Wednesday, February 20, 2008

Google's Options

Christian who writes for both Investor Geeks and his own blog BloggerJacks, writes some of the most thought provoking articles I have come across in the blogosphere. I always make a point of stopping by to read what he writes. While I was in Thailand he had a post and a reference that, in my opinion, takes the last of the shine off of Google.

You may recall that there have been many Googlenistas who, in addition to talking about the rapid growth of earnings at the company, also like to suggest that managment has a similar attitude towards capital structure as Berkshire Hathaway. Mostly I think they do this, because their target audience are small retail investors who are reluctant to lay out the cash for the shares at these nominal prices. They need retail investors to keep buying the stock, however, so they don't want anyone to wait for a stock split and sit on the sidelines (stock splits have no impact on the value of an investment, nominal prices are almost meaningless), however most people like to purchase round lots).

Apparently, Google has decided to allow employees to sell (trade) their options on the open market. This is a good thing for the employees, as it allows for rapid diversification, but not good for investors. Google, undoubtedly will argue that this is good for investors, as this change in policy *may* enable them to issue fewer options. Fewer options should mean less dilution which is positive as far as it goes. But the real reason that this is a bad idea is that it severs any link of risk and reward between employees and owners.

Allowing employees to sell options means that a significant portion of their compensation no longer comes from changes in the fundamental earning power of the company and is instead based on price movements of the stock - specifically, employees are now rewarded for encouraging additional volatility in the stock and for the length of the insurance contract that they can offer investors.

To understand this one must realize the the value of a stock option is based on several criteria: The strike price, the market price, the length of time to expiration, interest rates, volatility of the price of the underlying asset and (in the case of put options), dividends and whether the stock is European or American.

To understand why volatility is so important, one need only think of the insurance aspect of an option. It allows for a one-way bet that prices will rise or fall, and locks in a different price, protecting the holder against adverse movements. The larger the volatility, the more likely it is that that insurance will pay off (ditto for long periods of time).

This was NOT what options were intended to do. Options were a means of rewarding management for increasing the value of a firm. The problem was that salary was always paid based on short term (usually annual) performance, whereas real value creation by top management often took years to emerge, since many decisions were far-reaching and the actual wisdom or folly of those decisions might not be known for years. Indeed, if only short-term metrics were used, management had an incentive to under invest and instead prop up short term numbers to collect on bonuses, while actually destroying long-term value. (A good example was Chrysler Corp under Bob Eaton, which chose financial engineering over product development in the mid 1990's necessitating the sale to Daimler-Benz).

Options, with long holding periods were a means of tying management performance to long-term value creation. By issuing options at the current value, management participated in the upside gain that they created. Because (unlike the stockholders) they did not participate in the downward losses, it became necessary to ensure that options and the potential payoff were enormous to "guarantee" that management would go to any length to increase firm value.

With this system, however, employees can cash-in during periods of high volatility. In fact, there is an INCENTIVE to make decisions that enhance current volatility at the expense of long-term value. This is the exact opposite of Buffett's dictum that a Berkshire manager should "run the business like it is the only asset that his family will have for the next 100 years". Employees of Google who receive stock options should be looking at the company as a life-long investment. That long-term perspective is the REASON to award stock options. Otherwise, the firm could simply pay cash and employees who want to can purchase shares or options on the open market.

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