Stock Options Fueled California's Fire

Physician's Money Digest, October15 2003, Volume 10, Issue 19

By now, you're probably aware that California is in the midst of the first governor recall initiative ever to reach the ballot booth. There are many political and economic issues behind the recall, but a more comprehensive, honest representation of how stock options interact with state tax revenues might have allowed the state legislature to realize that the goose that laid the golden egg had indeed left the state.

Perceived Wealth

In the past 20 years, a tremendous amount of perceived wealth was created through the offering of stock options. During this time, many earned well-above- average incomes in salary, but their stock options greatly exceeded their salary in "wealth creation." This wealth creation was a compensation contract that outlined, "If you work here for a certain period of time, you will be allowed to purchase a specified amount of common stock at a designated price at a designated time in the future."

If Jack or Jane were awarded 100 shares of company stock at a strike price of $10 and, down the road, they sold these options at $110 per share, they would realize a $100 per share gain. This could be characterized as a cashless transaction. The recipient of the company stock option never funded the initial $10 offering, but they did receive a handsome reward when the options were exercised. Jack or Jane simply reaped the benefits of a $100 per share profit, which created pure realized wealth. Exercising options converted unrealized gains into real cash.

Trickle-Down Effect

What Jack or Jane did with the wealth earned from their options at $100 per share times thousands and thousands of shares was purchase BMWs, new homes, new furniture, and all those items that successful people just had to have. These spending endeavors and the trickle-down effect of this spending certainly did help keep the economy roaring.

However, before they bought those necessary items, they had to pay taxes. Jack or Jane paid taxes to the federal government and California at marginal income tax rates. California reaped huge tax revenue benefits, not only from the bottom-line earnings of corporations and the salaries of wage earners, but also from the exercising of millions of stock options granted by Silicon Valley dot-com startups and many established companies.

The wealth creation of the 1990s and early 2000s was fully taxed, enjoyed, and spent by the state of California. You might say the benefits of spending trickled down to countless merchants, but the benefit of increased taxes certainly trickled up to state tax collectors.

Belt Tightening

Now, rational people who realize that future paychecks will be substantially less would logically come to the conclusion that they will have to tighten their belts and readjust spending. They would shop at Target or Ross, rather than Tiffany or Nordstrom. Spending should change instantly, because they're aware of their reduced paychecks and the need to live within their budget. The average person adjusts rapidly when they see a change in their revenue resources.

However, the realization that state revenues from stock option wealth creation and other inflated tax revenues apparently escaped the legislature in Sacramento. Revenues and resources changed, but spending power did not adjust as rapidly. So, to the extent that the deficit situation in the state budget is an ignored root cause of the support for the governor's recall, the decline in tax revenues associated with worthless stock options certainly must also be considered a significant factor in the recall.

John Valentine specializes in portfolio management and in developing high-net-worth strategies. He is the principal investment advisor at the Valentine Capital Asset Management of San Ramon, Calif. He welcomes questions or comments at 925-275-0200, or visit www.vcrpg.com.