In Defense of Repricing Stock Options

This is actually news from last week, but Google announced that they are repricing their employee stock options.

John Batelle has fairly representative coverage on his blog.  His post cites coverage from Adam Lashinsky at Fortune (a personal favorite as a journalist) with a fairly typical dig on the issue.  Here’s the actual quote:

One last item of note. Google is offering employees the opportunity to exchange underwater stock options for newly priced options due to the stock price having been hammered. (The only catch in the exchange is that employees will have to wait an additional 12 months before selling re-priced options.) The stock price is  currently around $300, compared with $700 in late 2007. The number of shares eligible for exchange is about 3% of the shares outstanding, and the exchange will result in a charge to earnings of $460 million over a five-year period.

One must re-phrase this last bit in English: Google is transferring almost half a billion dollars in wealth from shareholders to employees, and for what ….? Motivation and retention, says Google. This a well known farce, as old as the Valley, which tells itself first that it offers generous stock options as a form of incentive and then, when share prices plummet, moves the ball so its employees, whose incentives apparently didn’t work (as if the stock price were under their control) can be re-incentivized. Retention? Would someone please tell me where the average Google employee is going to go right now?

To be clear, there have always been people who have a significant problem with employee stock option repricing, and with good reason.  Theoretically, options are supposed to align employee interests with shareholders.  In an ideal world, the employee wins if the shareholders win.   Repricing, therefore, breaks this model, because, after all, no one reprices the shares purchased by outside shareholders when the stock tanks.

Somewhere in the post-2000 bubble hangover, this criticism went from being a common argument to conventional wisdom.  Accounting standards were changed to require the expensing of employee stock options, and stock option repricing became largely verboten.

I rarely see anyone in the financial press explaining anymore why, in fact, there are very good arguments for stock option repricing.  So, I’m going to take a quick crack at it here.  Even if you disagree, it does a disservice to not reflect both sides of the argument fairly.

First, and foremost, it’s important to note that, while options are intended to help align employee interests with shareholders, stock options, in fact, do not do this in all situations.  The problem is the inflection point in the curve.

picture-11

This is a simple chart that shows the intrinsic value to an employee of a stock option with a strike price of 50 at different stock prices.  Notice the blue line, which is stock, actually reflects a 1:1 ratio of value.  If the stock is worth $10, the employee gets $10, etc.  For the stock option, however, there is a “break” in the line.  Below $50, the employee gets $0.  Above $50, the employee gets $1 for every $1 of stock price increase.

In general, employee stock options are granted at the strike price of the stock roughly on the date that they join.  So, the assumption is, this aligns the employee with gains after they join.  In theory, it’s even better than stock, because if the stock drops, they get no value for gains made before the date of their join.

This sounds good in theory, but we know that it has real problems, on both the upside and the downside.

On the upside, most stocks go up every year.  (Yes, I know.  In 2009, it’s hard to remember that.)  If the stock market itself goes up 7% every year, then an employee will see real returns on their stock options for just “matching the average”.  In fact, they can actually see real material gains over long periods even by underperforming their benchmark index.

However, since shareholders also enjoy that benefit, it tends to only get complaints when you see incredible gains by executives with huge option packages.   No one likes to see an outsized pay package for undersized performance.

On the downside, however, the problem is much more severe.  Let’s say our stock example from above drops to $25, a price that the company hasn’t been at for 3 years.  The good news is that shareholder alignment works, to a point, as advertised.  Not only are shareholder gains for the last 3 years wiped out, but so are the option grants for employees who joined in the last 3 years, and even any other employees who received grants in the past 3 years.

That part seems fine… at first.

Where does the company go from here?  Now we need to talk about the principle of sunk cost.  Sunk costs are costs that cannot be recovered, and therefore should be ignored when making future investment decisions.  (More rigorous explanation on Wikipedia).  For stocks, it’s important to remember the stock market does not care what you paid for a stock.  It has no memory.  The question for a shareholder (barring external effects like taxes, etc) is purely where you think the stock will go from here.

But now we see that the employee is no longer aligned with the shareholder!  From $25, most shareholders would love to see a gain of 20%, which would take the stock to $30.  But for employees, a $30 share price and a $25 share price mean the same thing:  $0.

Worse, if employees leave the company, and get a job at a new company, they will get option prices at today’s stock price.  In fact, if the employee quits the company, and then is rehired back, they would actually get their options priced at today’s stock price.

In a world of at-will employment, this is a big problem.  True, as Adam Lashinsky pokes at, most employees won’t be able to find a new job so fast.  But many of the good ones can.  And they will.  Because your competitor can actually come in with in a simple, fair market offer for the employee, and beat your implicit offer of zero.  Even if they don’t do it today, these problems tend to persist for long periods of time, and employees have long memories.  You may find that your best talent starts leaving, and then you get snowball effects because great talent is hyper-aware when other talent leaves.

So what is a company to do?

In a perfect world, the company would have a very tight and accurate evaluation of their best talent, and would target “retention compensation” proportionally to their people based on their value.  This would both minimize the risk of flight, and would also help “re-align incentives” for the gains going forward.

Unfortunately, the mechanics and accounting of repricing makes this fairly prohibitive.   As a result, it tends to be an all-or-nothing option.

The truth is, repricing stock options can be one of the best things to realign employee incentives going forward.  It resets the vesting period, basically treating employees like new employees.  The employees do not get to go back in time and recover their equity compensation for the past three years.  The new vesting period basically wipes out the history.  They literally no longer own the rights to the shares – they have to re-earn them.  In fact, if the employee quits the next day, they will take no stock with them, even if they worked for the company for three years.

As a result, stock option repricing actually re-aligns employees more closely with shareholders than nay-sayers give credit for.

Last thoughts

While I am explaining the reasons why repricing stock options makes sense, there is still the significant problem of “repeat abuse”.  If employees believe all options will be repriced for all drops, then you end up with a moral hazard, where you might actually want to drive down the price, get your options repriced, and then recover easy gains.  True, the market is fairly hostile to repricing due to the accounting charge, so it’s unlikely this would happen, but it’s still a real concern.

As a result, my recommendation would actually be that companies faced with this situation actually use the opportunity to not reprice stock options, but move to actual stock-based compensation.  Both have an accounting charge, but actual stock-based compensation serves three purposes:

  • The new stock grants can be better targeted to employees based on performance and value
  • The new stock grants have immediate value, serving as a kind of retention bonus
  • The new stock grants align the employee with shareholders going forward in both up and down markets

So while I do believe that repricing stock options gets a “bum wrap” in the financial media, I also believe that there may be potentially better compensation alternatives, particularly for public companies.

Obama Inauguration in Legos

I have to say, I am completely uninterested in the inauguration “event” that is going on right now.   Then again, I’m not really into the Academy Awards either.  My guess it has something to do with the amazing amount of real work to be done, and the amazing amount of time, effort and money being thrown instead into a party in Washington D.C.

In any case, of all the inauguration coverage, so far I’ve found this piece the most interesting:

That’s right, the entire inauguration, including hand-built mini-figures of over 1000 people, including the entire Obama family.  Note, these are not the typical mini-figs – they are actually 4-inch people made of lego blocks.  Amazing.

Now that’s historic.  Thank you, LA Times.

The Fifth Cylon as a Traffic Driver

I know I posted on this topic last week, but I thought I’d add an update after the big Battlestar Galactica debut this past Friday.  Interesting to see how frak parties everywhere translated into traffic.

So far, despite the debut on Friday, it looks like my traffic may have peaked yesterday, on Saturday.  5380 hits to the blog that day, with my most popular BSG posts taking the top 5 slots for article popularity.

Why?  Check out the top 10 referring searches from Google, Yahoo, etc:

top-queries

Notice a pattern?  I’ve discovered that my blog post is the number one result in Google for the search “fifth cylon”.  At least, it is today.

2009 Ultra High Relief Double Eagle Gold Coin Available on Thursday, 1/22

The US Mint has announced that the 2009 Ultra High Relief Double Eagle Gold Coin will go on sale at 12:00pm EST on Thursday, 1/22.


It’s unclear what demand for this coin will look like, given its price.  (Likely $1200).  This announcement reflects the new US Mint pricing strategy for precious metals – basically a premium over market price, in buckets.  Still, gold coins continue to exhibit considerable demand, and this is an extremely flattering classicly-designed piece.

You can read more about the coin here on my blog, or here on the US Mint website.

Update (1/20/2009): Found this product page today on US Mint website.  Price is $1189.00, and delivery might take 6-9 months!  Limit one per household.   Talk about delayed gratification.

Read Lag Problems on Seagate Freeagent 1.5TB External Hard Drive on Mac OS X

This is one of those quick posts that I write hoping to save others a lot of time.

For the past two weeks, I’ve been trying to diagnose and fix problems I have been having with my external 1.5TB Seagate Freeagent Hard Drive.  I use the hard drive as my iTunes library, which I drive FrontRow using Mac OS X 10.5 on a Mac Mini on a 1080P LCD TV in the living room.

Basically, it’s our video server.

The problem was as follows:

  • Loading Front Row, we’d easily get to the list of movies (I have about 500+ movies on the system)
  • Flipping between titles, however, there would be a 3-5 second lag before the cover art and title of the new movie would load
  • The lag would also occur periodically while scrolling
  • The light on the front of the hard drive would pulse, instead of glow straight, during video operations

Needless to say, with a video library driven by remote, this type of lag is intolerable, and makes navigating a 500+ movie library incredibly frustrating.

After doing a number of Google searches, I found reports of read/cache problems on Mac OS X and Linux with the 7200.11 drives.

Here is an official note from Seagate on the topic, and here is a community thread on the issue.  Thinking I needed new firmware, and since there was no download on the website, I resigned myself to calling technical support.

I called Seagate Technical Support, and after waiting 20 minutes, I got on the phone with a man who had never heard of the issue, had no idea how to get the firmware for an external drive, and no idea what a Mac is.

Fortunately, while he put me on hold for 15 minutes on 3 separate occassions, I had time to think.

The problem cited on line was a read issue with video, but it seemed to focus on RAID setups.  That didn’t sound like my situation.  The light was pulsing, likely because the drive was trying to lower power use.  Why would it do that?

Answer: Maybe it was overheating because I had it in the cabinet with the sattelite receiver, which is warm, and there is poor ventilation.

So, I took the drive out the cabinet, and reattached it in the open air, on top of the cabinet.

Problem solved. Video navigation is snappy, and the light no longer pulses.  Clearly, because of the heat, it was going into low power mode in some way to try and cool itself.  That would lead to lags when it spun up for a read request from FrontRow.

So, if you have a Seagate Freeagent Extreme drive, and it exhibits this behavior, make sure it’s not overheating in an enclosed space.

As a funny aside, not only did I solve this entire problem while listening to hold music with Seagate Technical Support, I also wrote this entire blog post.  The guy is *still* off somewhere, trying to find the firmware revision for my model of drive.  I’m worried that he booked a flight to Malaysia to investigate the manufacturing of this drive personally.

Oh well.  The end story:

Unventilated enclosure for hard drive, BAD.  Seagate Technical Support, TERRIBLE.  1.5 TB iTunes Hard Drive, GOOD.

Update (1/20/2009): Unbelievable.  It looks like Seagate released the firmware patch for the 7200.11 hard drives this week, and it actually bricked the drives.  Not for me.  I’m watching this thread, and I’m not installing anything from Seagate until it’s safe.

Bernie Madoff: YouTube Justice

I haven’t posted here to date on the Bernie Madoff scandal.  No sense writing a huge amount on the topic at this point – it’s been well covered elsewhere.  Let’s just summarize my feelings as:

  • We will never see an end to Ponzi schemes, because they work.
  • This exposes some of the flaws in the fund of fund approach to hedge funds.  Picking a manager is almost impossible, adding a level indirection truly is. (courtesy Dave Swensen)
  • The level of scandal for absconding with billions is historic.  The number of charity dollars, particularly from the Jewish community, is truly shocking, and likely deserves its own, new circle of hell (for those Dante fans).
  • There is no punishment that can fit this crime.  The impact will literally be felt by millions.
  • This failure will likely be used as a scapegoat and excuse to permanently damage the hedge fund industry in ways that may materially harm our markets for decades. (knee-jerk, political grandstanding regulation)
  • We still haven’t heard the worst of it.

Now, among friends, I’ve joked that while I’ve heard the expression “death by a thousand cuts”, this situation seems to be a good opportunity to actually test that theory out.  (yes, dark humor)

For my birthday, my brother actually forwarded me this Youtube video, and I couldn’t stop laughing.  So I’m posting it here, since it seems to have a shockingly low view count.

Enjoy.

Would You Ship a Broken iPhone to Réunion?

My brother dropped his iPhone in the Pacific Ocean.  An original, $399 iPhone.

Needless to say, saltwater does not do good things to an iPhone.  It doesn’t boot anymore.   No recourse with Apple or AT&T.  He had to get a new phone.

As a result, I ended up with my own variant of Pierre Omidyar’s famous broken laser pointer… I listed the broken iPhone on eBay.

Well, it sold today, for $122.50.  However, it sold to an international buyer… in Réunion.

Réunion, as it turns out, is a little island in the Indian Ocean, off the coast of Madagascar.  It is a French island, and happens to be the first place in world (due to time zone) to adopt the Euro.

So, would you ship a broken iPhone to Reunion?

They paid with PayPal.  All the info lines up, roughly.  eBay has a hotmail address for the user, but the payment came from a wanadoo.fr email address.  However, the name and address on both is the same, although eBay lists United States for the registered country (with the Reunion address).

That could be a sign of fraud.  Or it could be the sign of a user who moved.  eBay data is pretty messy at times.

He has made recent purchases with positive feedback.  A cheap piece of wireless equipment, and an expensive ($259) piece of tree climbing equipment.  So, not just trivial items.

So, do I ship it?  Not sure.  The worst that would happen is that the credit card would end up being stolen, so PayPal would seize the funds.  And I’d be out a broken iPhone.

But, on the plus side, selling to Reunion is a new destination for me.  I’ve sold to over 30 countries on eBay at this point, and it’s getting harder to attract buyers from new ones.

I think I’m going to ship it.

People are basically good… right?