Stock Options at eBay - Case Study Example

Stock Options at eBay: A Commentary eBay is the world's leading online website. Like many companies it uses stock options as part of its compensation package for its employees. Stock options are a good way for companies to align the interests of the employees with those of the company. It lets them have some ownership in the company and feel more connected and promotes employee retention. At the same time, companies do have to account for and expense employee stock options. There are different methods for expensing stock options and these methods can have drastically different effects on the apparent profitably of a company. Question 1: Why does eBay compensate employees with stock options rather than other forms of compensation, such as cash or stock eBay is the world's online marketplace, enabling trade on a local, national and international basis. With a diverse and passionate community of individuals and small businesses, eBay offers an online platform where millions of items are traded each day. It was started in 1995 with one employee and it has grown to employ thousands of employees today. Any company's future success and profits depend on their employees and the senior management. Even eBay feels that their success was dependant on their key management and their technical staff. As such eBay tries to retain their key personnel officers for the long-term to gain more profits, but they don't have any long term agreements with employees and they don't even maintain life insurance policies on their key employees. eBay attains more profits in land based auction businesses and those are dependent on specialists and senior management as these individuals have established good relations with sellers who transfer property for sale at auction. As the company is growing and the number of employees is also. The company has to attract more people and has to train them and retain them in the company for the long term, particularly the employees who are highly skilled, technical, and managerial. Stock options issued by a company allow the employee to buy specific amount of the company's stock at a certain price after a set period of time (the vesting period). Stock options are useful to align the interests of the employee with those of the company. Since the stock options will be profitable only if the company's stock goes up, the employee has incentive to work hard and ensure the success of the company. Also, since the options can only exercised after a certain period of time, the employee has to stay with the company. This promotes employee retention. Furthermore, by giving out stock options, the company can reduce other forms of compensation and reduce its immediate cash expenses. In this way, stock options are a better method of compensation compared to cash or stock. Let's take an example: Let's say you are hired by eBay and they offer you options to buy 10,000 shares of eBay stock at $10 within the next three years. This stock option gives you the right to buy 10,000 shares of eBay stock at exactly $10 after three years. Let's say after three years eBay stock is at $15, you can exercise your stock options, buy 10,000 shares for $100,000 and sell them on them for $150,000 making a $50,000 profit. Now, let's say eBay's price after three years is $5, your options would be worthless. Thus the options incentivize you to work hard to ensure eBay is successful as measure by a stock price greater than $10. Also, you are required to stay for at least three years to profit from your options. From this example, it is clear how stock options align the interests of employees with those of the company and promote retention. The options did not also cost the company upfront. Neither cash nor stock has all these advantages, and hence eBay compensates employees with stock options. Question 2: What are at least four benefits of choosing stock options over other compensation methods Compensation packages are a means by which companies can achieve several different goals related to recruitment, retention, and motivation, among other things. Such packages are constituted in a variety of different ways, and one issue that has been raised is what role stock options should have and how effective they are in the compensation package. The question is also asked as to whether they serve the needs of the company and the employee alike or favor one over the other. In general, stock options are seen as a favorable form of compensation. According to Blair (2004), they have several benefits (p. 1): 1. The reduction of cash employee compensation while also decreasing reported compensation expense. Since the issuance of stock options is done in concert with a lower salary, the issuing company reduces a company's cash expenses and the cash can be put to work in other ways. 2. The incentive for employees to improve corporate performance by aligning employee interests with corporate interests. Every issued stock option has an exercise price. The stock option will be profitable only if the issuing company's stock trades above the exercise price of the stock option. So, it is in the interest of the employees (the holder of the stock options) to ensure that the company does well enough that the company's stock trades above the exercise price of the option they are holding. Thus the interest of the employees is aligned with that of the company's. 3. The retention of employees. All issued options have a vesting period after which the options can be exercised. Usually the vesting period is about two to three years. Since employee has to stay with the company until the end of the vesting period to profit from the options, the options thus promote employee retention. 4. The reduction of income taxes. If the company issues a non-qualified stock option (NSO), the company can take advantage of a tax deduction when the employee exercises the option. In addition, it offers employees an opportunity to have ownership in their company and helps them feel like they are an integral part of the business, like a big family - they sink or swim together. Question 3: What is your opinion of eBay's current accounting treatment for employee stock options Support your opinion with at least two references from public resources. There are a few ways in which a company can deal with employee stock options from an account perspective. The most common are the Intrinsic Value Method and the Fair Value Method (Blair, 2004). The primary difference between the methods is how stock options are expensed in the financial statements. In the Intrinsic Value Method, the stock options are only expensed once the employee has actually exercised the options, unless there was a price difference between the exercise price and the stock price at the time of issue of the stock options. In the case of the Fair Value Method, it is argued that since the stock options have been issued to the employee, the company has to account for this liability every year, even if the employee has not yet exercised the options. Currently, eBay uses the Intrinsic Value Method to account for stock options when issuing financial statements. Though, eBay does disclose the adjusted earnings taking into account the Fair Value Method for expensing stock options in the footnotes of its financial statements (Wise, 2003). I think that the Intrinsic Value Method is the wrong to expense stock options. It does not present the true picture of the company's financial obligation. Once eBay has issued stock options, it is obligated to pay for them and this obligation must appear in the main body of the financial statement, and not just the footnote. If eBay does not do so, it makes it difficult to determine how profitable the company really is, if at all (McLean, 2004). Thus, I think eBay's current accounting treatment for employee stock options is wrong and deceptive. It essentially hides the true cost of its employee compensation programs and artificially inflates its profit numbers. In order to get a true picture of eBay's performance, it has to account for and properly expense all the employee stock options it is obligated to pay, especially given the fact that it has give out stocks options worth more than 10% of the company's equity. Question 4: Is footnote disclosure an appropriate substitute for financial statement recognition Support your argument with at least two references from public resources. I do not think that footnote disclosure is an appropriate substitute for financial statement recognition. Any financial data that affects accounting of current liabilities should be described and detailed in the main text and not a footnote (Coco and Ivancevich). Put another way, if the information released in a footnote could lead a potential investor to change their mind about investing in the company, then that information belongs in the main document. There are several problems with disclosing information in footnotes. The primary purpose of annual statements issued by a company is to communicate transparently with the stakeholders and potential investors the current status of the company and its operations. Disclosing information in footnotes is not transparent and is viewed by some as a way for companies to hide information (Wise, 2003). Many people will not read them and since they are not part of the main document, the context of the footnote is sometimes not readily apparent. The stake holders deserve transparency and footnotes prevent the transparent flow of information. In addition to assessing the current state of a company, financial statements are used to predict the future performance of a company. If information disclosed in footnotes can affect the outlook of a company's future earning potential, then that information does not belong in footnotes. Such information should be included in the main document. There is also reason to believe that information provided in the footnotes is less reliable than that found in the main document. This is because not much attention is paid to the footnotes even by the authors of the financial statements. Hence the use of footnotes is not appropriate. Thus, if the disclosure would or could impact any financial statement user's knowledge of that company's financial status, it should be disclosed within main body of the financial statements as opposed to hidden away in the footnotes. Footnotes should be used only to clarify minor points. References Blair, R. T. (2004). Accounting For Stock Options. UVA-C-2155. Charlottesville: Darden Business Publishing, University of Virginia Coco, A., & Ivancevich, D. (1995). Recognition Or Footnote Disclosure Of compensatory Fixed Stock Options The CPA Journal. Retrieved February 10, 2009 from http://www.nysscpa.org/cpajournal/1995/NOV95/a1195.htm Mclean, B. (2004). Weighing eBay's Options How profitable is eBay Hard to say. And that could be a problem. CNN Money. Retrieved February 10, 2009 from http://money.cnn.com/magazines/fortune/fortune_archive/2004/05/31/370700/index.htm Wise, S. (2003). eBay's Scary Stock-Option Specter. BusinessWeek. 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