At the upcoming annual meeting on June 13th, Tesla’s shareholders face a historic vote where they will be asked to ratify the 2018 stock option grant to CEO, Elon Musk. Why? On January 30, 2024, the Delaware court ruled that the 2018 stock option award, with an intrinsic value of $51 billion, ought to be rescinded.
The legal effect of the stockholder vote is, at best, unclear. Tesla’s asserts that section 204 of the Delaware code can ratify the 2018 option award to Mr. Musk. Professor Charles Elson (2024) has suggested in a proposed brief submitted to the Delaware court that there is no such thing as a statutory ratification of a fiduciary breach, where the breach refers to the circumstances associated with the 2018 award that the Court took issue with. He contends that section 204 was meant to only cover technical defects, based on his review of 32 reported and unreported cases citing section 204.
Prof. Elson goes on to say that “any attempt to revive the award after judgment is, in substance, a transfer of corporate assets ... for which no consideration at all is received. Such a transfer is in effect a gift” that can only be approved by a unanimous shareholder vote. Hence, in Professor Elson’s view, ratification will not reinstate the original option contract even if a majority of shareholders vote to approve the 2018 CEO award.
Importantly, however, the vote does not only present legal questions. There are also significant accounting questions. Tesla’s 2024 proxy statement seems to suggest that reinstating the 2018 award will result in no incremental charge to its bottom line.
I argue that this is an unreasonable interpretation of both the accounting guidance and the economics of the ratified award. Before they vote one way or the other, shareholders need to be aware that if the ratification is successful in restoring the 2018 award, it will likely lead to a hit to Tesla’s earnings of a number around or upwards of $25 billion.
First, performance-based stock options, by definition, involve a bet on the future. The unknown uncertainties associated with that bet greatly reduced the fair value of the grant and hence the compensation expense when the grant was awarded back in 2018. Hence, Tesla only booked an ex-ante value of $2.28 billion by way of compensation expense.
Today, however, that uncertainty related to the performance conditions has passed. Tesla has achieved all the relevant milestones. The intrinsic value of those options was approximately $51 billion at the time of the Delaware judgement (303,960,630 options at $191.59 which is the closing price of January 30, 2024, the date of the court order - strike price of $23.33).
Second, ASC 718, the Financial Accounting Standards Board (FASB) rule governing stock option accounting, assigns a great deal of sanctity to the distinction between ex-ante and ex-post events associated with performance-based stock option compensation. Rescission of the award by the Delaware court fundamentally changed the nature of any action taken now by shareholders.
If the Court had allowed the 2018 grant to remain in place, it would be very likely that Mr. Musk would have exercised the options to obtain a sizeable increase in his stake in Tesla and hence diluted the other shareholders. Rescission removed the expected cost of this dilution, as argued by Plaintiff’s experts in the Delaware case, Professors Lucian Bebchuk and Robert Jackson (2024).
In essence, the options that Tesla is asking shareholders to restore to Mr. Musk are deep in-the-money options or options that specify a strike price at which a share can be acquired considerably lower than the current stock price. ASC 718 states that the fair value of such a deep-in-the-money option should be expensed as compensation expense. If a successful ratification vote has the legal effect that Tesla says it does, it will give back to Mr. Musk an immediately exercisable 303,960,630 options, whose intrinsic value is $51 billion.
Tesla’s 2024 proxy statement seem to hint that a new award of equivalent economic value could result in a charge of around $25 billion to factor in discounts for mandating that Mr. Musk hold the vested stock for five years. Tesla’s statement that a vote to ratify and restore the prior award—with an identical economic effect—will not involve any incremental accounting charge seems implausible to me.
Even if we were to go with the conservative $25 billion number, Tesla will have to book that number as compensation expense. That charge will potentially wipe out Tesla’s pre-tax profits for the last two years of $14.9 billion and $12.5 billion.
This article was originally published on Forbes.com.