Cisco Proposes New Options Instrument

May 12, 2005 ( - Prominent technology company Cisco Systems has thrown a new wrinkle into the ongoing controversy over stock option expensing with a proposal to publicly sell a new options-related security.

Cisco has proposed to regulators the creation of employee stock option reference securities (ESORS), which it would sell to institutional investors when it issued options to its employees, according to a New York Times report. A key provision in the plan is that Cisco would use the ESORS sales to determine the value of its employee options.

That’s a critical consideration for tech firms such as Cisco because a lower options value would reduce the options’ impact on Cisco’s earnings. In its last fiscal year, Cisco granted 188 million options to employees and disclosed that had if it been forced to take the value of options as an expense, its net income would have fallen by 28%, to $3.2 billion.

Cisco’s proposal is also important because the company will be one of the first to come under the dictates of the Financial Accounting Standards Board (FASB)’s options expensing rule. That rule goes into effect June 15 for fiscal years beginning after that date; Cisco’s fiscal year begins July 31 (See  SEC Makes it Official: FASB 123 Implementation Date Moved Back Again ).

According to the Times report, buyers of the new instruments would not be able to transfer them and would have options that would vest over five years. Cisco hired the investment bank Morgan Stanley to put together its proposed security, which could be used to set the price of the options of any company wanting to participate.

Under the Cisco plan, securities would be offered to a limited number of institutional investors, so that the company might get a higher price from a smaller market because those investors would have an interest in putting in the time needed to analyze a new and complicated security.  There would also be provisions barring the owners of the derivatives from hedging their positions.

Perhaps the most controversial part of the proposal is that a buyer would not know how many options he would eventually have. That is because the ESORS would mirror the actual experience of employee options, which are canceled when employees leave Cisco, whether voluntarily or not. Last year, Cisco’s annual report states, 52 million options were canceled.