Cisco’s options lemonade

The Silicon Valley giant may have found the least painful way to expense employee stock options. But is it really the most accurate valuation method?

As quickly as regulators make rules, the regulated devise creative ways around them. Consider the state of the Financial Accounting Standards Board’s effort to have companies account for employee stock options as expenses in their financial statements.

Corporate CEOs have railed against the new rule, which FASB adopted in December, arguing, among other things, that there is no way to determine the true value of employee options. The Black-

Scholes formula, which is widely used for valuing puts and calls that trade on exchanges and over-the-counter markets, vastly overvalues employee options, they say. That’s because options granted to workers as compensation typically have vesting and forfeiture provisions and can’t be sold or hedged, making them worth less than marketable options.

Now that FASB has adopted the rule, which applies to public companies reporting results for fiscal years ended after June 30, companies are busy figuring out how to comply without taking too big a chunk out of their bottom lines. Cisco Systems, which led the charge against the new rule, has been working with investment bank Morgan Stanley on a creative solution.

Concurrent with its biannual employee option grants, the data networking giant plans to issue to institutional investors a small tranche of warrants (called equity stock options reference securities). The warrants are designed to look just like Cisco’s employee options. Cisco would use the price received at auction for its Esors to determine its employee options expense.

“We’re still opposed to the idea of expensing, but if it’s going to happen, we don’t think the [existing] models provide accurate valuations of employee options,” says Cisco spokesman John Earnhardt.

Sponsored

Before going ahead with such a deal, Cisco and Morgan Stanley are waiting for the Securities and Exchange Commission to signal that the accounting treatment is appropriate. But already other companies, especially in options-crazy Silicon Valley, have expressed interest in following Cisco’s lead. Among them are chip makers Intel Corp. and Qualcomm.

“One of FASB’s biggest problems with this has been how to value the options,” says Intel spokesman William Calder. “The auction seeks to get to a market price for them.”

It’s far from certain, however, that Cisco’s approach will result in more-accurate accounting. Why? Unlike most trades, in which buyers bid low and sellers offer high, both parties in the Esors auction would be looking for the lowest possible price. Institutions want to pay as little as they can to acquire what are essentially Cisco call options. (The company will issue new shares to settle the contracts upon exercise.) The lower the auction price, the smaller the expense Cisco has to record and subtract from its earnings. Worse, the bidders -- a small group of institutions, probably hedge funds, chosen by Morgan Stanley -- know going in that the seller desires a low price. That’s hardly a competitive market and thus is not likely to generate the most accurate valuation.

“Markets depend on liquidity to be fair, and the nature of this investment doesn’t lend itself to a market,” says Jack Ciesielski, editor of the Analyst’s Accounting Observer newsletter. “This would be a kangaroo market.”

Considering the financial stakes, it’s no surprise that Cisco has chosen this particular tack. Had it applied Black-Scholes to options issued in its 2004 fiscal year, which ended last July 31, Cisco would have wiped out more than a quarter of its $4.4 billion profit (see table).

The SEC, however, may choose to sanction imperfection. After all, the FASB rule purposely refrains from designating a specific valuation methodology, leaving it instead to each reporting company. Cisco’s solution may not be the most accurate, but neither is Black-Scholes. Throw in the fact that President George W. Bush’s nominee for SEC chairman, antiregulatory former California congressman Christopher Cox, has been a loud critic of options expensing, and Cisco’s proposal may have legs.

“I think Cox would be damaged by trying to reverse [FASB’s new policy on expensing],” says Ciesielski. “But Cisco’s experiment might represent a political compromise.”

And so continues the cat-and-mouse game between regulators and regulated.

Expensive

Counting employee options as an expense could hurt corporate earnings. Below are expense levels (using the Black-Scholes valuation model) for the latest fiscal years of nine companies with big options grants.

Related