Google's TSO Program Revisited: Let's Get it Straight

I had a really busy day and was minding my own business when I came upon my friend Paul Kedrosky's post concerning the initiation of Google's Transferable Stock Option (TSO) Program. This is a topic I had written on back in December, taking a balanced view (IMHO) of the potential benefits of the program as well as the potential accounting artifacts. As I read Paul's post I said to myself, "Hey, I don't really agree with his points and think I'll write a little comment." But then I read a comment to his post that was so off the mark it got my blood boiling and I said to myself, "I think I'll write a more detailed comment to this post to get some other (hopefully clarifying) thoughts out on the table." Since this communication happened on Paul's blog and since I thought my comment was, well, really good, I wanted to share it here.

First, Paul frames the issue and provides his views on Infectious Greed:

A quick refresher: Rather than non-executive Google employees either exercising the options and selling at the current trading price (net the exercise price), or holding them and hoping for higher prices later, employees will be able to sell the vested options on a new secondary market created by Morgan Stanley. Among many other things, this would attach a value to vested options, even vested options having grant prices above the current trading price.

I have said previously that I like the innovative thinking, but I'm not yet convinced of the program. Two issues:

1. Where is the transparency? I have yet to see how outsiders get a window into this internal option market. I see how it's informationally good for Morgan Stanley and for participating institutions, but how do the rest of us get a window into the option flow data?
   
2. I see how this is good for Google employees, as well as for management in increasing the perceived value of options used in hiring engineers, etc., but I have yet to be convinced that it sufficiently aligns interests with run-of-the-mill investors. The idea behind grant prices, vesting, and exercisable options is to keep investors and employees' interests aligned. If Google employees can now make more money from options, and that doesn't imply an increase in shareholder value, which this doesn't, I'm uneasy.

Next, the comment that raised my ire:

1. Comment by Seth Finkelstein -- February 22, 2007 @ 9:10 AM

As I said earlier, check me on this:

Exercised employee options turn into stock. Which dilutes the stock. Which send prices down. Which leads to people exercising more options while they're worth anything . Which further sends the stock down ...

But if they can resell the options, to someone else, the party continues that much longer. ..

Options finance experts:

Is my cynicism correct?

No Seth, your cynicism isn't correct, not even close. Seth had previously written a post on the topic which was equally as nonsensical. Now I don't know Seth but I've read his blog and it's good. When he writes about stuff that he knows, which is almost all of the time. Why he would choose to write a missive (and it was a missive) on topic as complex and domain-specific as equity derivatives is beyond me but he did. And it irked me. And Paul, you are a dude but we have a slight difference of opinion.

Finally, my comment:

2. Comment by Roger -- February 22, 2007 @ 12:04 PM

Paul, as you may know, I wrote about Google's option program back in December (http://www.informationarbitrage.com/2006/12/google_and_cita.html). In it I discussed the pros and cons of the program, but basically came down in the "pro" camp.

Concerning you questions/issues, I get your point on (1) but over-the counter derivatives transactions are just that, over the counter, and they happen every day as a part of prudent capital structure management. There is plenty of options information available on Google from the public markets, so I'm not really sure I view this as a gating factor in viewing this program as positive. With respect to (2), IMHO you are missing the boat. This DOES create value - potentially significant value - for run-of-the-mill Google shareholders, by giving Management the currency to further incentivize top talent to join even in light of the stratospheric increase in stock price. And make no mistake, this was a BIG problem suffered by our friends at Microsoft (not to mention Intel) after they saw their market caps approach $600 billion and subsequently drop. By enabling employees to extract a measure of time value while preserving upside, you are creating an additional lever which Management can use to attract and retain the best-and-brightest. If I was a Google shareholder (which I am not), I would view this as a win.

Seth, sorry, but your analysis and earlier post are simply wrong. On both counts. Exercising stock options does NOT drive stock price down. Analysts (not to mention GAAP) utilize this concept called the Treasury Stock Method adjustment, which converts the in-the-moneyness of stock options and puts them in the denominator of the EPS calculation, ergo, the dilution associated with the rising stock price is already baked into EPS. And analysts who don't make these adjustments from a valuation perspective are simply idiots and should not be analysts. But to be clear, most do. Concerning your ongoing party metahpor, you have made the significant (and unlikely) assumption that employees view their choices at a point in time as being either (a) sell my option today and collect my in-the-moneyness and the lesser of (two years or the remaining life of the option) of time value (which is the deal Google agreed to with Morgan Stanley), while the option lives on in the hands of Morgan Stanley or (b) simply exercise the option. This will NEVER be the decision. Why? Because (a) will ALWAYS be worth more than (b). The choice is either (a) above or (b) exercise the option at a later date, because I don't need the money and continue to be bullish on Google's stock price. So the Morgan Stanley arrangement will NOT result in an extended option life. Fact.

I hope this helps.
Roger

Make no mistake, there are pros and cons to everything, and you can be sure that Google's TSO Program has some of each. But let's at least be clear, intelligent and intellectually honest about what's going on here; false criticisms and opinions based upon flawed assumptions just cheapen the value of what should be an important and incisive dialogue. This is what the blogosphere is all about.

 

Comments

[1. Comment by Seth Finkelstein -- February 22, 2007 @ 9:10 AM]

As I said earlier, check me on this:

Exercised employee options turn into stock. Which dilutes the stock. Which send prices down. Which leads to people exercising more options while they're worth anything . Which further sends the stock down ...

But if they can resell the options, to someone else, the party continues that much longer. ..

Options finance experts:

Is my cynicism correct?

[2. Comment by Roger -- February 22, 2007 @ 12:04 PM]

No Seth, your cynicism isn't correct, not even close. Seth had previously written a post on the topic which was equally as nonsensical. Now I don't know Seth but I've read his blog and it's good. When he writes about stuff that he knows, which is almost all of the time. Why he would choose to write a missive (and it was a missive) on topic as complex and domain-specific as equity derivatives is beyond me but he did. And it irked me. And Paul, you are a dude but we have a slight difference of opinion.

Finally, my comment:

2. Comment by Roger -- February 22, 2007 @ 12:04 PM

Paul, as you may know, I wrote about Google's option program back in December (http://www.informationarbitrage.com/2006/12/google_and_cita.html). In it I discussed the pros and cons of the program, but basically came down in the "pro" camp.

Concerning you questions/issues, I get your point on (1) but over-the counter derivatives transactions are just that, over the counter, and they happen every day as a part of prudent capital structure management. There is plenty of options information available on Google from the public markets, so I'm not really sure I view this as a gating factor in viewing this program as positive. With respect to (2), IMHO you are missing the boat. This DOES create value - potentially significant value - for run-of-the-mill Google shareholders, by giving Management the currency to further incentivize top talent to join even in light of the stratospheric increase in stock price. And make no mistake, this was a BIG problem suffered by our friends at Microsoft (not to mention Intel) after they saw their market caps approach $600 billion and subsequently drop. By enabling employees to extract a measure of time value while preserving upside, you are creating an additional lever which Management can use to attract and retain the best-and-brightest. If I was a Google shareholder (which I am not), I would view this as a win.

Seth, sorry, but your analysis and earlier post are simply wrong. On both counts. Exercising stock options does NOT drive stock price down. Analysts (not to mention GAAP) utilize this concept called the Treasury Stock Method adjustment, which converts the in-the-moneyness of stock options and puts them in the denominator of the EPS calculation, ergo, the dilution associated with the rising stock price is already baked into EPS. And analysts who don't make these adjustments from a valuation perspective are simply idiots and should not be analysts. But to be clear, most do. Concerning your ongoing party metahpor, you have made the significant (and unlikely) assumption that employees view their choices at a point in time as being either (a) sell my option today and collect my in-the-moneyness and the lesser of (two years or the remaining life of the option) of time value (which is the deal Google agreed to with Morgan Stanley), while the option lives on in the hands of Morgan Stanley or (b) simply exercise the option. This will NEVER be the decision. Why? Because (a) will ALWAYS be worth more than (b). The choice is either (a) above or (b) exercise the option at a later date, because I don't need the money and continue to be bullish on Google's stock price. So the Morgan Stanley arrangement will NOT result in an extended option life. Fact.

I hope this helps.
Roger

Make no mistake, there are pros and cons to everything, and you can be sure that Google's TSO Program has some of each. But let's at least be clear, intelligent and intellectually honest about what's going on here; false criticisms and opinions based upon flawed assumptions just cheapen the value of what should be an important and incisive dialogue. This is what the blogosphere is all about.

[2. Comment by Roger -- February 22, 2007 @ 12:04 PM]

Paul, as you may know, I wrote about Google's option program back in December (http://www.informationarbitrage.com/2006/12/google_and_cita.html). In it I discussed the pros and cons of the program, but basically came down in the "pro" camp.

Concerning you questions/issues, I get your point on (1) but over-the counter derivatives transactions are just that, over the counter, and they happen every day as a part of prudent capital structure management. There is plenty of options information available on Google from the public markets, so I'm not really sure I view this as a gating factor in viewing this program as positive. With respect to (2), IMHO you are missing the boat. This DOES create value - potentially significant value - for run-of-the-mill Google shareholders, by giving Management the currency to further incentivize top talent to join even in light of the stratospheric increase in stock price. And make no mistake, this was a BIG problem suffered by our friends at Microsoft (not to mention Intel) after they saw their market caps approach $600 billion and subsequently drop. By enabling employees to extract a measure of time value while preserving upside, you are creating an additional lever which Management can use to attract and retain the best-and-brightest. If I was a Google shareholder (which I am not), I would view this as a win.

Seth, sorry, but your analysis and earlier post are simply wrong. On both counts. Exercising stock options does NOT drive stock price down. Analysts (not to mention GAAP) utilize this concept called the Treasury Stock Method adjustment, which converts the in-the-moneyness of stock options and puts them in the denominator of the EPS calculation, ergo, the dilution associated with the rising stock price is already baked into EPS. And analysts who don't make these adjustments from a valuation perspective are simply idiots and should not be analysts. But to be clear, most do. Concerning your ongoing party metahpor, you have made the significant (and unlikely) assumption that employees view their choices at a point in time as being either (a) sell my option today and collect my in-the-moneyness and the lesser of (two years or the remaining life of the option) of time value (which is the deal Google agreed to with Morgan Stanley), while the option lives on in the hands of Morgan Stanley or (b) simply exercise the option. This will NEVER be the decision. Why? Because (a) will ALWAYS be worth more than (b). The choice is either (a) above or (b) exercise the option at a later date, because I don't need the money and continue to be bullish on Google's stock price. So the Morgan Stanley arrangement will NOT result in an extended option life. Fact.

I hope this helps.
Roger