By GARY RIVLIN and FLOYD NORRIS
SAN FRANCISCO, May 11 - Adding a new twist to the continuing fight over the expensing of employee stock options, Cisco Systems is seeking regulatory approval for a novel financial instrument that could allow the company to assign a lower value to the stock options than under current valuation models.
A lower value for the options, which under new accounting rules will have to be recorded as expenses on Cisco's books starting this July, would reduce the impact expensing will have on Cisco's profits and could lead other companies to adopt something similar. The company said that if it employed a traditional valuation standard like the Black-Scholes model for expensing its stock options, its reported profits would fall by roughly 20 percent.
Options give employees the right to buy stock for as long as 10 years at a price set when the option is issued, and thus can become very valuable if the stock rises over that period.
Cisco's proposal is to create a market by selling new securities based on the employee options. By doing so, the company potentially could be changing the terms of the debate on expensing stock options. But details of the securities Cisco decides to sell, and the way it markets them, could prove crucial in determining how the approach works in practice.
The issue is important for Cisco because it grants options to all employees and because it will be one of the first companies to come under the new accounting rule that requires options to be expensed. That rule, adopted by the Financial Accounting Standards Board after a bitter debate, goes into effect on June 15 for fiscal years beginning after that date. Cisco's fiscal year begins July 31.
In its last fiscal year, Cisco granted 188 million options to employees. It disclosed that had it been forced to take the value of options as an expense, its net income would have fallen by 28 percent, to $3.2 billion.
The securities would be sold only to institutional investors. Cisco would sell new securities when it issued options to employees, and would then use them to value those options on its books.
Cisco confirmed the move after it was reported by Bloomberg News.
Cisco, the largest maker of equipment for directing traffic on the Internet, has been a leader among technology companies seeking relief from the rule from Congress and the Securities and Exchange Commission.
Some details of Cisco's proposal were disclosed Wednesday by two people who had been briefed on them and who asked not to be identified because details could still be changed.
They said the securities would be offered to a limited number of institutional investors, adding that the company believed that by limiting the prospective buyers, it might get a higher price because those investors would have an interest in putting in the time needed to analyze a new and complicated security. But it could also be argued that by limiting the number of investors, the company would be depressing the price.
That could be important because the company has two conflicting interests. As with any security it sells, it would benefit from getting the highest price. But Cisco would also benefit from a lower price if that allowed it to report higher profits.
Buyers of the new instruments, to be called employee stock option reference securities, or Esors, would not be able to transfer them, and would have options that would vest over five years. Both provisions mirror those in employee stock options.
Donald Nicolaisen, the S.E.C.'s chief accountant, said that he could not comment on Cisco's proposals. But in general, he said, "it certainly would be desirable to have a market value that could help validate the valuation models."
Last year Cisco, along with Qualcomm and Genentech, proposed an alternative valuation method intended to slash the value of options that the companies argued was simpler and more accurate.
The accounting standards body rejected their proposal. That proposal called for discounting the valuation for numerous reasons and drew criticism because it would have resulted in drastically lower valuations and therefore lower expenses, compared to the models endorsed by the accounting standards board.
"They've had plenty of time over the past couple of years, while this was all still being debated, to propose something like this," said Jack T. Ciesielski, editor of The Analyst's Accounting Observer. "And in fact they did propose something similar with their proposal last fall. That didn't work, so they're now trying a different route."
Cisco hired the investment bank Morgan Stanley to put together its proposed security, which could be used to set the price of the options of any company wanting to participate.
"We all wish there was a public market for stock options because then we'd have real evidence of what these things are worth," said John England, who runs the executive compensation practice inside the consulting firm Towers Perrin. "The idea is great but whether it can be pulled off is another issue."
There would also be provisions, which were not given in detail, barring the owners of the derivatives from hedging their positions. That mirrors a provision in employee stock options, but it could also serve to limit the number of potential investors if it constrained other trading strategies - selling the company's stock short or buying put options, for example - that would normally be available to institutions.
Perhaps the most controversial part of the proposal is that a buyer would not know how many options he would eventually have.
That is because the Esors would mirror the actual experience of employee options, which are canceled when employees leave Cisco, whether voluntarily or not. Last year, Cisco's annual report states, 52 million options were canceled.
A potential problem with that provision is that it could lead to understating the value of the derivatives. Employees who forfeit options when they leave voluntarily presumably do so because their new jobs offer sufficient compensation to offset the value of the forfeited options. But there is no similar compensation planned for Esors holders.
"I think one of the reasons the F.A.S.B. never picked a particular option-pricing model is because they were hoping that there would be advancements in ways to value these options," said Pat McConnell, an accounting analyst at Bear Stearns. "I think this is another step in that process."
Mr. Ciesielski, however, sees this as more of a step backward than forward. "If the S.E.C. were to give the green light to something like Cisco is proposing, it'd be nibbling away at the F.A.S.B. standard without public comment," he said.
The Cisco proposal is in some ways reminiscent of a plan Coca-Cola announced in 2002, when it said it would voluntarily take stock options as an expense. It then proposed to seek market valuation estimates from investment banks, with the possibility that banks would be forced to buy or sell based on their estimates. But that idea was later dropped because it was not in accord with the existing accounting rule, which gave companies the choice of whether or not to treat options as an expense.
The new accounting rule, however, specifies that market values, if available, can be used in valuing options.
Gary Rivlin reported from San Francisco for this article and Floyd Norris from Paris.
No comments:
Post a Comment