Novell investigating its options grants

Another tech company has announced it is conducting internal investigations into their options grant practices. This time it is Novell, a company known for its NetWare network operating system and more recently as a Linux company.

Novell said its audit committee began the investigation because of news about irregularities in the way that dozens of other companies accounted for stock options grants.

So it appears that Novell’s corporate governance has identified the need to and benefits of resolving any doubt about the company’s options accounting. Tech companies are the most frequent user of options as a form of compensation and have been the primary focus of the SEC investigation.

Options have to be accounted for at fair value on the date granted. If the options are granted in the money, the company must recognize the expense as being the difference between exercise and market price times the number of options granted.

So in the case of options abuses, the options were granted in the money at a certain date, then backdated to when they were out of the money, thus allowing the company to avoid reporting the expense while giving management options that are already in the money.

Stock options have been used as compensation in order to better align the interests of management and shareholders. Shareholders want the stock to go up, so options should guide management in making decisions that increase the stock price.

From a compensation standpoint, backdating makes sense. To reward a manager for doing well in the past year, you could give options dated at the beginning of the year so the manager can take advantage of the increase in the price during the year.

This ignores the more long-term outlook taken by shareholders, however. As well, sound management decisions this year will lead to stock price increases in future years as the benefits accrue over multiple years from, for example, deciding to upgrade to more modern and efficient equipment that decreases costs over its useful life.