Investing

As an investor, few things assure you'll go hungry like a board of directors cutting the pie into more and more pieces and handing them out. Excessive share dilution is precisely that.

Dilution

Dilution is such a critical issue, yet few investors seem to pay much attention to it. By owning a share of stock, you have an ownership stake in a company. The intrinsic value of that share is a function of only two things: the intrinsic value of the business and how many shares are outstanding. If the share count is rising, then the shares you own are losing value, all other things being equal.

Imagine for a moment that you own 100 shares of a business with 1,000 shares outstanding -- in other words, you are a 10% owner and are therefore entitled to 10% of any profit distributions, 10% of the proceeds if the business is sold, etc. Now, let's assume that management initiates a generous (to them) stock option program that increases the share count by 4% annually. In about 18 years, the share count will double to 2,000 and your stake in the business will have been cut in half. Even if the value of the business doubles over this period, you've done nothing but tread water. Management, of course, has done fabulously: While getting paid salaries and likely bonuses every year along the way, they now also own 50% of the company due to the options they've received (assuming they've held their shares).

To summarize, options cost nothing in terms of cash or reported earnings, generate cash and tax deductions when they are exercised, create incentives for employees to stay, enrich management, and boost growth rates, margins, returns on capital, earnings, and, in all likelihood, the multiple the stock market places on these earnings. Given this ludicrous accounting, I wonder why companies don't issue far more options. For example, why should options only be used as a form of compensation? Why not pay other expenses like rent and advertising with stock options? It sounds silly, but theoretically a company could pay nearly all of its expenses with stock options and then report amazing (read: artificial) results.

It appears that companies have, in fact, figured out this game, with the result that the issuance of stock options is spiraling out of control: According to Business Week, "Today, the 200 biggest companies by revenue allocate more than 16% of their outstanding shares for options...double the percentage allocated a decade ago." But shareholders are paying the price, in the form of a massive transfer of wealth from the owners of companies (e.g., the shareholders) to management teams.

The most obvious, important solution is to require that companies expense the cost of options granted, but this proposal is not surprisingly encountering fierce resistance in Corporate America. Companies typically argue that it's hard to value options precisely, but this is rubbish: There are innumerable items in financial statements -- pension costs, allowances for doubtful accounts and so forth -- that cannot be known precisely, and thus are estimated. Also, companies are already required to report what earnings would have been were options expensed, but in a lame compromise adopted in 1995, such information is only reported once a year -- and is buried deep in the footnotes of the 10-K filing.

Finally, companies argue that if they are forced to account for the cost of options (even though this is a non-cash item), then they will issue fewer of them, which would stifle innovation, new business formation, and so forth. Well, if that's true, then let's unleash a tidal wave of innovation and new business formation by allowing businesses to ignore other costs like rent and cash compensation. Think of the profit margins if expenses didn't appear on the income statement at all!

Don't be fooled by these self-serving arguments. The bottom line is simple: Managements in many cases are making enormous fortunes from stock options at the expense of shareholders, yet there is little protest because the absurd accounting obfuscates their true cost.

Employee Ownership Through Restricted Stock

One of the advantages restricted stock has from a management perspective is it is better at motivating employee to think and act like owners. When a restricted stock award vests, the employee who received the restricted stock becomes an owner of the company. He or she has to take no further action to make it happen. The employee is now part owner and can vote at the annual meeting.

Actual ownership of part of the company is a powerful motivating tool in trying to get employees to own the company's objectives. This makes them more focused on meeting goals.

Stock options, on the other hand, do little to instill a sense of ownership. They are viewed by most as a high risk gamble that has a potentially great reward. An individual may very well invest a couple of years helping a company grow and prosper when compensated for that time by stock options. However, their loyalty is to raising the stock price so the can cash out and make a bundle. They have no loyalty to the company and its goals. Often, they will choose actions which raise stock price in the short term, thus increasing their potential gain, rather than taking a longer-term view that will help the company.

Although ESOs have become an important means of motivating executives and employees and aligning their interest with those of shareholders, many corporate boards may not fully comprehend the total potential dollar value of the options they are granting. Current accounting standards do not require much precision in this regard. Today, companies may choose to merely disclose an estimate of the fair value of the ESOs they have granted on a pro forma basis in footnotes to their financial statements. ESOs are not currently an expense item on the income statement.

This lack of precision raises serious questions: Are current risk metrics providing senior managers and corporate boards with sufficient information to make informed decisions about options?1 Do boards truly understand the potential impact on shareholders of their option grants? Are boards and senior managers prepared to take responsibility for the accuracy of their ESO valuations?

A low expense figure for a company's options may be flattering to its profit and loss statement, but such a figure is fraught with pitfalls. Under the terms of the Sarbanes-Oxley Act, a company's CEO and CFO must attest to the accuracy of the numbers that appear on its financial statements. Should a company's valuation estimates prove inaccurate or unfounded, its senior managers or corporate board could be held responsible (or jointly liable with the hired valuation professionals)