fwd: Microsoft's Genius

Date view Thread view Subject view Author view

From: fielding@ebuilt.com
Date: Sat Feb 19 2000 - 15:57:44 PST

----- Forwarded on 02/19/00 03:56 PM -----

Why Microsoft's Stock Options Scare Me

By Rob Landley

Forget Windows 2000. As far as I can tell, the single most
lucrative product Microsoft (Nasdaq: MSFT) sells is its own
stock. Microsoft makes almost as much after-tax cash income from
the stock market as it does by selling goods and services.
Here's how:

Basically, Microsoft receives cash by issuing employee stock
options, after which the company then receives billions of
dollars in tax deductions from the IRS for doing so. Add in the
warrants it sells on its own stock, and the company made over $5
billion off the stock market last year (fiscal year ended July
1999), tax-free. For comparison, its after-tax net income was
only $7.8 billion. Microsoft may not be much in the programming
department, but its accountants are impressive.

Let's run through that again a little more slowly, using
Microsoft's most recent annual report. As with all annual
reports, the most interesting stuff is in the tables at the end.
In this case, search for the $3.1 billion dollar item "Stock
option income tax benefits," which occurs in the Financing
section of the Cash Flows Statement (the above link will take
you there). Lemme detour for a sec to explain what "Stock option
income tax benefits" are.

A significant portion of the wages Microsoft pays to its
employees comes in the form of stock options rather than in
cash. Compared to the rest of the industry, the amount of cash
Microsoft pays its programmers is at best mediocre. It attracts
and retains employees via stock options.

These options give the employees the right to buy a certain
number of shares of Microsoft stock at a tiny fraction of the
current market price. Employees can even take an automatic
payroll deduction to make the token payment to exercise each
stock option as it matures, and thus effectively get shares of
Microsoft stock as part of their wages.

Microsoft's options are "non-qualified," which means the
employee is immediately taxed when an option is exercised (i.e.,
used to actually purchase very cheap stock). The difference
between the price the employee pays for the stock and the
current market price for the stock they receive is counted as
taxable income on the employee's W-2 tax form for the year, as
if they'd received it in cash. The cost basis for the stock is
adjusted accordingly, meaning that if the employee immediately
sold their newly acquired Microsoft shares they wouldn't incur
any additional taxes. They've already been taxed on that income
anyway, and the only new taxes to accrue are capital gains taxes
if they sell the stock for a higher price than they bought it
at. (Capital gains taxes apply to the extra money gained by
selling an investment for more than it was purchased for. Only
the amount over the original purchase price -- the cost basis --
is taxed, and this has nothing to do with options.)

Corporations pay taxes on their own income (generally 35%), but
money they pay out in salaries to employees is deductible from
the corporation's income. Since granting options to employees
results in taxable income to those employees, Microsoft gets to
deduct that taxable employee income from its own taxable
corporate income, and that's where Microsoft got a tax-free $3.1
billion in cash in fiscal 1999: "Stock option income tax

But if you stop and think about it, Microsoft didn't really have
to spend actual money to provide the options. It even GOT a
little money from its employees, in the form of the cash the
employees paid (via payroll deductions) to exercise their
options. All Microsoft had to do was issue new stock
certificates, which more or less involves taking a vote in a
board meeting and then firing up a laser printer.

So Microsoft got $3.1 billion of tax money back from the
government, which at a 35% tax rate would be in exchange for a
$9 billion tax expense it never had to pay. Its employees got
taxed and paid that tax out of their own cash wages, and
Microsoft got the money refunded back into its corporate
coffers. It even got $1.3 billion of cash BACK from its
employees in that payroll deduction to exercise the options (the
"Common stock issued" line item, in the same Financing table as
the "Stock option income tax benefits"). Together, that's almost
$4.5 billion dollars Microsoft made directly from selling stock.

This is on top of a huge cash savings from substituting shares
of its stock for actual cash paid to employees in the first
place. Remember, Microsoft only made a $7.8 billion net profit
last year. To pay its employees an extra $9 billion in cash
compensation expense, it would go $1.2 billion into the red.
But it doesn't have to, as the stock market provides the money
to keep Microsoft going. Microsoft prints stock, pays its
employees with the stock, and the stock market provides the cash
for Microsoft's employees when they sell the stock or get margin
loans against it. Microsoft can print as much stock as it likes
in order to pay its employees, and as long as the market keeps
wanting to buy shares from those employees, then Microsoft
doesn't have to spend too much of its own cash to pay its
people. As of July '99, Microsoft had around $60 billion of
employee stock options outstanding, and it grants more all the

Of course printing more stock dilutes the value of Microsoft's
existing shares, but as long as the stock price keeps going up
nobody seems to mind. Microsoft can sell more and more stock
(through its employees) at ever-higher prices to generate more
and more income with which to support the stock price in a
never-ending pyramid, er, cycle. And of course Microsoft can buy
back some of its shares -- $3 billion in 1999 ("Common stock
repurchased" in the same Financing table as before) -- but since
it issued over $10 billion worth of shares ($9 billion taxable
income over and above the $1.3 billion the employees paid for
it), this buyback is a mitigating factor at best. But since a
lot of Microsoft shareholders hold on to their shares and live
on margin loans, the dilution doesn't increase Microsoft's share
float until they do decide to sell (i.e., the stock starts going
down and they have to pay off those margin loans). Meanwhile,
the buybacks help keep the stock price from dipping too much.

Employee options aren't the only kind Microsoft sells. It sells
another kind called "put warrants" to mutual fund managers,
giving them the right to sell Microsoft shares back to the
company at a fixed price (well below the price they're currently
trading at, of course). Mutual fund managers with a large
exposure to Microsoft stock buy warrants as insurance, giving
them a guaranteed floor price they can sell out at if the stock
collapses. If the stock doesn't collapse, the warrants expire
worthless after a few years, and provide Microsoft with
additional revenue (three quarters of a billion in 1999, "Put
warrant proceeds" in the cash flows statement).

So there you have it. $3.1 billion from a tax loophole, $1.3
billion from its employees, and $0.7 billion from put warrants
combine to give Microsoft over $5 billion from its own stock in
fiscal 1999. And it avoided paying $9 billion in wages. All that
from a company that only had $7.8 billion in net income. And as
long as the stock keeps going up, they can keep doing that ad

Maybe if Microsoft had recruited a few people from their
accounting department into the programming staff, they'd have
gotten Windows 2000 out on time, eh? Then again, who cares
about products if you can make this much money without them?

Date view Thread view Subject view Author view

This archive was generated by hypermail 2b29 : Sat Feb 19 2000 - 16:01:13 PST