Why No One Understands Backdating (And Why You Probably Do)

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Here's the main reason no one understands backdating: because no one understands how stock options grants are priced. And, to make things worse, even fewer people understand how stock option pricing affects overall executive compensation. (Yes, we realize we just wrote fewer than "no one" but that's about right.) Add backdating shenanigans to that and you've got a perfect recipe for absolute misunderstanding.
After our item on backdating this morning we received several inquiries about why we were suddenly backsliding on backdating. Were we finally admitting that the prosecutors, regulators and business press was getting the story right? Of course not.
But to understand why we're not saying that you have to understand stock options pricing. And, despite our earlier statement that "no one understands" it, we suspect that maybe you do. People paid to understand somewhat complex financial accounting are, after all, more than a bit over-represented in the DealBreaker readership.
But in case you slept through your financial accounting class or landed your job because your uncle runs a big hedge fund client of the bank, we're going to do some 'spaining after the jump.



How Options Work.
When a company grants a stock option to an executive, that option is assigned an exercise price and a term. The exercise price the price it will cost you to buy the stock when the term is over. The term is just the length of time you have to wait until your right to buy the stock kicks in.
Now the exercise price is typically the price of the stock at the close of the date on which the option is granted. So if your company's stock closes at $100 dollars on the day of the grant, that's going to be your exercise price when the term expires. If the stock is worth more when your term is up, you have the opportunity to buy the stock from the company at a price that is lower than the market price. So if the stock goes up, say, 25% over that waiting period, you can buy shares worth $125 on the open market for $100. You can then sell the shares and pocket the $25 you made or hold the stock and hope it goes up further.

How Options Are Priced.
So much for the a quick primer on how options work. The next question is how a company accounts for how much an options grant is worth. Financial types make is sound endlessly complicated but it's really not. The accepted accounting standard is basically a variation on something they call the "Black-Scholes Options Pricing Model" because this sounds like something Sauron would use on the peoples of Middle Earth and keeps anyone from figuring out how it works.
We'll call it the "How Much Is It Worth Model" or "How Much?" for short. According to the "How Much" model, to figure out what an option is worth today you take the exercise price and you do some subtracting to discount for the fact that the option can't be exercised for a few years. You are basically trying to answer the question "how much would a reasonable person be willing to pay today for the right to buy the stock at the exercise price three years from now?" The answer is always going to be less than the actual exercise price because, let's face it, a lot can happen over three years.
More particularly, the "How Much" model looks at a few specific things that could happen. First, you could take the money you would spend on the option and invest it in a risk free bond that paid, say, 5% a year over the same period covered by the option term. So you subtract the amount the you might have made by doing this from the value of the option. Second, you make an adjustment for the stock's volatility. Here you are subtracting for the risk that the stock might go down and adding back for the chance that the stock might go up. The way you attach a number to this to look at how much the stock has gone up and down in the past.
You can also then make a few fine-tuning adjustments to account for things like dividends that get paid out. But that's basically it. Take the exercise price, less the risk-free rate of return, throw in some volatility numbers and the dividends due to be paid out, and you've got the official, business school, accountant, SEC approved price of the option.
How Does A Company Disclose An Options Grant?
If the options are large enough or being paid to top executives, the company writes down the price according to the "How Much" model on a form provided by the Securities and Exchange Commission and gives it to the government to publish on the SEC's website and keep on file.

So Does The SEC Filing Tell Us How Much An Executive Is Making?
Not really. It tells us how much the executive might make if all those numbers we discussed earlier work out the way they are supposed to. But stock prices of individual companies have a way of not always obeying the rules set out for them by accountants. So a stock option priced at a certain amount and disclosed by the SEC might end up being worth far more to an executive if his company out-performs expectations. And it might be worth far less if it underperforms.
In one sense, this is great news. It means that executives have incentives to make their companies do better than expected. After all, they want to see those options be worth as much as possible when their term expires.
But in another sense, it's very confusing. Because a company that discloses it paid an executive $500,000 in cash and options worth $500,000 according to the "How Much" model, never has to go back and correct the numbers. The options are priced when they are dated, and future increases or decreases in the stock price don't change that number.
So the officially disclosed numbers have only a theoretical, best-guess, most-likely, pretty-much-ish relationship to what executives may actually make from their options.

What's a Backdated Option?
A backdated option is an option granted on one day but made to look like it was granted an earlier day. That's it.

Does Backdating An Option Affect the Value of The Option?
It might. Remember that according to the "How Much" model, the starting place for figuring out the value of an option is the stock price at the grant date. If the stock price is lower on the phony, backdated "grant date" than the actual grant date, the backdated option will look like it is worth less than it would if it were priced on the actual date.
This means that when a company hands in its filing to the SEC, it will look like it granted options that were worth less than they would have if they used the real date. So shareholders and other people who are worried the executives are getting paid too much won't have as much to complain about.
But don't get too worked up yet. There are two things to keep in mind. First, the difference between the value of an option dated on the actual date and a backdated option isn't as necessarily the same as the difference between the stock price at the phony date and the real date. Remember all that adding and subtracting we did to get the "How Much" value? Well, it still applies.
Here's how a smarty-pants named Helen Shaw put it in CFO.com (you can tell she's a smarty-pants by the way she throws around those evil sounding words like "Black-Scholes"):

Generally, people assume that there is a linear relationship between an option’s strike price and its value, observes Todd. However, “an option 10 percent in-the-money is not worth 10 percent more than an at-the-money option,” she explained.
Consider that a $10-in-the-money backdated option has an exercise price of $90. Without backdating, let's say, it would have been set at $100. Under the Black-Scholes option-pricing model, assuming a risk-free rate of a 5 percent return, the backdated option has a theoretical value only $1.80 higher than the non-backdated option. The backdated option with a 119-month term would be worth $68.88, while the regular option with a 120-month term would be worth $67.08.

So when the reporters at the Wall Street Journalmake a big deal over the fact that the stock price of Broadcom went up 23% between the phony date and the actual grant, they are being a little misleading. The stock price went up that much, but that doesn't mean the "How Much" value of the options went up by 23%.
More importantly, you have to keep in mind that what is being affected is only the value of the option according to the "How Much" formula. It's not how much it will actually cost the company to fulfill its obligations under the option or how much money the executive will actually make.

And Your Point Is?

The price of options granted to executives is an accounting fiction that never gets updated in company filings according actual changes in the company's situation. Someone with a calculator and a bit of time can figure out how the expected, best-guess value of options changes over time but hardly anyone does this. They just roll with the disclosed value.
The urge to backdate is in part created by the "one-off" nature of this disclosure. If companies had been required to update the value of past options grants according to changes in stock price—something that would have been very time consuming—or simply disclosed all the options granted during a year at the value they have at the end of the year, the opportunity and incentive to backdate would never have existed.
In short, the accounting rules of "How Much" created an artificial number for the value of options grants. And many companies found it irresistible to fudge a number that didn't reflect actual values anyway. This doesn't mean that fudging the numbers is okay but it does give us good reason to be skeptical about some of the hysteria over backdating. And, at the very least, to wonder whether this is really a matter for prosecutors and criminal trials.

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