Sunday, April 02, 2006

Gap Trap 
A reader takes me to task for the post on Gap, Inc. executive compensation:

Jason, I think you are way out of line here. The LAT article is simply quoting the Gap's own figures from their DEF14A SEC statement filed a few days ago:


(which, speaking of doing your homework, is something it took me about 60 seconds to find).

I expect that the valuation Gap placed on these options is arrived at via some standard scheme like Black-Scholes, though I haven't read the SEC statement in that much detail yet. Valuing employee options is necessarily imprecise but valuing them at zero is ludicrous. They cost the company very real money if they're exercised - though they may not be.

There's nothing specific to the LAT in this. Several other finance media articles quote the same figures. Don't go on a rant for the reporter taking the Gap at its own word.

Jon Leech

Well, I'm not up to going through the Black-Scholes equation, but that equation is simply a desperate GAAP accounting measure to get SOME accounting for options on a company balance sheet. My larger point still stands: The reporter went for a "gotcha" story on CEO/Board of Directors cronyism that just isn't there in this instance. Indeed, the strike price of the options is well above the current stock price of $18.68. Gap has quite a ways to go before the CEO can make the first cent with his options-which do not begin to vest until 2010 (the LA Times article leaves out both salient facts.) But still, note the headline: Chief's Pay Rises as Gap Struggles.

That's right - no bonus, plus no pay raise, plus options that don't begin to vest offor years, entirely congingent on the Chief doing well, and which, in any case, involve what the IRS calls a "substantial risk of forfeiture" equals the Chief's pay rising.

The current value of the options to Mr. Pressler is zero. For that reason, Mr. Pressler is not taxed on them. The cost to the company for granting them is zero.
And the cost of exercize to the company is zero (but in certain circumstances, the company can get a nifty tax deduction by slicing the present value of the options under the Black Scholes equation off its current income for the year).

The company only issues additional shares, which decreases earnings per share. The CEO will generally sell his exercized shares on the open market. But the dilution ONLY occurs if the CEO is successful in increasing the per share price of Gap stock. This is not something that costs the company money. This is something that enriches shareholders, and compensating the CEO for running the company is simply part of the cost of doing business.

By tying executive compensation to stock performance, via using options as the primary means of compensation (we hope), Gap, Inc. is conducting sound corporate governance, and the board is acting entirely reasonably.

For the reporter to write as if the board was irresponsibly giving Pressler a sweetheart deal for underperformance is reprehensible.

Further, my criticism of the LA Times for using the terms "stock" and "options" as if the two were interchangable still stands.


Tying executive compensation to stock price, rather than to company performance, is very much not in the shareholders' interests. It is too easy to manipulate stock price independent of performance.

Gap may issue new shares, or they may purchase them on the open market. Would have to look carefully at more SEC docs to determine which, if it's even determined this far in advance of the options vesting. Neither are a positive for shareholders IMO.

I'll go with Warren Buffett's views on options over yours. And either way, will not be buying stock in the Gap.

I don't care one way or the other about your anti-LAT crusade. I don't read it.

Jon Leech
You can play those kinds of games if the options vest next quarter. You can't play them when those options vest 4 years from now.

The most reliable way to increase the share price is to increase the profitability of the company.

But if company profits increase but the share performance doesn't (including dividends), that is no benefit to the stockholder.

Tie performance to company performance? As measured by what? Earnings? You can play a lot more games with earnings than you can with a stock price.

And if an executive increases earnings in the short term by moving the company to a higher profit but slower-growth industry, that will not necessarily benefit the stock price nor the shareholder - particularly if the shareholder is tax-sensitive, since the shareholder is going to prefer capital gains to dividend income (although qualified dividends change that dynamic).

Warren Buffett? What does he have to do with anything here? He supports expensing options on balance sheets. He doesn't oppose tying executive compensation to stock price. Indeed, he ties his own compensation to stock price, since he's compensated almost entirely with BRK stock.

I'm not on an LA Times crusade, either. Truth be told, I hardly ever read it. Happened to be in LA and happened to read the story.
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