VOTE AGAINST STOCK OPTIONS

VOTE AGAINST STOCK COMPENSATION

“Perhaps the sentiments contained in the following pages, are not yet sufficiently fashionable to procure them general favor; a long habit of not thinking a thing wrong, gives it a superficial appearance of being right, and raises at first a formidable outcry in defence of custom. But the tumult soon subsides. Time makes more converts than reason.” -Thomas Paine, Common Sense

I only ask that you divest yourself of preconceived notions and consider the contrary side of the argument regarding stock compensation. Each individual can determine through their own reasoning the relative merits of the alternatives.

In the following writings I will argue that stock options are a horrible method of compensating employees because there is a lack of pay for performance and ruined incentives, a high cost of dilution, difficulty in valuing options, a tendency towards wretched excess compensation, a giveaway to management because fixed exercise prices ignore the earnings that are retained by a company every year and because GAAP accounting can minimize the apparent dilution. In contrast, cash compensation tied to important business results that drive long term shareholder value which an executive has control over, remedy and correct these problems.

Although many constantly complain about excess executive compensation and lack of pay for performance whom has actually done anything about it? A little understood reality: Stockholders must approve all stock options by voting for the authorization of stock option plans. If they are not approved, they cannot be issued. To vote against all forms of stock compensation may seem extreme but it’s not and here’s why:

1. There is a repugnant lack of pay for performance. Employees receive stock options whose value is tied to factors over which they have no control. It is as if they were to come in blindfolded at the end of the year and throw a dart against a dartboard to determine their incentive pay. Even the CEO, ultimately, has no control over the unpredictable nature of the stock market. An employee could do a fantastic job within their scope of responsibility and get badly compensated with options that have little value. The opposite is also true; an employee could do a horrible job and yet make a windfall because the stock market goes crazy. Both examples illustrate how badly stock options rate on paying employees according to their individual performance and to factors over which they have control.

In fact, stock options ruin the incentive that a company is trying to create by making an employee’s compensation at the whim of the stock market rather than the more logical approach tying compensation to controllable factors, which will improve the business long term. By paying options, rather than cash, a business may miss opportunities because the incentive is off. The opportunities could include more quickly driving improvements in the business that would increase sales or net income.

Stock Options are a large part of the compensation many executives and employees receive at publicly owned companies. Management and boards of directors claim that they award stock compensation to align the interests of employees and shareholders. I beg the question, would you pay your maid or butler with options on your house? Of course not! You pay them according to how well they do their job to get the incentives right. Why should public companies be any different?

If boards want management to have share ownership they can mandate a given level of ownership. Shares should be bought with cash just as public shareholders have acquired their shares. With cash purchased shares there is real downside for the managers, as opposed to purely an option on the upside with all of the downside born by shareholders.

2. Dilution can be disgustingly costly over the long term. Many companies routinely issue stock options, which can easily dilute shareholders by 10% over a 10-year period. This is an extremely costly and unnecessary dilution that shareholders bear the cost of. There is no free lunch and the EARNINGS PER SHARE without dilution over 10 years would be much higher. Bottom line: Every time you vote to approve stock compensation plans or your mutual fund does, you pay for it with lower ultimate returns. If someone reached into your bank account and took 10% of your savings every 10 years it would hurt. The dilutive arm of stock compensation snatches away part of your company from you.

3. Long-term stock options are difficult to value. Black-Scholes (B.S. for short) doesn’t take into consideration basic fundamental valuation. A ten-year stock option on a company trading for a P/E of 5 vs. a P/E of 30 is worth a very different amount to a long-term educated buyer. Clearly, all else being equal, one is going to have more upside in owning the option striking at a P/E of 5 vs. 30, but the B.S. formula ignores this crucial point. Companies often end up expensing options at ridiculously low prices and end up giving the away the store by issuing options on undervalued companies.

4. Egregious compensation. Because of the complexity in valuing stock options, the incentive of management to take as much as they can and weak individuals on corporate boards, huge options grants routinely get issued to executives and create a climate of excess compensation. The stock option grants can be extremely lucrative for even badly performing CEO’s and can results in legal robbery from shareholders.

At times the stock market and wildly undervalues businesses. Management routinely issues themselves options at these depressed prices. Interestingly enough if a buyer showed up and offered the equivalent depressed price management would insist that the stock market has undervalued the business, but in a slap to shareholders, insiders are willing to sell a portion of the business to themselves at this depressed price locked in for 10 years. Owners are rarely well served by this sleight of hand of pricing options well below business value, ending in a windfall for management and huge loss for shareholders.

It is up to shareholders to stand up to the tyranny and collusion of management and the board of directors and hold them accountable for their pay. Unfortunately, the reality is, although we need LIONS on boards of directors to watch shareholder interests, we often are stuck with ASSES who are unwilling to challenge management.

5. Retained earnings not counted in exercise price. If you put your bank account away for 10 years and let the interest compound your money will grow. It’s exactly the same for the average corporation over time. They retain a big slug of capital every year and reinvest that for a return, which in turn leads to higher earnings. Stock options ignore this basic reality and it is a windfall giveaway to whoever receives them not based on above average performance, but on a lot of retained earnings. It’s as if you got paid a bonus for every time you baby took a crap. Both are guaranteed payoffs for doing shit.

6. GAAP accounting can be highly deceptive of true long term dilution. The current accounting under GAAP uses the treasury method in calculating fully diluted shares outstanding. The main problem is that the treasury method only looks at options that are priced below the weighted average stock price. If options outstanding on 20% of the upside of a company is above this price, GAAP completely ignores this huge potential economic effect in the fully diluted share count. The result can be a fully diluted share count and earnings per share that are highly optimistic of what the dilution will eventually be. In addition this give management more leeway in hiding the effect of large option grants from shareholders.

Conclusion:
Anyone but a compensation committee member can see that there are serious flaws in issuing stock options to executives. Here is a better alternative: Do exactly like Warren Buffett does and pay cash compensation tied to business operating results within an executive or employees control. It will depend on the nature of the business and what is important but cash incentives:

1. Can be tied to business results thus directly linking pay to performance.
2. Will not dilute out shareholders interests.
3. Are simple and transparent to value.
4. Can have long term vesting schedules.
The solution is simple; always vote against giving away a piece of your house. Vote against all stock compensation plans at any companies you own shares in. Then e-mail the board of directors of a company you own shares in a simple statement saying how you disapprove of stock options as they are an asinine way of compensating employees and they should pay cash for measurable results.

Tell anyone who also has shares of this site and we can make a difference against being taken advantage of by unethical CEO and boards of directors who routinely dilute out shareholders and overpay themselves with stock options that are more like bunches of lottery tickets.

F.A.Q’s

1. How do I vote against stock compensation?
It’s very easy. When you receive a proxy in the mail asking you to vote on company matters, vote against any stock compensation plans. Just check the box and mail it back or vote against it using the online proxy. Share plans must have shareholder approval to get issued. If they are never approved then shareholders can’t be diluted.


Keywords
Stock compensation, Stock options, executive compensation, compensation committee, proxy voting,

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