Most of us are quite aware of a new, brewing scandal — the stock option scandal. It has been revealed that some companies have “cooked the books” when it came to reporting dates of stock option grants.
The purpose of misdating the stock option was to accommodate executives by giving them the possibility of a higher profit when they cash in their options. Surprisingly, it appears that Silicon Valley is the scene of a disproportionately large amount of this activity.
The Mechanics of Stock Options
Actually, stock options work in a rather straightforward fashion. Whether you purchase a stock option, or an employer corporation grants it to you, you are thereby given the right to acquire stock during some future period at a “strike price.” The strike price is the price per share for which the underlying stock may be purchased.
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However, you don’t have to actually purchase the stock at some future date. You can merely turn in your option and obtain the difference between the strike price and the then current market price of the stock. The transaction is seamless to you in that you don’t have to go through the effort of first purchasing the stock at the strike price, and then selling it at the current market price in order to realize your gain.
You can obviously see how appealing stock options are for attracting and keeping key executives. In some cases, the bulk of an executive’s compensation comes from exercising stock options granted earlier by its employer corporation.
Backdating Stock Options
What has created this so-called scandal is the fact that some corporations have backdated stock options in order to achieve the maximum benefit for the recipient. For example, a stock option may be actually given to you today, the grant date, but dated a month earlier.
Why do this? Well, let’s say that today’s stock price for the granting company is US$20 per share. The corporation could backdate the option to a time when the stock was $12 per share.
This grants an immediate advantage to the recipient in that he/she can exercise the option today, or at some later date when the stock price is even higher, and realize a profit based upon the $12 strike price for the options.
Legality and Consequences
Actually, believe it or not, this date manipulation, in and of itself, is not necessarily illegal, but the company must fully report the discrepancy in its financial statements and in its governmental filings.
Transparency has been and will continue to be the key. Stockholders and regulators must always be accurately apprised of the goings on of a corporation. By the way, inadvertent errors usually don’t result in large fines and jail sentences.
It all goes back to the spirit of the Sarbanes-Oxley (SOX) law and why it was enacted — remember Enron, et al? My concern is that if, upon further SEC and other regulatory probing, it is found that not only did many companies backdate options, but they also hid the backdating from the regulators, the expected relaxations of SOX, especially for the benefit of the smaller companies, will never happen.
Additionally, there have recently been fewer Initial Public Offerings (IPOs) in the U.S., while there has been a good amount of offshore activity. Some experts feel that one of the reasons for this dearth of IPOs is the aversion by many companies to SOX. It would be a shame if this option problem gets out of hand and makes the U.S. less competitive in the IPO arena.
Is Silicon Valley Being Targeted?
About 200 companies are presently being scrutinized by the regulators for backdating their stock options. One can only hope this number won’t grow, but will eventually decline once some of these companies in question have been cleared of regulatory misbehavior.
It does seem that Silicon Valley is disproportionately represented among the companies being investigated today, however. I have several theories as to why this is so. First of all, Silicon Valley has, in the past, been quite active in using stock options to attract and keep key executives. Perhaps the Valley has been more active than others when it comes to utilizing this method of rewarding and compensating executives.
Another reason could very well be that the entrepreneurial spirit is alive and well in Silicon Valley. With this spirit come innovation, a keen competitive sense, and a rather healthy appetite for risk taking. Perhaps these entrepreneurial qualities are part of the cause of the current stock option problem.
I haven’t yet seen a study that talks to this point. My guess is that between the historical high use of stock options by Silicon Valley, coupled with its rightly deserved reputation as a major worldwide source of entrepreneurship and innovation, the odds of some sort of abuse in stock options might be rather high.
Let’s Get This Behind Us
Within about one year, we’ll certainly know of the extent of Silicon Valley’s involvement in the stock option scandal, and we’ll know of its impact on our existing laws, like SOX. At this point, I feel that SOX will not be negatively impacted by the misuse of stock options.
Stock options remain very much a valid way of rewarding executives. Even the backdating of options is not necessarily illegal. What is illegal is misrepresentation of a company’s stock options practices to the general public and to regulators.
So, on balance, I am optimistic that this latest “wrinkle” in corporate governance will be “ironed out” without too much discomfort. Companies that are transparent in dealing with the public and the regulators have the least to worry about.
Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at Ted@capitalsourcepartners.com.