Broad-Based Stock Options:
The Fight is NOT Over
Jeffrey Harris, Warburg Pincus
John Doerr, KPCB
Marc Jones, Visionael
NVCA, May 13, 2004
A Call To Action
• Proposed FASB rule changes will:
– Seriously hamper the entrepreneurial community
– Create misleading financial statements
– Add to the administrative and auditing costs of all
• Powerful forces are advocating these changes
• Time is running out to stem the growing tide
NVCA Position On Expensing
Stock Options
1. Reduces the information value of financial
statements by adding a highly abstract and
contingent deduction
2. Penalizes emerging growth companies who
use stock options to attract, incentivize, and
align employees interests
3. Expensing will reduce the use of stock options,
and stifle new company formation
4. Current option pricing models are not effective
for measuring the value of employee stock
options especially for non-public companies
Public Policy Messages
1. FASB’s actions jeopardize the use of
employee stock options that drive the
entrepreneurial economy and job creation
2. Implementation of new FASB rules
creates less transparent, less consistent,
less intelligible financial statements
3. Implementation expense is a deadweight
on the economy, but a boon to the
accounting and appraisal firms
Current Rules/Implementation
• Companies can expense and/or disclose
the amount of expense in their footnotes
• Intrinsic value at date of grant
• Non-public companies’ common stock
value determined by Board/auditors
FASB Exposure Draft
• “Grant date fair value” in the P&L (footnote
disclosure is no longer adequate)
• Expense determined using complex option
pricing models
• Private company rules
– Fair value at date of grant, or
– Intrinsic value at each reporting date (markto-market)
• Implementation period
NVCA Activity To Date
• Active participation in International Employee
Stock Option Coalition with Cisco, Genentech,
Qualcomm, etc.
• Multiple meetings with SEC Commissioners,
Chief Accountant, etc.
• Meetings with The White House
• Numerous Congressional meetings
• Testimony at numerous Congressional hearings
• Presentation to FASB (August 2003)
• Numerous Op/Ed pieces, considerable media
Effectiveness Of Our Effort
• Pending legislation in Congress
• Parts of the FASB Exposure Draft suggest
some of our message has been heard:
– Flexibility on implementation methods due to
the incremental cost to non-public companies
– An added year for implementation
Today’s Goal
• Provide awareness, resources to learn more
• If you share our concern, Take Action:
– Sign up 2 partners from your venture firm to
drive this initiative
– Substantive letters to FASB
– Personal e-letters to Congress
Why Stock Options?
Broad-based employee stock
ownership…delivers higher returns to the
shareowners of the companies who use
them, produces higher productivity, higher
returns on equity, higher returns on assets,
counting the effects of dilution…
It fuels innovation, and fires the
entrepreneurial spirit.
Source: Craig Barrett, Wall Street Journal, March 31, 2004
Where’s The Expense?
The consumption of a corporate asset
or the creation of a corporate liability
• An option is NOT an expense
• Options DO dilute existing shareowner
• Options do NOT affect revenue or cash
expenditures, or impact company
If Not An Expense, What Is It?
• Options make employees equity partners
• Expensing options confuses a capital
account transaction with a P&L event
• Financial statements aren’t the right place to
create corporate governance policies or
penalize management excesses
Says Who?
From the viewpoint of the grantor
corporation, no measurable cost can be
said to have been incurred.
(Accounting Procedures Committee– FASB
Predecessor, 1950 )
The FASB proposal would reflect, in effect,
a double dip or double cost of capital.
(Eugene M. Freedman, Chairman, Coopers & Lybrand,
February 5, 1993)
Says Who?
A year ago, the Mercury News' editorial board called
for the expensing of options, based, in part, on the
assumption that an accurate valuation method
could be found. That turns out to be a work in
progress. Further, it's clearer now that the abuses
uncovered in recent years won't be solved by
expensing. Finally, the industry's economic policy
argument must be fully studied. For all of those
reasons, Congress should impose a cooling-off
period so that the country can make an informed
choice about how best to serve the needs of
investors and to assess the impact on our
technological future as well.
(San Jose Mercury News, April 1, 2004)
And That’s Exactly the Bill in
• S.1890/H.R. 3574
• Mandates expensing of top 5 officers using
fair value at grant with 0 volatility models
• Exempts small businesses with revenues
• Prohibits broad-based options expensing
until completion of joint study on the
economic impact
• More than >108 bi-partisan co-sponsors
And Now, the Quiz….
C = SN(d1) – Xe-rtN(d2)
d1 = ((Ln(s/x) + (r-y+V2/2))/(V*t1/2)
d2 = d1 – V*t1/2
FASB Proposal Significantly
Overstates Option “Expense”
• Black-Scholes and binomial methods were
designed for freely tradable, fully vested options
• Even if options were “expenses,” their fair value
is significantly less than the value derived from
Black-Scholes/binomial method
• Our conclusion is that the methodology in the
[Exposure Draft] for calculating the fair value of
employee stock options significantly overstates
their fair value, but by how much is pure
conjecture. (Price Waterhouse, December 17, 1993)
Expensing Hurts Investors
• Will investors look through the expense?
– 50% on NASDAQ not covered by research
– Companies will have lumpier quarterly earnings and
higher stock volatility
– Worsens comparability: each company determines
variables for future volatility, option term and dividend
• How can CEOs & CFOs certify under SOX?
– Can’t accurately forecast Black-Scholes input variables
– Even if they could, the “expense” produced by BlackScholes is wrong
Inconsistent with Long-Standing
Accounting Principles
• Financial statements should record historical,
not unknowable future events
• Financial statements should record both the
burdens and benefits of a transaction
– Options cause dilution ONLY if the stock price rises
above the option price – where shareholders obtain a
benefit greater than the dilution
• Paid-in capital should only increase when cash
actually comes into the company
– Paid-in capital increases with option expense even
though no cash has been received
Impact of Expensing Options
• Broad-based stock options in jeopardy
– Need for ‘profitability’
• Slows economy and job creation
– Penalizes emerging growth companies
• Venture backed jobs are 11% of GDP
• 14M Americans hold options
– US less competitive in the global market
• China, India not expensing options
• China's 5 year plan for innovation calls for broadbased employee stock options
Marc Jones is Active
• CEO of Visionael, an enterprise security
• Privately held, 75 employees
• Testified to Senate Small Business
What Can You do? Take Action!
1. If you’re concerned, sign on to this
2. Substantive letters to FASB
– 2+ partners from each VC firm
– CEO & CFO of 20 ventures with each VC firm
3. e-Letters supporting congressional bills
– You and your partners
– Employees in all of your portfolio companies
Take Action 1: Sign on to this
• If concerned, pull out the ORANGE form
• Fill it in and hand in now
– Two names, emails addresses from each
venture firm
• We will help you track progress
– Through a database
– Weekly conference call
• Details to follow via email
Take Action 2: Letters to FASB
• Who: 2+ VC Partners & 20+
Venture CEOs & CFOs
• Deadline: June 15 to express
OPPOSITION to Exposure Draft
• Each letter unique, and
• Send to: [email protected] &
[email protected]
• Reference: File Reference No.
Take Action 3: e-Letters to Congress
• Who: Everyone
• SUPPORT "Stock Option
Accounting Reform Act"
(S.1890/H.R. 3574)
• www.savestockoptions.org, click
on Take Action!
• Personalize as much as possible
• Send an email to all your portfolio
companies requesting employee
• AL, AK, AR, DE, MD, LA, MS, NH,
Have Questions?
Jennifer Dowling: [email protected]
Mark Heesen: [email protected]
Alix Burns: [email protected]

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