Under the banner of stock options

Ten years ago, Bob Pavey, then-head of the National Venture Capital Association (NVCA), led the trade group's battle against stock option expensing. The NVCA succeeded – with a bit of Senatorial lobbying – in staving off a proposal by the Financial Accounting Standards Board (FASB).

Today Pavey – now a general partner at Menlo Park, California based Morgenthaler Ventures – is back in the fray, lobbying for the industry on behalf of the NVCA. But this time the battle appears to be lost. Mounting shareholder pressure following accounting scandals at Enron and Worldcom prompted the FASB to issue a March 31st proposal to mandate stock option expensing for all employees in both private and public companies beginning next year.

The FASB's move, in turn, has shot up red flags across the venture capital landscape because many venture-backed startups view the ‘options carrot’ as crucial to attracting and retaining entrepreneurial talent. Currently, the preferred practice for handling stock options for private companies is to list them as a footnote on the income statement. Under the new proposals, stock options would be figured in as an expense, thus reducing the company's bottom line and making it appear less attractive.

In a statement issued by the organisation the same day as the FASB's announcement, current NVCA president Mark Heesen went as far as to call the proposal “a blatant disregard for the challenges that small business will face in attempts to comply with this proposed standard. … Our economy is going to pay a considerable price.”

Pavey says the FASB is mistaken in thinking that accounting for stock options will improve financial statements or prevent another Enron. “Small venturefunded companies make more extensive use of options than any other companies. While large public companies may be able to accurately account for options expenses, small private companies cannot – the formulas simply do not apply. Life will become more difficult for us, our financial statement will be harder to understand, and we're not even part of the problem of large corporate malfeasance.”

The FASB guidelines, if finalised after a 90-day comment period commencing March 31st, would bring US accounting rules in line with those issued by the International Accounting Standards Board (IASB), the FASB's London counterpart that sets European accounting standards.

The proposed rules are a response to US investor wariness that current accounting rules misrepresent company income statements and lack consistent valuation guidelines, making it difficult – if not impossible – to compare one company's performance to another. In addition, proponents of options expensing argue the new standards will prevent companies from freely providing their top executives with lavish option rewards.

But changing accounting standards doesn't necessarily equate with delousing corporate governance. Bill Calder, a spokesman for Intel – which over the past five years has distributed nearly 580 million options, or almost 9 percent of all outstanding shares – says expensing stock options “won't fix excessive executive compensation issues. If we accept the fact that we really do need this financial clarity to see what these options are worth, you may end up with a reverse approach which ends up giving investors less clarity, not more.”

Indeed, while depriving entrepreneurs of incentives is a primary concern in the debate, expensing options also creates a valuation problem since the options are a promise of a certain price rather than an actually traded stock. For private companies that don't trade on the public markets, estimating expense values is more-orless a ‘best-guess’ game requiring the hire of costly financial professionals. The two options pricing methods sanctioned by the FASB – Black & Scholes and binomial – depend on traded stock figures for a volatility number for computation. Private companies had been allowed to use the ‘minimum value’ method that placed volatility at zero, given the lack of publicly traded stocks. But the FASB proposal does away with that, instead calling for an ‘intrinsic method,’ which, according to the NVCA, unfairly sets a high volatility number for private companies, resulting in inaccurate expense statement.

“It's putting something on the books that will not happen at the end of the day,” Heesen says. “Most of the options will not be expensed at the end of the day. And yet, a company has to carry this speculative figure for years, negatively affecting its income statement.”

Many venture capitalists are concerned because net income is key to evaluating financial performance. From their perspective, expensing stock options may result in unreliable financial statements, which in turn might distort perceptions about a company's viability, delay public listing or acquisition by a strategic buyer, and increase the amount of venture capital dollars needed to make the business more attractive.

Countermeasures to the FASB's proposal include legislation in both Congressional houses that would try to preserve broad-based employee stock option plans by mandating expensing only for the top five executives. Currently a Senate bill is being sponsored by the only accountant in the chamber, Republican Senator Mike Enzi of Wyoming. Nevertheless, there is doubt among Senate watchers that any such initiative will survive as support is not forthcoming.

It's difficult asking investors to stop biting their nails given the shock of corporate abuses and the disappointments of the tech crash, but the FASB's actions certainly have a political as much as an economical motivation. Are venture capitalists overreacting, or is the FASB throwing the baby out with the bathwater?

“It's something people tend to forget, but what is one of the core tools that created all these fabulous new technologies, that created Silicon Valley, which has been a wealth generator for us? Stock options,” says Calder. “They are the promise that there's not a lot of money now to pay you, but if you work really hard and we become really successful, there's a great benefit for you down the road.”