Kip Hagopian

Exchange with Professor Samuelson 

About Stock Option Expensing

Kip Hagopian to Paul A. Samuelson

Dear Professor Samuelson,

I am sorry if I intruded on your day. I really didn’t expect you to pick

up the phone; I was expecting to talk to your assistant.

As I said on the phone, Charlie Wolf suggested I contact you to see if you had an interest in the Employee Stock Option (“ESO”) expensing issue. I gathered from your comments on the phone that you have both an interest and a point of view. I also inferred that your point of view is at odds with ours. Nonetheless, I am hoping that you are sufficiently curious that you will be willing to read the enclosed paper. As I said on the phone, excluding exhibits, it is only 12 pages and includes a one page Executive Summary.

I regret that I didn’t do a very good job conveying an oral summary of

our case against expensing. This is a very complex subject that doesn’t

lend itself to a short explanation. I hope that the Executive Summary

will provide the summary you are looking for.

Given your obvious skepticism, there are a couple of things I would like to point out. First, you will see that our case against expensing is based solely on the accounting aspects of this issue and is not based on either the potential damage expensing will do to the technology sector of the economy or on the difficulties of measuring the value of an ESO. Both of these latter arguments were made repeatedly by the tech industry coalition during the debate. In our opinion, these arguments are not really relevant in deciding the issue; rather the debate must center on what is proper accounting. Unfortunately, (in my opinion) the accounting case did not really get a fair hearing during the FASB deliberations. Second, while we do not believe that the grant (or the vesting) of an ESO is an expense to the granting entity, we do believe ESOs can have an economic cost. As you will see in the paper, our position is that the cost (if any) is borne by the shareholders and is already measured and disclosed (albeit not clearly enough) by a standard accounting convention.

If you turn to the list of signatories, you will see many familiar names. I think you will agree that all of these people are substantive and well qualified to opine on this subject.

I am anxious to hear your reaction to the paper, whether positive or negative. We believe we have analyzed this issue correctly, but of course we could be wrong. We are seeking truth, so if you find flaws in our logic we would very much appreciate it if you would take the time to point them out. Of course, if it turns out that you agree with us, we would be thrilled if you would like to join our effort to get this point of view heard by the SEC.

I hope you have a great Thanksgiving.

By way of introduction, a few words about me:

During my career, I served as President and Chairman of the National Venture Capital Association. I also served on President Ronald Reagan's Business Advisory Panel and on President Reagan's “Commission on Industrial Competitiveness”. (When I was on President Reagan's Business Advisory Panel, I headed the committee on “Capital Formation, Innovation and Productivity”, and wrote the Committee's report to the President on this topic. Michel Boskin was an advisor to this committee and is still a good friend of mine.) I have testified before Congress, have beell published on tax policy and lectured at both the law and business schools at UCLA.

Among other boards, I am currently on the Board of Governors of the Pardee RAND Graduate School of Public Policy, which is how I know Charlie Wolf.

Kip Hagopian

Paul A. Samuelson to Kip Hagopian — November 29, 2005

N1r. Kip Hagopian

11150 Santa Monica Boulevard 

Los Angeles, CA 90025

Dear Mr. Hagopian,

What is “good accounting” is only what is good Economics. If, for whatever fancied business reason, my employer gave me instead of a taxable wage bonus 5 dated puts and 17 dated calls of designated exercise prices on respectively the S&P 500 index and the Bank of Boston listed stock, your (ridiculous?) point (3) would say (by “definition” of somebody or something) that not until I go laughing all the way to the bank with the realized profits on my positions will there be created for the first time a cost to the company.

No. I say, Today the Black-Scholes value of the five puts and the seven calls is taxable income to me and today the expense of buying those 12 options is a deducible cost to the company. Does it matter if the company did not shell out to buy those options, but instead guaranteed to pay me exactly what I would have got from owning them and exercising them at any later date of my choice? Not at all. The company is selling me for zip what is a calculable cost to them. Get serious. Option theorists know N ways for me to sell for hard cash now the options granted me today.

The high IQ Milton Friedman I’ve known for 69 years can be expected to agree with what is good economics. Did you check his penmanship signature before claiming him as a signatory?

Sincerely, 

Paul A. Samuelson

P.S. My usual fee for writing out good economics like this would be much more than your group could afford. As a friend of the public, in court I would do it for nothing.

cc: 

Charles Wolf, Rand Corporation 

Professor Milton Friedman

Kip Hagopian to Paul A. Samuelson — December 6, 2005

Professor Paul A. Samuelson 

Massachusetts Institute of Technology 

Department of Economics

50 Memorial Drive

Cambridge, Massachusetts 02142-1347 

Dear Professor Samuelson,

Thank you for taking the time to read the paper I sent you on Employee Stock Option (ESO) expensing and for responding so promptly. While I don't expect that we will agree on this subject, I feel your letter calls for a reply.

With respect to your statement that the issuance of puts and calls should be an expense, I agree with you. If a company, in lieu of wage income, gave an employee puts and calls on the S&P 500 and the Bank of Boston, there should and would definitely be an expense recorded on the company's books in an amount equal to the value of the options. (If the company purchased the options from a third party underwriter the price paid would be the company's expense; if the company wrote the options, it would be the FMV based on Black-Scholes or some other pricing model.) But I do not believe your analogy is valid with respect to employee stock options. It appears to me, with all due respect, that your puts and calls example reflects either a misunderstanding of what the paper says or an insufficient appreciation of the differences between an ESO and a transferable option. Perhaps the paper is unclear, but on page 8, Section IV (entitled “ESOs do not Meet the FASB's Definition of an Expense”), there is an explanation of how different these two instruments are and why they should not be accorded comparable accounting treatment.

The reason that the issuance of a transferable option would be an expense is that a transferable is convertible into cash and its issuance without consideration would clearly represent an opportunity cost in the amount of the cash forgone by not selling it on the open market. In other words, transferable options are like currency. In contrast, ESOs (which are not even options until they vest) are, by their learns, (1) not transferable and (2) prohibited from being used as collateral for a loan. Thus, there is no way to realize a cash benefit from them until they are vested and in the money. You state that: “Options theorists know N ways ...to sell for hard cash now the options granted...today”. As a venture capitalist and board member, I have been granting ESOs for over 30 years and I have never heard of a way to do that without violating the terms of the ESO.Recent conversations with option experts at Citigroup (Smith Barney) have confirmed this. These experts are unaware of any options dealers on Wall Street that have ever monetized an ESO. Can you please refer us to someone who can tell us otherwise?

The accounting definition of an expense, simply stated, is a transaction made in the conduct of the business, which results in the reduction of an asset account or an increase of a liability account. In my opinion, this also qualifies as the economic definition of an expense. We argue, that neither the grant nor the vesting of an ESO meets that definition. Perhaps we are wrong. But if so, we need to know which asset account is diminished or which liability account is increased as a result of either the granting or the vesting of an ESO.

In my view, the only way the grant of an ESO can be an expense, is if it can be shown that the grant represents an opportunity cost (Bodie, Kaplan and Merton, writing in the March 2003 Harvard Business Review, based their entire case for expensing on the opportunity cost argument). It is argued in the section of the paper that starts on the bottom of page 7, however, that (1) because of an ESO's unique terms, (2) because its issuance is limited to employees (or consultants and directors), and (3) because its only purpose is for incentive compensation, the act of granting an ESO cannot be an opportunity cost. Perhaps this is wrong. Please tell me what you disagree with in this section.

I know that it is counterintuitive to think that ESOs are not an expense. There is no question that an ESO has real value to the recipient; so how can there not be an economic cost on the other side of the transaction? The answer is, there may be such a cost, but not until the ESO is in the money. And when the cost occurs it will be in the form of a decrement to a gain. This is what defines an ESO as a gain-sharing instrument (see Section II of the paper), and why it is stated in point three of the Executive Summary (which you referenced in your letter) that there is “no cost unless and until there is a gain.” (Note: The puts and calls in your analogy are not gain-sharing instruments; they are simply an alternative form of guaranteed cash compensation.) In the case of an ESO, the gain is shareholder stock appreciation and the cost, which is not incurred until the gain occurs, is a decrement to the shareholders' stock appreciation. Since the gain is reaped by the shareholder, that is where the cost is incurred. This cost is in tha form of a transfer of value from the shareholders' balance sheets to the employees' balance sheets. The company's financial statements are not affected. This value transfer from shareholders to employees is fully accounted for by a standard accounting convention that is described in Section III and Exhibit 1.

All of the above references to “cost” should be qualified as follows: As stated on page 6 of the paper: “The objective of an ESO plan, like any other incentive compensation program, is to increase employee productivity, and in so doing, to raise the market value of the enterprise to a level in excess of the value that might be attained if the plan did not exist. If this objective is achieved, the use of an ESO plan will result in a net economic gain to shareholders, not a cost.” This means that the “gross cost”, the decrement to the shareholders’ gain, will be more than offset by the “increase in market value from the incentive effects of the ESO. Of course, if “too many” (no one knows what is too many) ESOs are granted there could be a net economic loss as well. But the determination of whether the grant of ESOs will ultimately end up as a net gain or a net loss should be made by the marketplace and not by accountants.

A couple points of clarification: (1) With respect to yOUf “...laughing all the way to the bank...” comment, you may be surprised to hear that even before the adoption of the new expensing standard, when an employee realized profits from an ESO, the granting entity did not record an expense for reporting purposes. The IRS, however, did and continues to allow a tax deduction of the employee's gain at the time the gain is taken. Perhaps that is what you are thinking of. As stated in the paper, the cost of the ESO was and still is reflected as a transfer ol value from the shareholders to the employees. This value transfer is in addition to the charge now being required on the company's books. (2) In your second paragraph, you say that the B-S value of the puts and calls is taxable income to you, etc. That is true in the case of transferable puts and calls, but it is not true for an ESO which has never been taxed at the grant or vesting date. To my knowledge, the IRS has no intention of changing this policy as a result of the new accounting standard.The primary stated reason that the IRS does not tax ESOs on the grant or vesting date, is because there is no “readily ascertainable value” for them on those dates. If, in fact, there were a simple way of turning ESOs into cash, I suspect the IRS might take another look at this regulation, since the receipt of an ESO would then be constructive receipt of cash income. (3) In your second paragraph, you make reference to the company (I'm paraphrasing now) “...guaranteeing to pay you exactly what you would have gotten from exercising the option (the spread) at a later date”. I'm not sure what you are referring to here, but in the case of an ESO, the company makes no such guarantee, nor does the company ever pay the employee anything in cash. The grant of an ESO is a completely non-cash transaction (a fact that should give us pause).

Again, I would like to thank you for your time. It is important for us to hear challenges to our thinking. It causes us to dig deeper into the subject matter for the right answer. As I say in Section V on page 10, reasonable people do disagree on this very complex issue.

Sincerely, 

B. Kipling Hagopian

cc: 

Dr. Charles Wolf 

Professor Milton Friedman

Paul A. Samuelson to B. Kipling Hagopian — December 7, 2005

Mr. B. Kipling Hagopian

Apple Oaks Partners, LLC

11 TO Santa Monica Boulevard

Suite 1200

Los Angeles, CA 90025

Dear Mr. Hagopian:

I have no wish to alter your present knowledge about contingent stochastic finance theory. How would option dealers know what recipients of tax-free option grants have been able to do legally to affect their personal risk taking?

This ends any correspondence between us.

Sincerely, 

Paul A. Samuelson