If the option expensing freight train is not derailed—and time has all but run out to derail the Financial Accounting Standards Board (“FASB”) pronouncement requiring publicly traded companies to expense stock options—then it is time to look at some of the consequences that are likely to result from option expensing, induding some that may not have been considered—or desired—by the option expensing proponents. The premise behind expensing employee stock options is that if the employee went to the public market to purchase an option to buy a share of, say, Intel, that option would cost the employee money. to buy.

Under financial theory, if the market sold an option that had equivalent terms to most employee stock options (exercisable for 10 years at the current market price, subject to vesting, not transferable, not salable), the market would put a price on that combina­tion of features and limitations, and, FASB says, when a company grants an employee a stock option, it is in effect “paying” an employee an amount equal to that hypotheti­cal price for that hypothetical option.

Option expensing will require that the esti­mated value of such option grants will be deducted from a company's reported earn­ings — that is, the estimated value of hypo­thetical price in a non-cash transaction will be used to reduce the amount of reported GAAP earnings.

Likely consequences of this arrangement include:

1.   Fewer Options

The recent years debates over option expensing have already resultedin the most obvious course being taken: In order to avoid expensing Qptions, companies are issuing fewer options, or doing away with option plans.

Traditionally, high growth companies have used options to lure talented employees to create that growth. the options let employees participate in the wealth that the employees create. If the growth of the company out­strips the dilution in earnings per share cre­ated by the issuance of additional stock, that is not a bad economic trade-off—all share­holders gain, and the U.S. economy keeps generating innovative companies that are the envy of the world.

Fewer options could affect the pace of innovation—although that impact would not be visible for years to come, and could be obscured by dozens of other factors.

2. Quicker Vesting Traditionally, options were supposed to serve as an employee retention tool, with vesting periods going out for years. Employees would stay at the company to col­lect the option benefits.

Some companies are now accelerating the vesting of options before the new FASB rule takes effect, in order to avoid having to show an expense next year under the new rules.

This undercuts the retention effect of options.

3. Analyst Estimates
Option expense information (as calculated unaer the old FASB rules) has been in the financial statement footnotes for nearly 10 years, and generally ignored. If the new expense formula is part of the GAAP earn­ings, will stock analysts ignore or “back out”

the option expense so that they can do meaningful comparisons to the earnings of the period before the option expense rules were adopted? Will companies restate prior years earnings to make comparisons possi­ble?

No one knows yet The math will get tricki­er, that much is certain.

4. Restricted Stock
Grants of restricted stock (that is, an actual issuance of stock, rather than a right to pur­chase stock in the future like an option) have some of the same retention incentives as options. The issuing company has a right of repurchase that lapses over time, similar to the way the right to purchase shares under an option vests over time.

The difference is that the issuance of shares means that the shares are actually outstanding, and their holders have voting rights and other shareholder rights. The out­standing shares are also used to calculate whether a chance of control occurs for pur­poses of determiningwhether an executive “golden parachute” payment is or is not sub­ject to special treatment under the tax code (whereas options, representing only a right to buy shares in the future, would not).

There will undoubtedly be other conse­quences, seen and unforeseen, arising from option expensing.

What we don't know is whether the propo­nents of option expensing, once they see all. the result, will be glad that they got what they wished for.

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Bruce Dravis is a partner atDowney Brand LLP, operating primarily in the firm's Sacramento and Roseville offices, specializing in corporate, securities and business law. His column appears in The Daily Journal on the third Monday of each month.