| Stock options are a horrible method of | | | | and let the interest compound, your money will |
| compensating employees because there is a high | | | | grow. It's exactly the same for the average |
| cost of dilution, a lack of pay for individual | | | | corporation over time. |
| performance which ruins incentives, difficulty in | | | | 6. GAAP accounting can be highly deceptive of |
| valuing options, a tendency towards wretched | | | | true long term dilution. The current accounting |
| excess compensation, a giveaway to | | | | under GAAP uses the treasury method in |
| management because fixed exercise prices ignore | | | | calculating fully diluted shares outstanding. The |
| the earnings that are retained by a company | | | | main problem is that the treasury method only |
| every year and because GAAP accounting can | | | | looks at options that are priced below the |
| minimize the apparent dilution. In contrast, cash | | | | weighted average stock price. |
| compensation tied to business results which an | | | | 7. Incentive Stock Options are generally not tax |
| executive or employee has control over, remedy | | | | deductible for companies. Incentive Stock Options |
| and correct these problems. | | | | (ISOs) are often a key component of option |
| Here are the main problems with Options as | | | | plans issued by companies to employees. If a |
| compensation: | | | | company and employee follow basic ISO rules, |
| 1. Dilution can be disgustingly costly over the long | | | | the company CANNOT claim a corporate income |
| term. Many companies routinely issue stock | | | | tax deduction at any time for the ultimate value |
| options and shares, which can easily dilute | | | | given to an employee. |
| shareholders by 10% over a 10-year period. | | | | Conclusion: |
| 2. Stock Options are a horrible incentive. | | | | Anyone can see that there are serious flaws in |
| Employees receive stock options whose value is | | | | issuing stock options to executives. Here is a |
| tied to factors over which they have no control. | | | | better alternative: Do exactly like Warren Buffett |
| 3. Long-term stock options are difficult to value. | | | | does and pay cash compensation tied to business |
| Black-Scholes (B.S. for short) doesn't take into | | | | operating results that are within an executive or |
| consideration basic fundamental valuation. | | | | employees control. It will depend on the nature of |
| 4. Egregious compensation. Because of the | | | | the business and what is important but cash |
| complexity in valuing options and weak individuals | | | | incentives: |
| on corporate boards, huge option grants routinely | | | | 1. Will not be highly dilutive to shareholders. |
| get issued to executives and create a climate of | | | | 2. Can be tied to business results thus directly |
| excess compensation. | | | | linking pay to performance. |
| 5. Retained earnings not counted in exercise price. | | | | 3. Are simple and transparent to value. |
| If you put your bank account away for 10 years | | | | 4. Can have long term vesting schedules. |