Published Aug 12, 2006

I’ve had a couple of friends IM me asking “what’s going on with the whole Apple stock option SEC trouble thing?” Now, I know nothing more about this than the average business school student with a few classes on options and on financial reporting, but I guess that’s a few more than average so I’ll expound a bit on what appears to be going on, and if it’s serious or not. Everything below should be taken with a small grain of salt, at least, since there have been no public, comprehensive statements on what’s going on by either Apple or the SEC, but the stories in the press appear to be quite consistent and clear in what they’re describing.

What’s an Option?

Let’s start by getting our basic terms down. An option is the right to buy a share of stock at a certain price after a certain date. Imagine that I have a company, Juniorbird Inc., and the stock is trading in the market at $10/share. If I gave you an option to buy one share of stock at $5, you could then immediately re-sell the stock at the $10 it’s trading for in the market and make a quick $5. This may not sound like much, but then assume I give you 10,000 options — that’s a good chunk of dough! Typically, options can’t be exercised (an option is exercised when you pay the company the value of the option and they give you a share of stock) now — they “vest”, or become usable, at some point in time in the future; that can provide an incentive for the option-holder to look to the long-term success of the company, sticking around until their options vest and working to get the stock price as high at possible at the time at which they can exercise options, in order to make as much of a profit as possible.

It’s possibly worth noting that options don’t entitle the holder to buy a share of stock that’s already in the market; instead, the option-holder gets to buy a share of stock that is owned by the company. Technically, this means two important things:

  • That the company should own enough of its own stock to be able to cover all of the options it has outstanding. Technically, many companies don’t; if all of their options are exercised, then the shareholders of the company will have to vote to issue new stock, which is a bad deal for the shareholders — by issuing new stock, they make their total holding a smaller percentage of the company than it used to be.
  • That, if a company uses a lot of options as part of its incentive program, people who have bought shares in the market can find that they own very little of the compan, because the number of shares owned by the company and given away as options is high compared to the number of shares that had been in the market.

Both of these are interesting points but aren’t really relevant to our discussion here; I only include them for their nerdly value.

How Are Options Priced?

An option is more or less priced at whatever the company pleases to price it at. Typically, to keep accounting single, options will be given out to employees in large blocks, all with the same price; for instance, all options granted in a six-month period may be granted at the same price. Of course, because the value of a $10 option is different if the stock is at $12 or at $50, companies will, from time to time, change the price at which they grant new options to keep compensation relatively equal across time (if you want to give an employee 1,000 options worth $10,000 dollars, you’d better price those options at $2 when the stock is at $10, but at $40 when the stock is at $50; if you don’t increase the option price, then you end up giving the employee $48,000 worth of stock options).

The important thing is that, once an option has been granted, the price shouldn’t change. Re-pricing options is an accounting nightmare for companies and can have tax consequences for companies as well. Re-pricing options is an act that, itself, brings up ethical concerns; typically it’s done when the stock price is not high enough to allow the option holder to make a profit on the options, but, since the point of options is typically to incentivize the holder to work to bring up the stock price, re-pricing options gives the holder a gain even though they didn’t accomplish the stated goal. Re-pricing is a good way to piss off stockholders, because the re-pricing company is basically saying “‘sorry, we didn’t manage to increase the value of your investment in our company but we’re going to give this person a windfall profit anyway.”

So What Did Apple Do?

As you can see, it’s really important to get an option at the right price, but you generally can’t change the value of an option once it’s granted. As I described above, options are often granted with an exercise price that changes at a few points in time — so therefore it’s desirable to get your options granted before a decision is made to increase the exercise price of the option. Sometimes, a grant of options will be backdated to come before some change in exercise price. This is perfectly legal.

What Apple apparently did is change the date of options granted after granting the options, which ,when you think about it, is pretty much the same thing as re-pricing options, as discussed above. They didn’t file the proper declarations that they re-priced their options, didn’t go through the proper accounting procedures, and therefore hid from shareholders — and even other option-holders, since Apple apparently only did this for senior executives — what exactly they were doing.

Apple’s said that they will re-state their earnings for past years, which means that we’re not just talking about a few dollars — there are real differences in Apple’s financial results caused by this stealth option repricing. Reasonable investors might have made different investment decisions, had they but known about the option repricing, and Apple’s officers had a legal obligation to make this information known to the investors.

What are the Consequences for This?

Well, I’m no lawyer, but this sounds like securities fraud. Laws passed after Enron require the CEO and CFO of publicly-traded corporations to personally certify the annual reports given to shareholders, annual reports which must now be restated. Thus, we can be sure that Steve Jobs has at least some responsibility here. Since Enron, the SEC has been disinclined to seek out slap-on-the-wrist punishments, which might mean that someone senior would go to prison; fines, at least, seem likely, and anybody found guilty of securities fraud would be ineligible to serve as a director or officer of a publicly-traded corporation. (The SEC has recently filed criminal charges against officers of other companies involved in this kind of a backdating scheme, a scheme which has apparently been pretty common in Silicon Valley.)

So could Steve Jobs go to prison? I can’t guess, but I also wouldn’t want to think of Apple without Steve. If he were convicted, they could keep him on with some sort of a VP or “Chief Innovation Officer” - type title, but he couldn’t run the place. I do tend to think that Apple is concerned that Jobs will suffer some type of consequences here, because, at their latest developer’s conference, the keynote, which is typically given by Jobs alone, was given by Jobs and three other people, all of whom would usually speak but none so much. I tend to see this as an audition to find out who might be a good face for Apple, and, if you watch the WWDC, you can see that VP of Platform Experience Scott Forstall was young, artsy, engaging, and natural on stage — a good successor, at least for a public leader. Of course, given Jobs’s recent brush with prostate cancer, this might just be good succession planning in general — but I do wonder a bit.

The SEC clearly wants companies to be squeaky-clean these days, and, as both an investor and an entrepreneur, I think this is a good idea. The free flow of investment funds to help companies grow depends on investors being able to trust the companies in whom they invest, and that includes not hiding stock option repricing when it’s material to the companies’ results, as it cleary is in the case of Apple. So that is what I think is going on and what I fear might happen. (I realize this entry might have fit better at, but I’ve already written it here and I’m too lazy to move it, so you’re stuck reading it.)

1 Comment

Why is everyone always picking on the poor, over-worked corporate executives. They slave away their whole lives just trying to make things better for the working class masses, so they can clock out at 4:59 and enjoy their weekends, sick days, and unlimited vacation on their party boats. If they have to bend a few trivial little rules, who’s that hurting?