Facebook (NASDAQ:FB) has been the talk of the town since it was listed back in May this year. Despite all the hype surrounding the company (or maybe because of it), the stock has performed miserably in the past few months. Earlier this week, the stock touched its half-way IPO price. A lower stock price isn't a bad thing at all. First, it flushes out most of the speculators. As in all bubbles, speculators eventually drive up prices of an asset to unsustainable levels, which leads to an eventual crash. For long-term investors, a drop in price shouldn't be a major concern unless there are fundamental changes to the firm's condition. This is not the case with Facebook right now. The second reason is much less obvious, but has much more impact to the company's bottom line and shareholders. It is the company's stock options.
A lower stock price, if sustained, will lower Facebook's option expense when these options are exercised. A look at Facebook's prospectus and 10Q, one will see that the company has 173.8 million out standing options. If all were vested at Friday's price of $19, these shares would be worth roughly $3.3 billion or 7.9% of Friday's market cap.
The cost to Facebook is the difference between the exercise price and the market price of these options when exercised. This is why a low share price is beneficial to Facebook. If the shares were in the $30s, the cost to exercise these options would be roughly $5 billion over the next four years. Considering the company had $1 billion income in 2011, the option cost would be significant drag on its future income. The effect can already been seen in its first half results, the company reported a net loss of 8 cents a share because of the expenses related to its restricted stock units, which is another expense on top of options.
Morgan Stanley (NYSE:MS), in its stock initiation report, estimated the cost of these option and restricted stock units at around $14.4 billion ($10 billion after taking into account of tax benefits), but Morgan Stanley estimated it at $33 a share. Strangely though, the cost was not included in its models. So at today's price of $19, the cost to Facebook is reduced to $8.4 billion or $5.8 billion net after tax benefits in future years - $5.8 billion is still a significant amount for this $40-billion market cap company.
Why Facebook is so generous with its stock options
The main asset of any technology company is arguably its people. In many start-up acquisitions, you will hear talent acquisition being cited as one of the reasons for the deal. Silicon Valley is going through the start-up fever and the price for talent is expensive. To keep its talent, Facebook has generously dished out millions of stock options at such low exercise price that the company is basically giving its shares away. In other companies, the exercise price of option is generally similar to the stock price, so no expense would be booked when the options are granted. Option expense, while non-cash, is a significant expense item on the income statement. In addition to its high costs, stock options also dilute existing shareholder's equity.
Dilutive Effect On Shareholders
Even though the company will save billions from a lower stock price, the dilutive effect to existing shareholder will still be the same, since the number of shares being vested will be the same. So Facebook might grow significantly in the future, but the drag of its option expense will be very significant. Since retail investors can only buy A class shares in the company, any investors should be very aware of the future dilutive effect of these options.
Comparison with the Google IPO
A quick comparison with Google Inc. (NASDAQ:GOOG) will see how much the competition for talent has changed. Google launched its IPO in 2004, when the Valley was still recovering from the burst of the tech bubble. The price for talent was a lot lower. In Google's prospectus, it only had about $500 million of future option expense out of a $23-billion market cap when it was listed. Facebook's IPO was a little over 4 times bigger, but it faced a potential option expense bill over 10 times bigger.
Facebook is a great company. It commands over 1% of people's waking time, but with its earning potential still unproven, the stock is still commanding a $30-billion enterprise value. Although the stock has retreated by 50%, investors should still be very careful before investing in the company - at least in the near term.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.