The discussion about option grants has been a contentious issue for a long time. In the current discussion here two things have been omitted. The first is the reason option grants became popular and the second is taxes. A discussion of option grants without the tax consequences is not very realistic.
Some time ago the Congress decided that executives were getting paid too much. Their fix was to cap the salaries that could be deducted as expense for income tax purposes. I believe the cap was one million dollars. If an executive got ten million only one could be deducted creating an additional $2,700,000 tax burden ($9 million at 30%). Guess what? Business found a way around the social engineering! Unintended consequences.
As you can see from the linked piece, both the company and the shareholders wind up better off with options than with salaries. But people like Buffett don’t like dilution so he was becoming less competitive. One way to even things out is to expense the options lowering the company’s profits.
June 11, 2002
Every time you guys write something it just gives me something more to think about. I really appreciate all these different view points. It helps me become a better investor. I really hate dilution but after reading your blog I am going to have to think this over.
You can be a pain in the patoot! Up until I read your post the way I dealt with options was to completely ignore them. Now it seems like I should be paying attention. Is this really, really important, or is it another accounting thingy which is in reality materially irrelevant?
brittlerock, thank you for the compliment, if the post made you think it was worth writing!
Accounting was invented to keep track of business. If you want to understand a transaction you use accounting methods. Accounting is not an exact science, record keeping is subject to the discretion and good sense of the accountant.
While not a CPA, I have studied and practiced accounting. Option Math is my interpretation of the effect of option grants on the company, on the employees receiving the grants and on the shareholders. Others may differ. Warren Buffett, more than likely, is one who would.
Why was Buffett so vehemently opposed to stock option grants? Because it goes against his interests. Buffett is one of the best – if not the best – investor of our lifetimes. The Buffett you see on TV, at annual meetings and other public performances is not the “complete” Buffett. There is nothing sneaky or underhanded about it. Buffett has said publicly that he will not disclose all, only what is required and beneficial to Berkshire-Hathaway.
What Buffett does not disclose we have to guess at. Buffett’s thesis revolves around investing using cheap money, other people’s money, money that is not easily callable. In a word: “float.” Anything that dilutes his holdings is bad. Paying high executive salaries is bad for him. Letting the competition pay high salaries and not take a hit to the bottom line puts Berkshire-Hathaway at a competitive disadvantage. It is in Buffett’s interest to have option grants expensed even at the cost of destroying GAAP even more than it already is.
All the above is my own interpretation. Others may differ. As far as I’m concerned, Option Math is not “another accounting thingy” but others may differ. But ask yourself this: Why was Warren Buffett so adamant about destroying employee stock options? My best guess is that it’s a good thing that he can’t or won’t use. If option grants were irrelevant he would not have campaigned against them.