There's No Hiding It

All the cool companies are expensing their options. Can your business survive without that extra earnings padding?
Magazine Contributor
4 min read

This story appears in the November 2002 issue of Entrepreneur. Subscribe »

When The Company first volunteered to treat options as an expense in its financials as a service to shareholders, the response from the was lukewarm, even skeptical. Other corporate behemoths, unexcited by the idea of leveling earnings with a big compensation charge, were not prepared to jump on the bandwagon. But in recent months, the trickle of companies following in 's footsteps has become more of a stampede, as businesses race to prove to investors that they, too, are dedicated to giving investors the whole truth. Now, with the practice not yet law, but quickly becoming the fashion of the day, small public-company CEOs have to figure out whether to follow suit.

The debate has come a long way since 1994, when similar proposals by the Financial Standards Board (FASB) were quickly quashed. But while the FASB has recently stated it will not revisit the idea of requiring companies to expense options (until the International Accounting Standards Board does so), it did decide to propose requiring that companies disclose the value of options in the footnotes of quarterly financial statements, rather than in their annual reports.

CEOs of 23 companies being investigated for accounting irregularities made
more than typical large-company CEOs from 1999 to 2001.
SOURCE: Online Publishers Association

Other bills are still on the table. One piece of legislation, introduced by Sen. Carl Levin (D-MI), would allow companies to claim tax deductions only for options they expense. Proponents say changes are necessary to keep companies from lavishly doling out options to senior executives without having to include the cost of the options on their financial statements.

But opponents argue that options don't require a cash outlay like other expenses and are difficult to price accurately. They also contend that companies will simply stop issuing options to anyone but the senior ranking executives, leaving lower-level employees out in the cold.

Small-business advocates say entrepreneurs will be disproportionately disadvantaged. Not having options-or sufficient cash-to lure talent will hamper their ability to compete. "Bigger companies can afford to offer more perks and benefits to attract the best people," observes John Chal-lenger, CEO of Chicago-based outplacement consulting firm Challenger, Gray & Christmas. "It's smaller that will bear the brunt of this."

"They're going to be caught between a rock and a hard place," agrees Harry Friedman, a tax attorney in law firm Greenberg Traurig's Phoenix office, "because while they don't have the cash to pay employees, there will be a cost to utilizing options." Unless the market understands that these expenses aren't actually cash expenses, he says, the lower earnings you report will make investors angry.

Being unable to afford to offer options at all could put entrepreneurial businesses on the losing end of the war for talent, says Karen Jorgensen, a human resources consultant in a La Cañada, California, and the author of Pay for Results (Silver Lake Publishing). "I can tell you from a human resources and compensation perspective that employees still demand options as part of a company's compensation package, and they will continue to do that."

John Hollister, CFO of Cicada, a company that vends semiconductors, says options have been a critical incentive for recruiting talent at the Austin, Texas-based company. "High-quality design engineers are still in very high demand, so we don't take anything for granted," he says. The company grants options to all of its approximately 70 employees, and because it still has the option to do so, Cicada chooses to disclose the expense in a footnote rather than expensing it on its P&L statement.

When it comes to issuing options, Hollister adds, the more important issue is-and should be-dilution. Investors tend to focus more on the capitalization table, which tells them how the newly issued options impact the ownership percentage they hold in the company.

While the final chapter in the accounting treatment of options has yet to be written, the momentum is driving toward mandatory expensing. If that happens, one alternative benefit that may gain favor is the employee stock purchase plan, which doesn't stick companies with a compensation charge, but still offers them some discount when they purchase shares. On the other hand, such a plan doesn't offer the same long-term employee ownership that entrepreneurial companies have sought to build. For some small public companies, the only solution may be to go private and, in the process, forfeit access to much-needed capital fuel. Then again, as Challenger points out, there could be worse times to consider that.

C.J. Prince is a New York City writer specializing in business topics and executive editor of Chief Executive Magazine.

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