Ronna Abramson

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Siebel's Case Shows a Hole in Black-Scholes

Ronna Abramson

Just days after an international board recommended expensing stock options, Siebel Systems offered a novel example last week of how that can become a messy proposition.

The San Mateo, Calif.-based maker of customer relationship management software said it intends to report in a footnote of its 10-K filing at the end of the year that the estimated cost of employees' unvested options with a strike price of $40 or more will reach up to $650 million.

That footnote, required under accounting rules, won't affect the company's bottom line. Instead, Siebel will deduct the amount of cash and stock the company is actually paying to cash out those same out-of-the-money options. And that cost, which will affect its income statement, comes to only $54.9 million -- just one-twelfth of the $650 million charge to be disclosed in the footnote.

So, what gives? The huge gap between the estimated cost Siebel will disclose in a footnote and the actual cost the company will deduct on its income statement illustrates a flaw of the formula used to estimate options expenses, which is especially dramatic when stocks swing as wildly as they have these past couple of years. And it buttresses the case of those companies arguing against holding them to a model that overestimates the value of outstanding options.

"This [Siebel] really is a case study. It's a perfect example of a major shortcoming of the Black-Scholes model, where it doesn't accurately depict the true expense," said Friedman Billings Ramsey analyst Daniel Ives, referring to the formula named after economists Fischer Black and Myron Scholes to calculate option values. Ives has a market perform rating on Siebel. His firm hasn't done any banking business with Siebel.

Siebel's $650 million value for the options, calculated using the Black-Scholes model, stems from an unusual offer by the company to buy out unvested options with an exercise price of $40 or more.

Siebel ended up exchanging 28.1 million options -- 88% of those eligible -- at a cost of $51.9 million, or $1.85 per share, in cash and stock; with payroll taxes and other charges, the cost came to $54.9 million.

According to accounting rules, however, Siebel is required in its footnote to use the value as determined by the Black-Scholes model at the time the options were granted, about 2 1/2 years ago, when the stock was trading at more than $100. Under accounting rules, the company had to spread that cost over the vesting period of the options -- three or four years in Siebel's case.

As a result of its exchange offer, Siebel canceled the options early and consequently had to accelerate its recognition of the $650 million "expense" this year. The reduction in outstanding options, meanwhile, will mean Siebel's estimated expense will drop in the following years.

Alfred Rappaport, an accounting and finance professor emeritus at Northwestern University's Kellogg School of Management, said what is important is that Siebel discloses and recognizes the $54.9 million cost of canceling the options as a compensation charge.

Meanwhile, he suggested that including the $650 million mentioned in the footnote may not even be necessary, because Siebel canceled those options and they will no longer be outstanding at the end of the year.

"Procedurally, I understand it [the charge]. Economically, it makes no sense," Rappaport said. "That amortization is premised on the idea that this is the value, assuming it would continue to be outstanding. It turns out you don't need to guess on those anymore because there are some checks written and stocks issued."

But Rappaport added that even the estimate of the remaining outstanding options is "nonsense." It overstates their value because it was calculated when the options were granted -- when shares of Siebel were trading at more than 10 times their current price.

In a recent contributing article to The Wall Street Journal, Rappaport offered Yahoo! as an example of this problem. In 2000, Yahoo! granted options with a weighted average exercise price of $102.42.

The estimated cost using Black-Scholes was about $55, according to Rappaport. But by the end of 2001, Yahoo!s shares had fallen to about $18, and the cost of the options granted in 2000 sank to less than $3. Still, the options expense reported in Yahoo's 2001 footnotes had to reflect the 2000 cost of $55, overstating the expense.

Jeff Brotman, a law professor who teaches accounting at the University of Pennsylvania, said the gap between the $650 million estimate and the $54.9 million charge taken by Siebel is "not that shocking."

It reflects the large drop in value of Siebel's shares since the options were granted, he said. By Brotman's figuring, the unvested, outstanding shares were valued at roughly $38 at the time of the exchange plan. He says that cost is not so outlandish given that Siebel's shares were trading at roughly $100 when the estimated value of the options was calculated, Brotman suggested.

"We've had tremendous diminution in value," Brotman said. "The fact that things turned out to be less valuable than people had anticipated, that's no different than during the '90s when many, many times options turned out to be incredibly more valuable than if you used Black-Scholes."

But even Brotman acknowledged the $650 million charge to be footnoted by Siebel does not offer a lot of meaning to investors. "It shows investors that it [the option] was worth a tremendous amount of money at the time they gave it," he said.

Ives of Friedman Billings Ramsey said most investors would view the footnote charge as a "nonevent," but it does reveal one thing. "When you see such a big charge like this, it just illustrates the amount of options that Siebel is dealing with," he said. And that could be a concern for investors because the more options outstanding, the greater the potential for share dilution.

Siebel CFO Ken Goldman called the $650 million estimate "meaningless" and a "fictitious expense," though he said the company informed investors that it would be included in an upcoming footnote in the interest of "clear disclosure."

Like other opponents to expensing stock options, Goldman argued in an interview Friday that being forced to move that cost from a footnote to the income statement would merely create another form of pro forma earnings because analysts would likely deduct the options expense to get a clearer picture of the company's operating performance.

Tech Firms' Alternate Proposal

Siebel joined with 32 other companies -- mainly tech firms -- in a proposal that would offer information on how options dilute total outstanding shares, instead of counting them as an expense. Technology companies came forward with that plan a week after the International Accounting Standards Board outlined its proposal to require non-U.S. companies to expense options.

Meanwhile, Siebel has recently decided to issue fewer grants in the future, Goldman said. The company, known as one of Silicon Valley's most generous distributors of employee options, reduced its outstanding stock options by 21% between Dec. 31 and Sept. 30, in part because of layoffs, according to the company's filing last week with the Securities and Exchange Commission.

Goldman insisted the possibility of being required to expense options in the future had "zero" to do with its exchange offer and the decision to offer employees fewer options.

Rather, Siebel wanted to eliminate the distraction of out-of-the-money options to employees, Goldman said. "In today's environment, employees don't value options as much as they used to," he said, explaining why the company is limiting future grants. The company has not raised salaries to make up for fewer options because it believes the pay is still competitive, he said.

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