Thursday, October 27, 2005

Options backdating is not always unreasonable

Stock options as a component of employee compensation are intended to serve a simple purpose: tie the employee's future to the value of the company, so he is rewarded for any increase in value that he contributes to. Motivated thus, an employee frequently chooses behaviors favouring company performance. "Do the right thing."

The challenge is, how do we figure how much the company increased in value? For that matter, what is a company worth?

The easy measure is the current capitalisation of the company. To wit: multiply stock price by the number of outstanding shares. Very simple.

And being simple, arguably wrong, or perhaps more accurately, sometimes wrong. Notably in cases of speculation.   Create a bunch of buzz around future products and the stock price can run up a lot. Stock prices are benchmarked in terms of company earnings, but Price/Earnings (P/E) ratios can vary wildly depending on speculation on future company growth.  And this is only speculation - the company has no new products or technology (yet), no new revenue (yet), and so is at least arguably not worth any more than it was yesterday or last month.

So in compensating an employee to help build the products the industry is speculating on, what is reasonable as the basis for a grant? To value the company for purpose of that grant in terms of the inflated stock price, where the growth in value driven by the new product is already factored? Or the pre-speculation price so he can benefit from the value of the product he builds?  The pre-speculation price seems to me to be more consistent with the rationale behind granting options in the first place. So one might reasonably back-date the options grant (or perhaps more precisely, the grant price) to the stock price several weeks or months ago, when rumour and news started driving the price up.

None of this is to say that there hasn't, isn't and won't be abuse and fraud in the granting of stock options, but that is being covered pretty thoroughly elsewhere. Use your favourite search engine and you'll find as much as you care to read.

Disclaimer: Working in the tech industry, stock options have been a feature of my comp plans for years. None, however, have ever been backdated.

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