On Dec. 16, the US Govt. Financial Accounting Standards Board passed into law, a resolution that requires all corporate entity’s to start expensing stock options, beginning mid-2005. This resolution applies to all corporate entities, with startups and private companies being given an extended deadline. My favorite software Guru - Joel Spolsky, explains why expensing stock options is a good thing. In short, it boils down to this:

A company may choose to pay compensation in form of cash. Suppose this cuts liquid cash reserves by half. This means, the company’s stock value is cut down by half. Now, instead of doing this, imagine the company doubling its stock (to distributing it among employees), this would halve the stock by half anyway.

However, now the company has cash on hand- cash which it can show in its annual report and claim as profit. Joel makes the case that companies should expense one million dollars. But I do not think it is accurate. My argument consists of three points:

• Suppose my current share is worth Rs. 1 this year and I issue one option at Rs.1 .What is my expense: 0

Now, next year if my share price rises to Rs.2, my expense is Rs.1. If however, my share price falls to 0.75, then my expense is still 0. So expensing stock options at issue, does not seem to be very effective.

• Cash in hand is always better.

There must be some discount, on the basis of existing Reserve Bank interest rates, on the value of cash in hand. This is the least that you can do, since cash can always be re-invested, fuel growth and insulate against downturns. Your stock is worth zilch, if a startup had no cash to pay its ISP’s after the first year.

• The expense estimate calculation is not accurate

I’m sure this is an oft repeated concern. The Black-Scholes method for expensing options, is only directly applicable to negotiable instruments, with short vesting periods. ESOP’s are not negotiable and have a gestation period of several years. The method has to have an added discount related to the strike-price of the stock and the vesting period.

del.icio.us Tags: sarbox business accounting