cashed in at the top, only the little people take on risk.

It encourages management to treat the company as part of a casino game rather than as a business enterprise. Pay that depends on share-price puts share price ahead of performance, and in the end incites some managers to make misleading and even fraudulent disclosure.

Most ominously, it rewarded those shareholders that voted with their feet, rather than shareholders that had their money in the company. In this, the objectives of management and a certain class of shareholders were almost perfectly aligned. If the share price is the sole measure of a business’s success, then (as economist John Kay pointed out in a penetrating commentary in the Financial Times) the chief executive is no more than a fund manager, obliged in the end to run up the stock price in the hope that the mother of all Greater Fools shows up with an open wallet. That means neglecting markets, business development, operations, and innovation on the way. It doesn’t build a business, it inflates a bubble.

We said last week that sensible investors may yet come to see stock-based compensation plans as a bad sign of a company’s prospects. At the very least, properly assigning a cost or liability to options would let investors, and the money-managers that act for them, make a reasonable assessment of the risk they are taking.