The options for employee compensation
A few months back, I overheard the COO of a prominent dot-com company casually mention that her executive secretary, after two years with the company, held $2 mn worth of stock options. That evening, as I sat at my desk picking through my receipts and wondering if I'd be able to count a $7 burrito as an 'expense', I thought to myself: Why not convert my moderately impressive typing skills into an attractive secretarial options package?
That was January, and as everyone knows, since then a vast number of high-tech employees have seen their paper net worth dwindle. Not that everyone is in the poor house, though. At today's prices, that executive secretary is still worth a few hundred thousand dollars; and I'm still fumbling around, organizing my meager taxi receipts.
But despite the downturn, and in some cases perhaps because of it, companies are still doling out options plans at unprecedented rates. And although many normally contemplative employees are no longer jettisoning carefully nurtured, secure careers for even the sketchiest job.com opportunity, options fever has already spread to old-line companies trying to attract and retain talent.
The widely accepted argument in favour of stock options is that they are an excellent tool for linking employee compensation to performance. The results of a 1999 survey by Virginia-based Executive Compensation Advisory Services (ECAS) support the performance link. The survey report notes that while average options value rose some 35 percent for chief executives of 295 Fortune 500 companies from 1996 to 1998, that rise resulted from market gains rather than from increased grants.
The results, however, are reflective of a period when stocks were soaring to unprecedented highs. Of course, that's no longer the case, but options continue to dominate the landscape. Precisely what that means is open to debate, and not only in the US, as many foreign companies, especially within the tech sector, are addressing compensation more aggressively.
'UK companies feel they have to follow the US model if they want to get the best employees,' says London-based Hermes Lens Asset Management CEO Peter Butler. 'We have a major problem, therefore, because we think the US market has not faced up to the realities of these options plans.'
Overcompensating
One of those realities, according to Butler, is that options often 'ratchet up' the pay of managers who wouldn't, in reality, be fleeing to other jobs. No one is adverse to giving options to directors who perform so long as the options are performance related. He concedes, 'We're worried that there are large issues of options or shares that reward average or below average performance.'
Some companies are quick to point out that compensation packages have grown in line with the tremendous rise in stock prices over the last ten years. Stock options also allow emerging technology companies to compete with the salaries offered in the old bricks and mortar world. That's a rationale which investors such as Butler are sympathetic to. 'Different sectors have to reward in different ways. Clearly options are more appropriate for human intensive businesses than for capital intensive businesses.'
The question is how much is too much? A National Bureau of Economic Research working paper from March of this year finds that the average CEO's compensation, including option grants, is the same regardless of what has contributed to a company's profits or stock price rise - be it events outside a company's control (otherwise known as luck) or strong management. Of course, there's good and bad luck, which is what some might call the market's current infatuation with gravity and the even more precipitous drop in tech shares.
Other options
Which brings us onto the subject of underwater options (options that have dropped below their strike price, rendering them worthless). Following a new accounting rule from the Financial Accounting Standards Board (Fasb) in the US, companies that reprice options are required to take charges that reflect potential stock market gains when their shares rise. While this rule has made repricings distinctly costly for many companies, repricings are not yet extinct.
'Many tech companies will still reprice because they have little to lose,' argues Carol Bowie, director of publications at ECAS. 'The penalty is an accounting charge, but they don't have any profits. To remain competitive in keeping talented employees, they'll have to do it. Most old-line companies aren't going to reprice,' she claims.
But while many investors shrug off options grants, most join the chorus of shareholder activists. 'Repricing stinks,' avers one institutional investor. 'I don't have a problem with options, especially for technology companies,' he says, 'It's a good way to link performance and compensation. But I don't like to see options repriced. To me, management is getting something for doing nothing.'
Companies have other stock-based compensation choices they can turn to, including offering employees restricted shares which guarantee a fixed value. These shares represent a one-time accounting charge instead of a variable charge, so the hit to earnings is predictable. The problem, however, is that they are not performance based, which puts them out of investors' favor (and generally makes them non-deductible).
Blank check
So, stock options continue to represent the most visible and the most popular form of stock-based compensation. And for the most part, investors seem willing to give companies a wide degree of latitude when it comes to issuing new plans. Yet as the use of stock options continues to expand, some investors, and even compensation experts who have long touted options, have begun to question the conventional corporate wisdom.
'A lot of companies are overpaying for a lot of jobs because of this idea that these options are free,' says James Reda, Atlanta-based Southeast practice leader in Arthur Andersen's human capital division. 'Companies aren't looking at the big picture, especially dot-com companies,' he argues.
By issuing stock options, companies forgo cash they might have received for their shares at the full market value. This is especially critical for many dollar starved dot-coms, given the level of well publicized 'burn rates' - the high pace with which some dot-coms manage to burn through their cash. 'Companies have to carefully figure out their sustainable burn rate based on a review of competitors and what investors are willing to support. So you look at what you have in terms of people and where you're going, and you decide what you want to give in terms of options. I've found that companies are ending up giving away two to three times as much stock as they should be giving,' says Reda.
One major topic of concern is dilution, which occurs when stock options are issued. The more stock options that are granted, the greater the 'overhang' - the percentage of all shares outstanding that all outstanding options would represent if they were executed. To minimize dilution, companies must maintain a balance between shares outstanding and options outstanding. This means either forgoing issuing new shares or buying back stock. Given the increasing size of the options grants that companies are presently issuing, managing this 'overhang' may, for some companies, lead to some pretty crippling costs in the future.
The concern for regulators is that because companies aren't required to record options as a cost on their books, investors are overlooking the extent to which billions of dollars worth of options negatively impact earnings. According to a July 1999 Bear Stearns study on options and dilution, the aggregate diluted EPS for S&P 500 companies would drop 4 percent if the fair value of employee stock options were charged to earnings. For the technology sector, 22 companies would register double-digit EPS declines.
Companies are required to include a footnote in their annual reports and disclose the degree to which options could dilute their shares. But as Reda points out, it takes a couple of years for the overhang to build up to danger levels. 'We don't have any mechanism to keep track of stock overhang on a real-time basis. You find out what happened last year based on the proxy.'
Free pass
In the case of Cisco Systems, for example, accounting for stock options would lower the company's earnings 20-plus percent (as opposed to 17 percent in 1998). But as Cisco spokesperson Abbey Smith points out, companies that ask their investors to approve shares for employee stock options need to prove that the benefit of offering the options outweighs the problem of dilution. 'Cisco has certainly proven that in our case, it does,' she says.
Investors seem to agree, rewarding Cisco with the second largest - and for a brief moment in March, the largest - market cap in the world. 'I would say options packages are a tool for recruiting and retaining employees. Whether the company does that is more important than any dilution they would experience,' says Rob Martin, an internet analyst at Virginia-based Friedman Billings Ramsey.
But according to Jack Ciesielski, a Rhode Island-based accounting analyst who advises both buy-side and sell-side institutions such as Deutsche Bank, even seasoned investors are apt to overlook the impact of stock options. 'Dilution is not necessarily reflected in the diluted shares. It's only there if the shares are trading above the exercise price - if they're in the money. That still has nothing to do with the value that they were given at. So you're missing a piece of the equation.'
As for investors, Ciesielski says they seem to be more interested in looking for a rationale to excuse the explosion of options. 'It's one of those things everyone grumbles about, but they don't do anything.'
Just vote no
Some investors are now beginning to grumble, however, with a report by the Investor Responsibility Research Center (IRRC) in Washington, DC finding the number of no votes for stock option plan proposals steadily climbing. In 1999, new executive stock option plan proposals at companies in the S&P 500, S&P 400 MidCap, and S&P 600 SmallCap numbered 210. Average opposition to option plan proposals was 18.3 percent of total votes cast, which shows a half-point rise from 17.8 per cent a year earlier. In all some six plans were actually voted down. The IRRC has also discovered that higher dilution generally means more no votes, with the percentage of opposition rising directly with the percent of dilution.
Options plans have even raised the wrath of investors in Spain, where Telefonica's charismatic chairman, Juan Villalonga, has drawn intense criticism for the company's option plan. Critics said Telefonica's options were too generous for a recently privatized telecoms company that still functions as a de facto monopoly in Spain, and some analysts are still wondering if Villalonga will be looking for a new job in the coming months.
In the UK, where option plans have to go to shareholders for approval, there are investors demanding a quid pro quo. 'We have voted against or abstained against several this year,' says Butler. 'We base our decisions on several different factors. Are the plans out of line with shareholder return? Do they cripple the earnings down the line? And are options paying out just because the market is up, instead of because the company is up against its peers?'
For Reda, the growing size of options plans represents a sort of Pandora's box, with implied consequences that investors and companies will eventually be forced to face up to. 'I get the feeling this is a tough issue to get back in the barn because some managers responsible for doling out options act as if they're free, and it doesn't become a problem until a few years down the line.'
Balancing act
To offset or reduce the dilution of stock options, companies can either forgo issuing new shares or they can buy back shares. Bristol-Myers Squibb is one of the more aggressive companies when it comes to managing dilution.
'We have had a strong share repurchase program in place. Over the past five years Bristol has repurchased more than 189 mn shares at a cost of nearly $6 bn. We have been buying back at least enough shares to offset or break even on the number of options being exercised,' explains Chuck Triano, Bristol's director of investor relations.
Once an options holder registers to exercise their options, the company buys back the shares. But Triano also adds that in the most recent quarter Bristol actually bought in more shares than needed to cover option exercises. 'If you don't have a share repurchase plan or some other strategy to protect shareholders, you're going to dilute everyone else.'
Investors may be willing to turn a blind eye when it comes to dilution for some high techs, but they're less forgiving for more traditional companies. 'Investors definitely ask what we're doing to offset dilution and keep a watchful eye on any announced transactions and how they may relate to dilution' says Triano.
'I remind them of our continuous share repurchase program, and I offer that we are in the midst of an additional $2 bn authorization for share repurchase. That's what the board has given us. So I can assure investors that we have an ongoing and active program. That's different than saying we want to do a buy-back but don't have money to do it, or announcing a board-approved buy-back but not implementing it.'
Some investor relations officers at dot-com companies may soon be wishing they could claim the same.