Google and Citadel: Innovation at Work

Overview

Well, Google finally did something many of us in the derivatives business had talked about for years - create a vehicle for transferring and monetizing employee stock options prior to exercise. Why? To capture the time value inherent in an option prior to maturity, which is lost once the option is exercised. And this is something that is easy to do if you are a dealer (by delta hedging, vega hedging, etc., as the price of the stock oscillates, time to maturity shrinks and the probability of the option's exercise changes), but almost impossible to do if you are an individual. Google talks about this program on their blog, and provides an example of how the program would work and the accounting impact of initiating the program. While I have some questions about the financial motivation of this move (separate and apart from the employee compensation/HR implications of this move), it is, without question, highly innovative, very necessary and will invariably be copied by companies everywhere.

I've said it before and I'll say it again: these guys are smart. Really smart. Smart financially. Smart strategically. But, most importantly, smart about how they attract, retain, manage and motivate their human capital. They serve as a model for how growing companies - no, all companies - should be maniacally focused on creating a positive, exciting, stimulating and challenging work experience. Because it is stuff like this that creates long-term, sustainable competitive advantage.

Innovation in the Culture

Citadel's recent bond issuance, while representing innovation in an different kind of company for different reasons, came to mind when I saw Google's announcement. I had blogged about this a week or so ago. Their debt issuance, like Google's new stock plan terms, represents a structural change in the way firms in their industry view risk. While Citadel's move shined a bright light on liquidity risk, and was a shot across the bow of prime brokers everywhere, Google's move shined a bright light on human capital risk, and was a shot across the bow of all employers with whom they compete for talent. Whether one is in the hedge fund business or in the technology/advertising business, innovation is the life-blood of sustainable advantage. Especially when it is ingrained in the culture. As it is at both Citadel and Google.

Google's New Option Plan - What's in it for Them?

So, it is pretty clear that Google benefits from a recruiting and retention perspective by giving current and prospective employees options that offer them the chance to monetize a portion of the options' residual time value prior to maturity. This is good. And due to this new feature, which is simply an add-on to the options' existing terms, they will have to take an accounting charge to reflect this increase in compensation expense. This increase in expense is a function of an increase in the expected life of an option, since, if the option is transferred, the options life is generally reset to two years (the lesser of two years or the remaining life of the option, which will almost always be two years). And they assume that new expected option life is additive - that the current estimate of option life is simply increased by the two year period post-transfer. But behind this charge is a key assumption: the estimated life of an option. It is here where the questions begin.

The key question: how will employee behavior be modified by this new liquidity feature? It seems to me that Google's assumption that expected life will remain at four years is highly tenuous. While I am sure most people at Google have imbibed the Kool-Aid, I am equally sure that many who work there can use a few extra bucks for that cool Trek racing bike, a shiny new windsurfer, etc. So I wouldn't be surprised to see a drop - a substantial drop - in the expected life of an option. And if their estimates of option life are too high, they will essentially "undo" the excessive expense taken today through reduced option expenses in future years. Why not take the big charge now while earnings are rocking, get the PR benefits of this innovative program today and enjoy the benefits of lower compensation expeneses in future years when income growth might not be as prounounced? Am I being overly cynical here? I guess it just in my DNA from my derivatives days, what can I tell you.

Conclusion

None of this undoes the innovative nature of the program or the fact that, at its core, it is a brilliant HR move and, quite frankly, the right thing to do. Does it place a little more pressure on Google to perform, else people take too much advantage of this program and the long-term motivation benefits of the options lose their teeth? Yes. However, from where I am sitting the recruitment and retention benefits of this tool far outweigh the potential costs. And this further reinforces Google as an innovator, and not just in technology but in the cultivation of positive management/employee relationships and the creation of leading-edge HR strategies. They, like Citadel, are blazing the trail. Others should watch and listen. They might learn something.

Comments

[Roger]

RK, but that's not the conventional valuation. Conventional valuation takes into account time value. The problem with the whole option valuation issue is that for a non-dividend paying stock the optimal exercise behavior is to wait until option expiration. This, of course, is not what most people do.

So I want to be clear in distinguishing between what an employee might perceive as more valuable versus what the true valuation of the option happens to be. Most employees will forego significant time value for certainty, which is why they seldom act in a "rational" way to lock in intrinsic value. This is the issue Google is getting at, where even if an employee acts in an irrational manner they still can benefit by at least capturing two years of residual time value, which would otherwise be flushed down the toilet.

Further, as noted in my post, if employees use this opportunity to sell the options even earlier than that would ordinarily have exercised, Google stands to benefit from recapturing expenses previously incurred and reducing expenses in future periods.

[RK]

The new option pricing would also allow Google to issue fewer options in future years once the company can prove to their employees that the options are worth more than that is given by conventional valuation (i.e., the difference between the market price and the grant price of the Google stock).

[Kris Tuttle]

I give Google credit for doing this. I've been at a few firms that really needed to do it but didn't because their CFO/GC types said it was "way too hard" to implement. As far as I know companies like SAIC have also blazed a trail here as well as the MSFT example Yasar describes above.

There are always issues around doing things like this because they push the envelope. Seems to me that's what managers are supposed to do rather than lament how hard it might be and what the downside is.

Employees have different durations and risk profiles, allowing them to trade options and restricted stock to balance it all makes perfect sense to me.

[Yaser Anwar]

The nonexistence of TSOs (on a widely used basis) makes it difficult, not to mention costly, for companies to consider granting TSOs to their executives and employees, partly because of the tax and accounting purposes (GOOG seems to have that covered).

Roger do you recall the MSFT TSO? It was back in July 03 where MSFT switched to restricted stock and allowed their employees to transfer/tender their options to JPM.

GOOG's foray into TSOs are likely to be remarkably effective in meeting the major challenges of designing effective equity-based pay plans.

TSOs offer robust, higher value-cost efficiency, and greater transparency while maintaining the leverage advantage of options.

By doing so GOOG has created significant upside (and downside because the value of TSOs falls much faster than that of restricted stock for a given decline in the company’s stock price. One may even argue they represent a riskier instrument, per dollar of company cost, than restricted stock.) while largely avoiding the “pay for pulse” problem of restricted stock.

[Roger]

Now, Bill, if that's not the pot calling the kettle black! Coming from you, that's high praise! Thanks for the good laugh.

[Bill a.k.a. NO DooDahs]

"Am I being overly cynical here?" No, you're being wildly cynical, dude.

LOL