Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [20]
Most stock options give the employee a window of time in which to exercise the option after it vests, so even if the option cannot be exercised for cash when it first vests, it may become valuable before the window of time is up, also known as the expiration date. Figuring out exactly what the value of the option is today, before the option vests and before the expiration date requires assumptions. One has to estimate the probability of a future gain and the timing of a future gain, and it makes sense to come up with a standard way of estimating today’s value. Every unexpired option is worth something.The options have a positive value today, since they give the employee the right to a potential gain tomorrow.
After divorcing his wife of many years and devoted mother to his children, one of my acquaintances crowed that he had “screwed her out of millions.” As part of the divorce settlement, he kept his entire passel of unexercised stock options. He persuaded his wife’s lawyer that these options were virtually worthless and negotiated away other much less valuable assets instead. Shortly afterwards, he monetized the options and figured his after-tax take was around $3 million. Did I mention he is an acquaintance, not a friend?
In 2004, the Financial Accounting Standards Board (FASB) finally drafted a proposal requiring companies, whose stocks are listed on U.S. exchanges, to show the value of employee stock options as an expense. Neither Warren Buffett nor I anticipated the possibility that corporate executives might manipulate the value of the options awarded them by “backdating.” We were concerned about arguably more benign distortions of reported value.
In April 2004, I told the Financial Times it is still possible to manipulate the value of the options and therefore manipulate the amount of the expense.4 Wh+ichever option pricing model a corporation uses, the biggest fudge factor in determining value is the volatility assumption. Volatility is related to the price of the stock. For a call option, lower volatility means a lower option price, which means a lower corporate expense. One proposal had surfaced suggesting that one could assume zero volatility. Have you ever heard of a stock price that never moved?
Then, in July 2004, Warren penned an editorial for the Washington Post. I dubbed it “Warren’s Kill Bill article.” The U.S. House of Representatives proposed a bill that would allow corporations to expense only those stock options awarded to the chief executive and the other four highest-paid officers. Other employee stock options would not be expensed. Obviously, this would have created a huge accounting distortion. Warren advocates expensing all stock options. Warren admonished Congress. “Legislators,” he warned, “should remember that it is better to be approximately right than precisely wrong.”5
In December 2004, the FASB adopted a new standard (SFAS 123R) requiring that employee stock options be valued on the date they were awarded and expensed over the vesting period of the options. Somehow, the FASB still could not bring itself to require mark-to-market accounting.
Almost a year later, in November 2005, the Wall Street Journal opined that data patterns suggested some stock options were backdated to set the lowest possible stock price in the relevant time period. The call options were much more valuable than if they had been awarded without this hindsight benefit. Eric Lie, a “mere” assistant professor at the University