2002: Does expensing stock options cause them to be double counted in per share metrics?

AUDIENCE MEMBER: Yes, good afternoon, Mr. Buffett and Mr. Munger. My name is Ho Nam (PH), and I’m from San Francisco, California.

I have a question related to an issue you touched on a few moments ago on the debate over whether or not stock options should be expensed and reflected on the income statement of companies.

With the current system, shareholders are incurring the burden of stock options since exercised options dilute earnings per share.

As a shareholder of companies that issue stock options, I think I’m OK with that, especially in entrepreneurial companies that may not have enough cash to attract talent from larger competitors, or in cases where you have younger employees or lower-level employees who do not have the cash to purchase stock without the use of options.

I have a two-part question. If companies are required to expense stock options and it hits — impacts the P&L, does it — would that lead to double-counting the impact of stock options?

And the second part is, if the use of stock options are largely eliminated, might that impact the competitiveness of entrepreneurial companies which help drive innovation and growth and create more of a dividing line between shareholders and employees?

WARREN BUFFETT: Yeah, the first question is that there really isn’t the double-counting necessarily.

For example, let’s just take a company with a million shares of stock outstanding, selling at a hundred dollars a share.

And let’s say that options are granted for 9 million shares — we’ll make it extreme — at a hundred dollars a share. At that moment, you’ve given 90 percent of the upside to the management. We’re taking a very extreme example. That’s been a huge cost to the shareholders.

Now, interestingly enough, if the stock was selling at $100 a share, the fully diluted earnings are exactly the same as the basic earnings in that year, because the dilution is not counted at all unless the stock is selling above, and then only by the difference in the market value and what it costs to repurchase the optioned shares. So, there is not double-counting.

And you can — you could issue — the very fact that you issued that million, the options on 9 million more shares at 100, would undoubtedly cause the price to actually fall well below 100 and there would be no dilution shown in terms of the way GAAP reports diluted earnings.

The second question, as to whether, if you expense the options, it would discourage the option use.

Well, the argument, you know, that is made when there — people issue options is that it’s doing more for the company than giving people cash compensation. It may be more convenient than cash compensation, too, for young and upcoming companies.

But the fact that you are doing something in terms of paying people in a way that you say is even more effective than paying them in cash, to say that therefore you shouldn’t have to record the payment, I’ve never really followed.

I don’t have any objection to options under some conditions. I’ve never taken a blanket position that options are sinful or anything of the sort. I just say they are an expense.

And to be truthful with people about what you’re earning, you should record the expense. And if a company can’t afford to be truthful, you know, I have trouble with that.

And we will take, as we’ve said, you can pay your insurance premium to me in options. There’d be lots of companies I’d be happy to take options in and give them credit.

I’d take options above the market. Give me a 10-year option 50 percent above the market in many companies, and we will take that — appropriate number of shares — and take that in lieu of cash.

But that means we simply like, you know, the value of what we’re getting better than the equivalent amount of cash and we think the company that gives it to us has incurred an expense.

We’ve received something of value, they’ve given something of value up, and that’s income to us and expense to them.

And I think all of the opposition, at bottom, to the — to expensing of options comes from people who know they’re not going to get as many options if they’re expensed. And you know, they would like cash not to be expensed, but they can’t get away with that, you know. I mean —

CHARLIE MUNGER: Yeah. (Laughter)

WARREN BUFFETT: If you had an accounting rule that said the CEO’s salary should not be counted in cash, believe me, the CEOs would be in there fighting to have that rule maintained.

I mean, because no one would — they would feel that they were going to get more cash if it wasn’t expensed, and options are the same way.

It’s another argument I get a kick out of, I was just reading it the other day, where they say, “Well, options are too tough to value.”

Well, I’ve answered that in various forms, but I notice that — what is it, Dell Computer, you know, has a great number of put options out, and it’s going to cost them a lot of money on the put options they have out.

And for a company to say, “We can’t figure out the value of options, and therefore we can’t expense them,” and then at the same time be dealing in billions of dollars’ worth of options, they are saying, “We are out buying or selling options in the billions of dollars, but we don’t know how to value these things.” That strikes me as a little bit specious — a little disconnected, cognitive dissonance, as they say.

Charlie?

CHARLIE MUNGER: Yeah, I’m not at all against stock options in venture capital, for instance. But the argument that prominent venture capitalists have made, that not expensing stock options is appropriate because if you expense them it would be counting the stock options double, that’s an insane argument.

The stock option is both an expense and a dilution, and both factors should be taken into account in proper accounting.

John Doerr, the venture capitalist, as he argues to the contrary, is taking a public position that, “Were it offered to me as part of my employment, I would rather make my living playing a piano in a whorehouse.” (Laughter)

WARREN BUFFETT: We always get to the good stuff in the afternoon. (Laughter)

I hope the children are in bed.