The Price of Backdating

If you’ve been paying attention, you’ve probably noticed that we’ve been skeptical about how big of a scandal this whole backdating really is. It’s always had the feeling of a panic or a witch-hunt helped along by heavy-breathing media coverage. Especially since it seems that many of the companies that engaged in backdating weren’t trying to secretly pad their C-level executives compensation package. Instead they were trying to find creative ways to pay employees without bleeding to much cash or running into tax and accounting trouble by granting in the money options.

Yesterday Fortune’s Roger Parloff reported on a conversation with Stanford law professor Joe Grundfest. The gist: the gains from receiving backdating are even less than you think.

Though recipients of backdated options received unfair gains, and shareholders were deceived--and I'm not defending either injustice--in each case the extent of the harm may be a little less than some of us are assuming.

Suppose a company gave you, in 1999, one option to buy one share of stock whose closing price that day was $20. Suppose further that the company backdated the grant by a week, so that it could give you an exercise price of only $19. You haven't received $1 of profit yet, however, because your option won't vest for at least a year, and you don't know what the price will be then. In Silicon Valley, options typically vested over a four or five year period, with a one-year "cliff" before the first of them started vesting. Because of the bursting of the tech bubble, a great many, if not most, were out-of-the-money and worthless by the time they vested.

One way to measure what you've received would be to calculate the difference between a Black-Scholes valuation of the $20 option and a Black-Scholes valuation of the $19 option. When we were talking, Grundfest then went to one of the many Black-Scholes calculators on the web, filled in some hypothetical parameters--the calculation will vary a little depending on factors like volatility and expiration date--and found that the fair market value of his hypothetical backdated option (with a $19 exercise price) would have been $13.31, while the fair market value of the non-backdated $20 option would have been $13.06. So, in a sense, you were given about a quarter, not a dollar.

And the plots thinnens.

Backdating: A little less than meets the eye [Fortune via Ideoblog]