Siebel's Case Shows a Hole in Black-Scholes

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.