By Arnold Kling
First, to answer Arnold’s question – since all economic values are subjective, there is no question of there being a ‘correct’ valuation. All voluntary economic exchanges depend on the two parties valuing the exchanged goods in reverse order.
I have yet to hear a convincing argument for the requirement that options be counted as expenses in the company report. That is not to say that one does not exist; rather, I simply have not heard one.
Let me make an attempt.
First, I want to clear away some underbrush. Established, public companies typically redeem employee stock options by issuing new stock. This dilutes the ownership of existing shareholders, and this can be confusing to analyze.
In a start-up setting, venture capitalists will not tolerate dilution. They typically require entrepreneurs to “set aside” shares of stock to cover stock options. In other words, stock options come out of the entrepreneur’s hide.
For analytical purposes, let me assume the venture-capital model, in which stock options are claims on existing shares granted by the owners. Assume that I am the employee, but that the major decisions that affect the firm are made by management.
As an ordinary employee, some of my effort is observable by management and some of my effort is not observable. The observable component can be rewarded with wages and bonuses. The rationale for stock-based compensation is to increase the unobservable component.
However, as an ordinary employee, I have little influence on the company’s aggregate value. Moreover, most of what influence I have comes from the observable component of my effort. If the value of the company is only infinitesimally correlated with my unobservable effort, then my stock options will not provide much incentive for me to increase my unobservable effort.
The stock options that you as the entrepreneur grant to me as an employee necessarily reduce your wealth and increase my wealth. If you could obtain another employee for the same wage without granting options, then it would be rational for you to do so. Therefore, the only reason I am getting stock options is because I am willing to take a lower wage.
Suppose that the market wage is $40,000. If you pay me $30,000 plus stock options, then unless I am a fool those stock options have to be worth at least $10,000. From this perspective, my stock options have to be viewed as a form of compensation. That is why they must be expensed.
There are many real-world complications with valuing stock options. There are restrictions on exercise. Options are often “out of the money” when granted. And a case could be made that if options are expensed when granted, then the firm will experience capital gains and losses over time as its outstanding options change value, so these gains and losses ought to be in the income statement as well.
For Discussion. As Warren Buffett says, if stock options are not compensation, then what are they? And if compensation is not an expense, what is it?