Proper accounting for stock warrants

Sunday, 01 December, Year 5 d.Tr. | Author: Mircea Popescu

Of the four companies currently listed on MPEx, two (S.MG and S.NSA) have issued Stock Warrantsi while two others (S.MPOE and S.BBET) have not. Of the two companies previously listed on MPEx (S.BVPS and S.DICE) none had issued Stock Warrants.

The AN0 accounting standard - which is the applicable accounting standard for pretty much all Bitcoin ventures (as opposed to Bitcoin scams) - makes no provision for the inclusion of Stock Warrants in the balance sheet of abiding companies. In practice both MPEx listed companies using Stock Warrants have taken no charge or otherwise reflected them in the balance sheet, but have instead reported them separately, pursuant to recommendations in AN0-1-6.

The appropriate manner in which Stock Warrants should be treated in accounting has been a contentious topic in fiat accounting for about five decades. Let us consider the following quote from Warren Buffett :

The most egregious case of let's-not-face-up-to-reality behavior by executives and accountants has occurred in the world of stock options. In Berkshire's 1985 annual report, I laid out my opinions about the use and misuse of options. But even when options are structured properly, they are accounted for in ways that make no sense.

The lack of logic is not accidental: For decades, much of the business world has waged war against accounting rulemakers, trying to keep the costs of stock options from being reflected in the profits of the corporations that issue them. Typically, executives have argued that options are hard to value and that therefore their costs should be ignored. At other times managers have said that assigning a cost to options would injure small start-up businesses. Sometimes they have even solemnly declared that "out-of-the-money" options (those with an exercise price equal to or above the current market price) have no value when they are issued.

Oddly, the Council of Institutional Investors has chimed in with a variation on that theme, opining that options should not be viewed as a cost because they "aren't dollars out of a company's coffers." I see this line of reasoning as offering exciting possibilities to American corporations for instantly improving their reported profits. For example, they could eliminate the cost of insurance by paying for it with options. So if you're a CEO and subscribe to this "no cash-no cost" theory of accounting, I'll make you an offer you can't refuse: Give us a call at Berkshire and we will happily sell you insurance in exchange for a bundle of long-term options on your company's stock.

Shareholders should understand that companies incur costs when they deliver something of value to another party and not just when cash changes hands. Moreover, it is both silly and cynical to say that an important item of cost should not be recognized simply because it can't be quantified with pinpoint precision. Right now, accounting abounds with imprecision. After all, no manager or auditor knows how long a 747 is going to last, which means he also does not know what the yearly depreciation charge for the plane should be. No one knows with any certainty what a bank's annual loan loss charge ought to be. And the estimates of losses that property casualty companies make are notoriously inaccurate.

Does this mean that these important items of cost should be ignored simply because they can't be quantified with absolute accuracy? Of course not. Rather, these costs should be estimated by honest and experienced people and then recorded. When you get right down to it, what other item of major but hard-to-precisely-calculate cost-other, that is, than stock options-does the accounting profession say should be ignored in the calculation of earnings?

Moreover, options are just not that difficult to value. Admittedly, the difficulty is increased by the fact that the options given to executives are restricted in various ways. These restrictions affect value. They do not, however, eliminate it. In fact, since I'm in the mood for offers, I'll make one to any executive who is granted a restricted option, even though it may be out of the money: On the day of issue, Berkshire will pay him or her a substantial sum for the right to any future gain he or she realizes on the option. So if you find a CEO who says his newly-issued options have little or no value, tell him to try us out. In truth, we have far more confidence in our ability to determine an appropriate price to pay for an option than we have in our ability to determine the proper depreciation rate for our corporate jet.

It seems to me that the realities of stock options can be summarized quite simply: If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?

The accounting profession and the SEC should be shamed by the fact that they have long let themselves be muscled by business executives on the option-accounting issue. Additionally, the lobbying that executives engage in may have an unfortunate by-product: In my opinion, the business elite risks losing its credibility on issues of significance to society-about which it may have much of value to say-when it advocates the incredible on issues of significance to itself.

It is important to note that unlike the case of fiat companies, for Bitcoin companies it is a fact well established through both practice and legislationii that there exists no outside authority which may in any way influence any aspect or facet of their business, from accounting to taxation.

This principally means that as Bitcoin entrepreneurs we are and remain responsible to do the right thing, and can't readily hide behind the "incompetence" of legislators or regulators we've conveniently appointed - in the manner of the corrupt pretend-entrepreneurs of the fiat world - for the very purpose of providing a convenient hiding spot. It is therefore very important to get this (as well as any other) point right, exactly right, precisely right. Anything else will have miserable consequences, for us first of all, for our business partners, creditors and associates, for our investors and beneficiaries, for the entire community in the end. The responsibility that rests on our shoulders could not be overstated exactly as it can't be eschewed, which is why I believe this point must be considered very attentively by anyone contemplating the use of Stock Warrants.

My judgement as to why Stock Warrants do not belong on the balance sheet is constructed as follows :

  • Whether limited in time or not, and whether limited in any other manner, from the point of view of the issuing company Stock Warrants represent an asset, not a liability. Indeed, at least in the formulation used on MPEx, all Stock Warrants can be reduced to a unilateral promise of the company to accept a BTC deposit from a third party for which it will advance its own shares. As no company can ever go bankrupt by issuing more shares, and as no company can ever go bankrupt by receiving a BTC income, the Stock Warrant does not meet the definition of a liability.iii
  • Stock Warrants do indeed convey a benefit and impose a cost. The benefit is always conveyed to the third party named as a beneficiary. The cost is always imposed upon the shareholders of the company, and not upon the company directly, for instance through the mechanism of depressing future share price.iv Inasmuch as the issuance of Stock Warrants does impact the equity of shareholders, they must be apprised of this circumstance. Nevertheless, inasmuch as the issuance of Stock Warrants does in no way affect the balance sheet of the company itself, that balance sheet should then not be muddied with extraneous considerations.
  • It is the right of a company to issue more shares in itself. This right may be restricted by specific, explicit provisions in the company charter (such as the Listing Agreement in the case of MPEx companies), but outside of such restrictions that right stands. How should that right then be priced, if we subscribe to the view proposed by Mr. Buffett ? If indeed a corporation could write an infinity of Stock Options, and if those can indeed be valuable, then how would the right to do so be reflected in the balance sheet ? Clearly such meta-considerations are the path to nonsense.
  • The one exception, of course, are Stock Warrants issued at a par value inferior to either the nominal value of the company or the current trading value of the company shares, whichever is higher. Such Stock Warrants do in fact reflect a conveyance above and beyond the normal case, and as such that portion - if at all allowed - should be at the very least reflected in the balance sheet, if not outright detached as a companion conveyance leaving the Stock Warrant free of such encumbrance.v
  • Of particular concern is the proposition that "these costs should be estimated by honest and experienced people and then recorded". As the most honest and the most experienced of the people in Bitcoin, I will plainly confess that I lack the first inkling of a clue as to how to value SSWs, and moreover I am firmly persuaded that any others who may profess a different stand on that score are simply confused as to the actual extent of their experience and understanding (in the more nefarious cases coupled with a quite plain absence of the other horn in the requirements).vi

I would definitely like to hear other opinions on this very important topic.

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  1. The definition, as it appears in the S.MG contract, where the concept was introduced :

    Special Stock Warrants (abbreviated SSW) are numbered and GPG signed instruments which create the right for a beneficiary specified by GPG fingerprint to purchase a specified number of S.MG shares directly from MiniGame for a specified price, no earlier than a specified date. To be valid a SSW must be published by MiniGame at the time of its issuance.

    A typical such instrument is included in the IPO report for that asset. There is also an article discussing the instrument more in depth : The Stock Warrant instrument explained. []

  2. If you perceive a difference between the concept of "law" as used in the fiat world and what my publishing an article on Trilema achieves, you're more than welcome to delineate it in writing, I'd be curious to read such. []
  3. Liabilities are strictly those arrangements, or parts of arrangements, which may in some circumstances cause the bankruptcy of the company. Thus a promise to pay 1 BTC is a liability, because it engenders the bankruptcy of the company that doesn't have at the proper time the one Bitcoin. A promise to deliver one ounce of salt is a liability, because it similarly engenders the bankruptcy of the company that doesn't have at the proper time the required quantity of salt. []
  4. If a company has a large bulk of Stock Warrants that go in the money at the price of 1.2, and the current price is 1.19, it is likely the transition to 1.21 will take longer than it would have taken in the case of a company in all respects identical but without the bulk of Stock Warrants outstanding. []
  5. An example of this is the case of the heraldry contract, which rather than work as a SSW-under-par was split into a cash part and a SSW part, the former being reflected in the balance sheet as any other payment. []
  6. For comedy relief, kindly review the history of Usagi-run forum "companies" and the ensuing valuation comedy. []
Category: MPEx
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