Unit 7 Stocks, shares and investment

Lead-in

Work with a partner to discuss the following questions:

1. How do you think if the term “investment” is the same thing as “capital expenditure”?

2. What is Russia’s policy concerning foreign investment?

3. Do you think that investing into shares is a risky mean?

4. Is there any difference between shares and bonds?

5. What gives hire profit?

6. What do you know about mutual funds?

Useful language

gilts	ценные бумаги с фиксированным процентом
premium	плата за страхование; страховая премия
life assurance	страхование жизни
minority stake	второстепенное участие (в капитале)
stag	лицо, покупающее вновь выпущенные акции с расчетом продать их с прибылью
stake in ownership	от имени клиента; сертификат о депонировании в банке иностранных ценных бумаг
depository receipt	свидетельство учреждения США, что оно купило определенное количество иностранных (не американских) акций

clearing banks	клиринговые банки
farsighted	дальновидный
shortfall	дефицит
M3	наиболее широкое определение денежной массы
to plot out	делить на участки, распределять
securities	ценные бумаги
oversubscription	подписка на ценные бумаги сверх предлагаемой суммы
to make a dazzling entry	совершить блистательное вхождение
to underprice an issue	занизить стоимость выпуска
fiscal year	финансовый год
variable inputs	переменные компоненты
underwriter	гарант, поручитель
trough	низшая точка делового цикла
tradeoff	выбор (обмен)

Reading

1. Read the following text and be ready to summarise the main idea. Text I. Apple Pie Stock Options

The aggressive use of options in the start-up arena is a key concern of people like Mark Edwards of iQuantic, which structures compensation packages for high-tech companies. "These things are like candy," he says. Edwards adds that while the typical Fortune 500 company grants options equal to about 1.25% of its outstanding shares each year, the number for the typical high-technology company is 3.5% - almost three times greater. Edwards labels that number the "burn rate." It signals how much of the company is being transferred from investors to employees each year. Software and Internet companies, desperate to get to market even faster than other high-tech companies, have median burn rates of 5% and 8%, respectively. Says Edwards, "A lot of these companies don't have the discipline to think about options the way they would think about real money."

Now a commodity, options have long since become diverted from their original purpose of rewarding a cadre of managers for a job well done. While they can reward hardworking employees, options also smack of financial and accounting gimmickry that could someday collapse a company's equity like a house of cards.

Companies use options as a portion of employees' compensation, so one would assume those options are of demonstrable value. But virtually all companies deem them worthless on their books:

current accounting rules do not require that companies show options as an expense. Companies granting large numbers of options thus show a fatter bottom line than they would if those options had been listed as an expense. For now, in valuing stocks, the investment community has tended to ignore the drag on earnings that a more realistic valuing of options would produce. If sentiment were ever to shift and require a more conservative accounting treatment of options, corporate earnings would suddenly fall, likely taking share prices with them.

That is implicitly acknowledged by even the staunchest proponents of options. David Hofrichter, compensation consultant in the Hay Group's Chicago office, ardently defends options, arguing that it's the stock market that pays whatever bonus the employee merits, through the enhanced market value of the stock. And yet he cautions that it might be risky to account for options in a more conservative fashion. "If I show less income, people will stop investing in my stock, which brings the whole thing down."

The current nonaccounting for options is a practice that sickens some investors, especially those with a nose for value. Charles Munger of Berkshire Hathaway says, "One thing we hate with a passion is this phony accounting. We regard it as a detestable compromise of ethics and good sense."

Even those who work closely with the high-tech growth companies that use options liberally concede the point. "A large reason companies like options is because of the attractive accounting treatment, no question about it," says Scott Spector. Asked about the claim often made by management that options need not be listed as an expense because they are worthless, Spector replies, "That's a lot of gibberish. Those things can be valued."

When growth companies grow too reliant on options, another quandary for managers - and a concern for investors - arises. It is now quite common, should a stock collapse, for companies to lower the purchase price on options already granted to employees, in order to stem a mass exodus of talent. That practice is called "repricing."

"I can't think of anything more irritating from an ethical standpoint than when companies reprice options," says Dennis Beresford. As he notes, while investors who have risked their funds in a company "lose real dollars" when a stock declines, option holders lose nothing and even get a second chance to buy the stock at a better price. Repricing undermines the primary reason for granting options: to reward superior performance.

Repricing, in fact, rewards mediocre and even poor performance. Still, it's common in Silicon Valley because it's about the only tool that managers of a wounded company have left to keep employees from joining a competitor. Beresford recalls meeting some years ago with two dozen contentious chief financial officers of Silicon Valley companies who opposed a proposal by FASB that would force the expensing of options. After a number of them spoke about how vital options were to the fortunes of their companies, Beresford recalls how one participant objected. "He said, 'Let's be honest. Half of us in this room are worth a lot because we have a lot of options and our stock is up. With the other half of us, the stock is under water and our employees are worrying that their options are worthless. They're not thinking about how to make the company perform better.'"

While repricing may be a hot-button issue for investors in growth companies, the real time bomb is dilution. Pat McGurn, a vice-president at Institutional Shareholder Services, which reviews proxy questions for institutional clients, cautions that the issue could trigger "the battle of battles" between shareholders and management. Dilution becomes an issue as a company's management continues to issue new rounds of options in order to attract and keep talent. Says McGurn, "In Silicon Valley the attitude right now is, 'If I [the CEO] go for a little more dilution each year, my investors won't figure it out.'"

Dilution becomes a threat when a company's stock rises and employees begin cashing in their profitable options. That increases the shares outstanding and dilutes the stake of existing shareholders, since shares issued by the company through the exercise of options are not sold in exchange for cash at fair market value but are exercised at a discount.

Dick Wagner is the president of Strategic Compensation Research Associates, in New York City, a consulting firm that helps companies design stock-plan proposals. He says that options represent nothing less than "a commission paid to employees by investors out of the future growth of the firm." But what is unknown is whether a company's growth will be robust enough to pay off those future obligations to employees without weakening the financial performance of the company. Options, says Wagner, are long-term and "irrevocable" contracts between company and employee. What happens if a company's earnings slow down and the stock price remains high? One likely scenario: to forestall dilution, the company would have to venture into the market and buy back large blocks of stock as wave after wave of options granted in earlier, more profitable times get exercised.

Which brings us back to Siebel Systems, which, as employee Heather Beach attests, would appear to be a surefire advertisement for the wisdom of stock options. And yet, buried in a footnote in Siebel's latest 10-K filing is the fact that the company has granted options to employees to buy 9.8 million shares at an average purchase price of $6.46. If those options were exercised and the stock was then sold at, say, $40, it would amount to a bonus of almost $330 million--the market price less the strike price, times the number of options granted--paid out to Siebel employees over the next nine years. That's a lot of cash, given that Siebel earned just $12.5 million over the first nine months of 1997. Are investors prepared to think that Siebel's employees are worth it and to pay that bonus by continuing to buy Siebel stock without fear of dilution?

Or might they have second thoughts, knowing that Siebel's board has granted the company's management the

authority to increase the number of options granted to 20 million?

Insight into how Siebel might fare can be gained by looking at a legendary growth company. Microsoft's stock is now among the most widely held by American investors. But the company has also granted 290 million options--against 1.2 billion shares outstanding. Last year Microsoft spent 91% of its $3.4 billion in net earnings repurchasing 37 million shares to avoid diluting existing shareholders' stock. A closer look at those transactions, according to Dick Wagner, reveals that Microsoft ended up buying back shares on the open market at $84 each, while it had previously sold them to employees via option grants for $13--not exactly a great deal for shareholders.

Meanwhile, as Microsoft was all but vaporizing its hard-earned profits to buy back those 37 million shares last year, it was busy issuing another 45 million shares that employees had exercised through the option plan.

Another curiosity of the accounting system: when companies issue shares to employees exercising their options, the company can take a tax deduction as compensation expense. It's a neat trick--having what starts out as a nonexpensable item, stock options, turn into deductible "compensation," which is, in fact, appreciation in the stock's market price.

It is axiomatic in the world of finance and investment that if an idea sounds too good to be true, then it probably is. Employee stock options fit that description because they make, in effect, a set of imposing presumptions. Those presumptions include the idea that corporate earnings and share prices will rise steadily, well into the future, and thus it will be an appreciating stock market - not cash from company coffers - that will compensate workers who have taken options and their attendant risks as a substitute for salary.

With employee stock options, the period of undue rewards has ended, and the period of intolerable risk is about to begin.