TCS Daily

The Opposition Does Understand

By James V. DeLong - October 9, 2003 12:00 AM

The expense-the-stock-options bandwagon keeps rolling along, with the Financial Accounting Standards Board expecting to propose a rule by next February. Silicon Valley hates the idea, and argues that options are extremely important (true), that a requirement that options be expensed would cause a cut back on grants to lower level employees (possibly true), and that because no good way to value employee options exists the whole expense 'em enterprise will turn into an unholy mess (absolutely true). The latest tech industry blast came in the Washington Post, authored by Intel Chairman Andrew Grove and Reed Hundt, former FCC Chairman and current Intel board member.


According to the subscription newsletter TechDaily, the Washington reps of the tech industry are optimistic, claiming enough votes in Congress to prevent any FASB rule. But this could be whistling past the graveyard. If the tech industries had sufficient political support, the FASB bandwagon would have run down before now.


The basic problem is that the techies show little awareness of the game they are playing. They assume that they have a problem in public education, that those who are trying to stick it to them just don't understand, and that once the issues are explained the opponents will say "eureka!" and go away. But it isn't exactly so, and to win this contest the tech industry will have to get serious in three ways.


First, the putative reformers have a couple of good points. Options granted to top level managers can indeed distort incentives and foster dubious practices. Most obviously, managers with loads of options will want to avoid paying dividends and thus build up retained earnings so as to raise the price of the stock. Options can also skew incentives toward risky behavior because top executives who win big if a gamble pays off and lose little if it fails are tempted to become high rollers. As the current scandals show, some succumb.


These are not insoluble issues. They are primarily problems for shareholders and lenders, not the public at large, and are readily cured by disclosure and contract. But they make useful clubs, and so are wielded vigorously. They must be conceded and the proper solutions supported.


A second problem is that that tech reps seem not to have thought much about the nature of intellectual capital in the modern firm, and how it affects the issue of stock options. Historically, options were a solution to problems of principals and agents. Capitalists furnished the money, workers operated the machines for pay and under close supervision, and managers were in the middle. The capitalists' problem was keeping the managers from diverting resources to their own ends, and motivating them to do their best when performance is hard to monitor and when individual performance measures can actually be inimical to the needs of the overall organization. (Viz., A VP-Production paid by units of output will ignore quality.) The answer is stock, to align the incentives of shareholders, managers, and the organization as a whole.


This characterization of the issue still dominates academic analyses, which is why such work favors restricted stock rather than options. The legendary Alfred P. Sloan felt the same way, by the way. He wanted GM execs to have a large part of their personal net worth in GM stock, so that if the company suffered, they suffered.


But a funny thing has happened to capital in the past few years. A couple of decades ago, book value of hard corporate assets accounted for around 80 percent of market cap. Now, hard assets account for nearer 30 percent. The rest of corporate value is in the intangible products of the intellect, ranging from copyrights, patents, and trade secrets to customer lists, brand names, franchises, and the presence of staffer names in thousands of computerized contact files.


The full ramifications of this change are murky. But some things are obvious. The split between capital and labor is much less sharp because capital in the form of intangibles is provided by the workers, not the money people. Broad grants of stock options are a response to this new reality that the people furnishing the money and the people furnishing the ideas are both capitalists, and that "capital" and "wages" do not capture the essence of the modern company. Options also solve some problems of valuing intellectual product and foster the continuity of the teams necessary to produce IP in the modern age, problems not addressed by restricted stock. (For further argument of this point, go here.) As a result, Intel's top five execs get only 2% of options granted, and employee participation runs at 95%. Other tech companies are close.


A third problem is that the tech reps do not yet seem to fully grasp that their opponents know perfectly well that their proposals would discourage options, and that that is precisely why they push the proposals so adamantly. Every time the techies mutter darkly, "but this will be the end of options!" their opponents are further inspired. The Valley does not have a problem in education; it is in a political struggle. (See Options Wars.)


In this contest, the techies are hobbled by the fact that many of them are Democrats and the opponents of options are the core constituencies of the Democratic party -- unions, public employees, and large bastions of entrenched capital, such as the Warren Buffets of the world and the TIAA. Each of these groups has good reason to oppose the trend toward broad grants of stock options. Unions do not want to blur distinctions between capital and labor. Conventional capitalists see options as the tool of the venture capitalists, and as a mechanism by which they might be forced to share with the upstart creative classes. Public employees have no interest in helping the private sector, and are, increasingly, entrenched capitalists through their pension funds.


So the techies keep insisting that "the opposition just does not understand," and try to explain it once more. Like others caught in the cross-hairs of reactionary liberalism, Silicon Valley cannot quite believe that it is now being demonized as the bad guys, and to admit that their opponents understand full well what they are doing would force the techies to admit to the reality of an intraparty civil war.


So Silicon Valley can "educate" all it wants, but unless it realizes that it is in a political fight over important values, it will lose.


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