Their Gain, Your Loss

Shmulik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Rewarding employees by giving them stock warrants is a common practice in corporate America.

In theory, it makes a lot of sense. By attaching an employee's paycheck to the performance of the company, you align the interest of this employee with the interest of the company. It is a win-win game.

In practice, though, things are much less rosy than in theory. I will mention two arguments against this popular method of compensation:

  1. Share price and performance: Very often, the share price has almost nothing to do with the performance of an employee. When gold skyrockets, the share price of gold companies will experience a corresponding jump. This barely has something do with the effort and success of employees and much more to do with the price of the yellow metal.
  2. Volatility and price: Volatility is positively correlated with warrant prices. As volatility increases, the price of options increase along with it. This means that the more volatile a stock becomes, the pricier the warrants of employees become. This, of course, has absolutely nothing to do with how successful employees have been in their work.

This situation causes a strong form of moral hazard:  Employees will benefit from any increase in the share price but will not participate in any losses as a result of any decline. In other words, they will only benefit on the way up but will not suffer on the way down.

But whether you agree with this method or not, the fact is that stock warrant grants are the most popular form of payment other than salaries, especially among high-tech companies.  

The essence of this method

Employees, usually senior ones, are granted stock warrants, usually on an annual basis. Each option warrant gives them the option (not the obligation) to exercise a warrant and convert it into one single share of the company at a predetermined price. This price is usually much lower than prevailing market price for the shares at the time of the grant. This creates an instant profit for the employee.

Aggressive dilution

For many years, companies elected not to classify this 'instant profit' as an expense. Naturally, they preferred to leave it out of their reports. But this situation changed in the early 2000s after immense pressure was put on corporate America from academics and investors alike. Today, each grant of warrants must be classified as an expense to the company and must show on its quarterly P&L reports. This expense is deducted from quarterly income, which decreases the net income attributed to shareholders of the company.

A 'live' demonstration

When the share price of a company experiences a fierce jump, you are likely to find a lot of warrant exercising activity. Take Mellanox Technologies (NASDAQ: MLNX), for example. Over this past year, shares have jumped from the $40 level up to the $120 area, only to retreat to $60 as of this writing.  Take a look at this roller-coaster below:

<img border="0" height="237" src="http://chart.finance.yahoo.com/c/1y/m/mlnx?lang=en-US&region=US" width="512" />

This jump in price did not go unnoticed, of course. In the third quarter of 2012 alone, employees of the company exercised approximately a million (!) stock warrants at an average exercise price of $13. Most of those shares were sold to investors in the open market at an average price of $100 a share. This whopping $90 million of profits was recorded as an expense in the 3Q report of the company. As a result of this aggressive warrant exercise,  the company's official GAAP earnings for the nine months stood at $2.13 per share, in comparison to an unofficial per share earnings of $2.92. This whopping decline in EPS is attributed in the most part to this aggressive warrant exercise by employees.

A slightly different trick

When shares do not shoot up, like shares of Mellanox did, there is still another way for employees to benefit. Rather than wait for the share price to gradually climb, why not lower the exercise price of the warrants?

Nice Systems (NASDAQ: NICE) did just that. In its 2011 annual report, the company repriced 1.024 million option warrants from their previous exercise price of $30.25 to an exercise price of $22.53. The company accounted for the re-pricing as a modification and recorded an additional compensation expense, in the amount of $2.082 million.

Again, this $2.082 million of income was erased from the gross income of the company, attributable to its shareholders. 

The Foolish bottom line

Whether you believe that option grants are a proper form of compensation or not, you must always review announcements by companies on warrant grants carefully. By definition, such grants are at the expense of investors and have direct impact on the earning per share of the company. 

In most cases, their gain is your loss. So pay close attention!


shmulikarpf has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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