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Stock Option Scam

Several European Technology Firms pulled a tried and true American trick out of their hats to transfer wealth from stockholders to employees. It is not a move that was good for US stockholders, and it might be time to kick up a fuss about it. These firms are re-pricing employee stock options that are currently worthless.

Spanish mobile telephone operator Telfonica Moviles SA and Marconi PLC are asking shareholders to approve plans that would bale out employees with expiring options that are worthless. Stockholders generally approve such plans because management argues they are necessary to retain employees.

This is a double standard that needs to be looked at by investors in firms on both sides of the Atlantic. When the stock market was booming companies gave lavish stock options at below market prices to their employees as a reward for a job well done. It was done to retain them and was legitimate when those efforts led to increased shareholder value.

Now, the situation is not the same. These employees who benefited greatly from the bull market are now going to be insulated from the fact that things have changed. Be it business conditions, factors controllable or not, the fact is shareholder value has suffered. Why shouldn't employees feel some of this pain? Maybe it will motivate them to help the company make more money?

The problem with the way many companies use employee stock options is this. Issuing stock is like printing money. If a company has a lot of shares outstanding, adding a few more shares won't really change things. If you print too much money, eventually the value of the money goes down. Same thing works for stock.

Take the example of XYZ corporation. It has 1 million shares outstanding, valued at $10 a share, giving it a market value of $10 million. What the stock market really does is discounts the future earnings, and other things of value of a company. For various reasons, XYZ corporation is valued by the market overall at around $10 million. If XYZ corporation prints up 100,000 shares and lets employees buy them at $5 a share, there is a potential problem.

The problem is nothing at the company changed fundamentally. The value of the company is still $10 million as far as the market is concerned. But now there are more shares to spread that value over. In our example XYZ company has 1.1 million shares outstanding. If the market doesn't decide the company is worth $11 million, then who gets hurt?

XYZ company now has a value of $10 million and 1.1 million shares outstanding. All things being equal, the value of those shares sinks to $9.09 a share. The employees who got the options at $5 are still pretty happy. They can turn over those shares on the market for a quick 80% profit. The stockholders just took a 10% hit. Wealth was transferred from the stockholders to the employees. The question then should be, why do stockholder tolerate this?

This can happen with larger companies as well. Dell Computer issues millions of new shares every year below market as part of their employee compensation. Those shares pile up and over the long haul can dilute the value of the company. In all fairness, Dell purchases millions of share of their stock back, taking them off the market.

Not all companies are as ethical as Dell. The issuance of employee stock options can over time in a very stealthy way transfer wealth from the stockholders to the employees. Often times these plans transfer great wealth to the top few managers at a company.

It is important for stockholders to be aware of this. If management isn't doing a good job increasing shareholder value, then maybe they don't deserve a rich stock option package.

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Shmuel Protter
investmenttool.com

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