How the tax man can help get us out of this options mess.
As you read this, hundreds of Silicon Valley CEOs are under their desks in full duck-and-cover mode, fearing that the Department of Justice or a shareholder mob might pounce at any time to cart them off for "backdating" or "spring-loading" stock options. The paranoia has gotten so bad that corporate lawyers from San Francisco to San Jose are charging $600 an hour to scour records, all in an effort to clear companies’ reputations before they get besmirched. And it's a good thing — the "everyone was doing it, even Teflon Steve Jobs" defense doesn’t appear to be working.
Whose fault is this? Greedy CEOs? Ambitious human resource pros? The Securities and Exchange Commission? The Financial Accounting Standards Board? Congress? The Immigration and Naturalization Service? In some respects, all of them, but the root cause may be the Internal Revenue Service. And that agency holds the key to avoiding the problem in the future.
Of course, before you can understand how, you have to look at why backdating stock options is so tempting to so many companies. Options, as we all know, are one of the few legal means available to hire and retain great employees. After all, how else can you get those writing code, discovering drugs, or dreaming up marketing strategies to work 24/7? Certainly not with raises and bonuses, those uninspired incentives from a bygone era. Getting employees to send insomnia-induced "just a thought" emails at 1:12 am and thumb-mash BlackBerry keys on the stationary bike at 5:45 am requires a tastier carrot. Options are real, you can’t take them away, and they’re not subject to internal politics. Plus, if you make sure that they take four years to vest, options function as handcuffs, too. Perfect.
But if you give an employee anything of value (beyond health insurance), the IRS insists on taxing it. So brilliant CFOs hit on the idea of handing out options at the current stock price: If the stock is $10 at the time you're given options for 10,000 shares, you have the right for, say, the next seven years to buy those shares at $10 each. So today, it’s worthless, right? As far as the IRS is concerned, yes.
Soon, however, the competition to land hotshot talent led to more extravagant bait. If every company can give (worthless) options, why not offer engineers, programmers, and scientists options that already have value? Hey, that same stock was $8 two weeks ago, let’s just change the date of the option grant and — voilà — free money! No one will notice.
This is really sleazy. If a badass programmer deserves a signing bonus, pay it and don’t try to hide it. Backdating screws existing shareholders who don’t realize they are paying for this perk — issuing more shares dilutes their stake. CEOs and other employees aren’t crooks by nature, but if you leave the keys to a tax-free Ferrari lying around, more than a few will take a joyride. Boards of directors with audit and compensation committees are supposed to prevent this by representing our interests. We rely on them to keep those keys locked up. They failed. At Apple, none other than Al Gore is on the board's compensation committee. He and fellow director Jerome York were all too happy to clear Steve Jobs of wrongdoing. Undoubtedly, countless other boards have either approved the backdating of options or at least looked the other way while it was going on.
OK, so we can't trust companies to price options, but we want them to be able to hire and hold onto smart employees. What to do? It’s quite simple. First, if a company wants to issue shares with value, it should institute rolling pricing. Instead of creating temptation by using fixed pricing dates, just set the value based on the average stock price from 30 (or 60 or 90) days before and after options are granted. Of course, the IRS could still tax these distributions. But they don’t have to, and they shouldn’t. The government will get its bite when the options are exercised. Meanwhile, the agency can just issue a no-comment letter, indicating that it won’t pursue the matter.
And finally, companies need to let us know every time options get issued. We've got 10-Qs, 13Ds, and 8-Ks. It’s time for a 5-O. Option grants shouldn’t be made official until they are filed electronically with the SEC, which now uses a filing format with searchable tagging technology. This information should be used to provide real-time alerts of every option grant and price. The stock market will punish manipulators and excessive granters. This way, CEOs who want to drive the Ferrari will have to tell the world first.
— Andy Kessler