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This piece comes after a rather long sabbatical. It’s been somewhat due to lack of ideas & largely
due to lethargy. I am very finicky about shareholder friendliness & admire corporations whose
actions conform to this objective. In this piece, I will write on the subject of Employee Stock
Options (ESO) & my views on it. Most employees love it, some corporations, I’ll try to be a little
euphemistic here, ‘use’ (mis?) it for their benefit. Rather than rewarding the exceptional
performers proportionately to their performance, which is what should ideally happen, most Stock
Options have a Socialistic feel about them. While there are lots of corporations that use ESOs
judiciously, I will write on why I think they may not be very shareholder friendly in lot of cases. In
fact, in some cases they are not ‘employee friendly’ as well!

The most common reasons corporations cite for issuing Employee Stock Options (ESO), is that it
motivates the employees to strive towards a common goal, & that it aligns shareholder &
employee interests etc. etc. Indeed, for a lot of them, ESO’s are a way to attract & retain top
talent. The Internet companies not so long ago used (misused?) it to rather good effect,
seemingly achieving their objective in the process. But did they achieve the commonly ranted ‘we
are shareholder oriented’ baritone as well?

Some of the abuses that strike me as utterly un-shareholder oriented, & in cases un-employee
oriented, includes Backdating of ESOs, non-expensing of option grants, & finally the Pricing &
Repricing of ESOs. Each demands some ‘piece-space’ here & so I’ll dive directly into each of
them. The shareholders perspective is mostly the same under all these cases.

BACKDATING
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What is ‘Backdating’? Simple. Assume today is 6 Aug 2006. A company’s stock price as of
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today is Rs.120. It decides to grant ESOs dated 1 Jan 2006, although today’s date is 6 Aug
st
2006. This is ‘Backdating’. Why would someone do that? Assume that the price on 1 Jan 2006
was Rs.100. This act achieves the purpose of taking advantage of a lower stock price as on the
previous date compared to the prevailing market price.

This gives the employees; including the Top Brass, an immediate paper profit (Rs.20 in this
case)…& the poor shareholder is the one who is the sufferer. In hindsight, this may seem very
profitable for the employees, but it’s not always the case. This is why.

‘Non Qualified’ Stock Options as they are called, attract a tax treatment that is slightly different
from ‘Incentive Stock Options’. For employees, ‘Non Qualified’ Stock Options attract tax payment
at the ordinary Income Tax Rate (which is about 30% under US Tax code), while the ‘Incentive
Stock Options’ attract a lower Capital Gains Tax Rate (about 15%).

Now if the unfortunate employee was unaware whether the Options granted to him are ‘Non
Qualified’ or ‘Incentive based’ he will get into a shit hole later when the taxman comes knocking
on this doorstep. That’s because he would have paid the lower Capital Gains Tax assuming the
Options to be ‘Incentive based’, while in reality, he should have paid the full ordinary Income Tax
Rate as the Options were ‘Non Qualified’! Employee friendly?

EXPENSING (OR LACK OF IT)

This is a no-brainer. When Stock Options are included as Compensation when HR works out your
package, I think it’s pretty straightforward to record it as an Expense on the Financial Statements.
But most don’t do this! The US code has now made it mandatory to expense all granted Stock
Options, but corporations continue to abuse this rule.

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A recent example that springs in my mind is that or Brocade, which has been accused of regularly
backdating options, without expensing them! Once this is taken as correct, a cascade of charges
hit the company. Misrepresentations to auditors, botching books, misrepresentation by the CEO &
CFO thereby violating the Sarbanes-Oxley Act & finally, the big one Misrepresentation of
Financial Statements to Investors! Whew! I wonder who benefits from all this pain, for a rather
small gain (in the form of paper profit)!!!! Certainly not the corporation & most certainly not the
naïve Investor who commits his money oblivious of this hanky panky.

PRICING & RE-PRICING

This to me is one of the extreme examples of selfish human thinking!

When a corporation receives a take-over bid from a competitor, it quickly & vehemently points out
how the price offered, which in most cases is slightly higher than the prevailing market price, is
too low (Think Arcelor-Mittal). But when the same corporation grants Stock Options to itself, they
are invariably at a juicy discount to the current market price! I don’t see any further room for
expanding selfishness & stupidity than this!

As an example of the latter case, the Indian Bauxite/Bentonite company Ashapura Minechem has
an outstanding Employee Stock Option grant that is exercisable at Rs.65 / share. The Prevailing
price is about Rs.200 / share. Why on earth should a company ‘take’ the right to buy an additional
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stake at 1/3 the prevailing price?

I can’t fathom & digest the fact that managers are unwilling to sell themselves to an ‘outsider’ at
the prevailing market price, but gleefully sell to ‘themselves’ a stake in their company at a super
discount to the same prevailing market price! Shareholder friendly or plain stupid? I think both.

When an unwitting pay-off occurs to employees due to extraneous factors & they have an option
to exercise, one can’t find anybody complaining, but if the same pay-off were to occur to an
‘outsider’ (including investors) you can rest assured there will be a huge hue & cry over it!
Chrysler being a striking example.

When the US Government, which had an option on Chrysler during its near-bankruptcy days, got
an unintended pay-off, Chrysler cried like hell over the ‘injustice’ but if the same pay-off had
occurred to themselves, I wonder how many would have cried hoarse…

The subject of Pricing & Repricing of Stock Options seem inherently un-shareholder friendly.
Ideally, the Exercise Price should be around the Fair Value of the company, but this is seldom the
case. Employees can readily & at times at a substantial discount, exercise their Options, make a
neat profit & dilute Equity.

Equity Dilution has the effect of reducing EPS (Earning Per Share) & who suffers? Shareholders.
The scene goes on something like this.

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In the beginning I had mentioned that ESOs have a Socialistic feel about them. This is why. The
Exercise Price is the same for all employees. So, the hard-working exceptionally talented guy
receives the same reward as a one-foot-on-another guy who does mostly nothing! The ESOs,
which are apparently constructed to reward employees don’t seem to achieve their purpose!

When corporations preach passionately about how shareholder friendly they are, they need to
actually walk the talk. Which unfortunately, most don’t do. An instrument that gives employees
unlimited upside & minimal downside, which is the way ESOs are structured, is not exactly my
idea of shareholder friendliness.

This is not to say that ESOs are useless instruments but I think they need to be structured
realistically, not only in terms of pricing but also in terms of the parameters that clearly
differentiate exceptional performers from the duds. One of the ways out of this is to devise ESO
systems that are directly connected to Person X’s department’s performance rather than the
performance of the overall corporation. Unfortunately the latter is mostly prevalent & so mostly
ESO tend to be instruments that turn out to be neither shareholder friendly nor employee friendly!

Who benefits from all this then, you may ask? Well, I don’t know. Hardly few, with the prevailing
ESO system at least!

“Hope…can’t substitute Reason”

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