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Some second thoughts on options

ACA Journal; Scottsdale; Spring 1998; Adam Bryant;

Volume: 7 Issue: 1 Start Page: 96-100 ISSN: 10680918 Subject Terms: Stock options Executive compensation Criticism Compensation plans Stockholders Shareholder relations Geographic Names: US

Abstract: A body of evidence being built by compensation experts suggests that stock options may have some unintended side effects. There is growing concern among shareholders about the ballooning liability these options represent. Data compiled by Strategic Compensation Research show that the percentage of "no" votes is rising against management proposals to issue more stock options. In another measure of shareholder discontent, the Investor Responsibility Research Center said that the average proportion of stockholders voting against stock option plans climbed to 19% in 1996 from 3.5% in 1988, a more than fivefold increase. In a flat stock market, companies may feel pressure to reprice options or issue more of them to satisfy demands of employees who have come to expect a payoff. Either way, says Richard H. Wagner of Strategic Compensation Research, companies are going to find that shareholders are likely to grow increasingly intolerant of overly generous stock-option grants.


What could possibly be wrong with stock options?

Considering the number of companies that have embraced them as a way to reward not only top executives but also lower-level workers, stock options seem to be practically a religion in some parts of corporate America. They are widely promoted for their many virtues: They align the interests of shareholders and employees, they can help attract and retain scarce talent and they have turbocharged the remarkable economic engine of Silicon Valley. Options are even spreading to countries like Japan and Germany that once outlawed or discouraged their use.

"There is a rightness to them," Andrew S. Grove, chairman of the Intel Corporation, said in a recent interview.

But not everyone is nodding in agreement. Compensation experts are building a body of research suggesting that stock options may have some unintended side effects. And there is growing concern among shareholders about the ballooning liability these options represent.

"Investors are scrutinizing stock options like never before," said Richard H. Wagner, president of Strategic Compensation Research Associates in New York, a consulting firm that helps companies design stock-plan proposals. "They are assessing whether they are a good investment or a waste of corporate assets."

Even in Silicon Valley in Northern California, where stock options have become standard in most compensation packages, some people are having second thoughts about whether stock options deserve their great reputation.

To the degree that there is a backlash against options, it is a surprisingly swift one, considering that the spread of incentive pay is precisely what many activist shareholders and experts in corporate governance called for in the 1980's and early 90's. In response to broad criticism that top executives were paid like bureaucrats, companies started using stock options to put much of their pay at risk.

Stock options - which are, in their most basic form, a promise made by a company to offer a number of its shares at a set price, for a fixed period - have spread quickly because they let companies have their cake, eat it too, and get a second helping. Corporations, for example, do not have to record stock options as a compensation expense on the set of books they show shareholders, and therefore there is no charge to earnings. But when employees cash in their options, the cost to the company is treated as an expense and corporations get a tax deduction.

"It may appear to be free money," said P. Jane Saly, professor of accounting at the University of Minnesota. "But clearly, there is a cost to shareholders."

But with the remarkable climb of the stock market in recent years, and boards issuing megagrants of a million or more options to top executives, the practice has led to rich, and widely publicized, pay packages for top executives. That in turn has led many investors to question whether executives deserve such a hefty tip for their companies' performance.

Nevertheless, stock options are growing as a percentage of shares outstanding at companies. At the nation's largest 200 companies, options represented 11.8 percent of the shares last year, compared with 6.9 percent in 1989, according to Pearl Meyer & Partners, an executive compensation consulting firm. At 23 of those companies, including Morgan Stanley, Travelers, Warner-Lambert and Microsoft, more than 20 percent of all shares were set aside for stock-related incentives. The investment firm Sanford C. Bernstein & Company has estimated that the total value of shares set aside for options at all public companies has risen to about $600 billion from about $60 billion in 1985. But shareholders are saying, in greater numbers, that enough is enough.

Data compiled by Strategic Compensation Research show that the percentage of "no" votes is rising against management proposals to issue more stock options. Of 1,072 companies requesting option authority over the last year, roughly a quarter of them received "no" votes totaling more than 20 percent of outstanding shares. At 35 companies, the "no" votes represented more than 40 percent of the shares outstanding. At several companies, including Electroglas Inc. and Omni Multimedia Group, proposals for stock-option plans were voted down.

Those numbers also understate the backlash against stock options, said Mr. Wagner of Strategic Compensation Research. Many companies, sensing that they are likely to suffer an embarrassing defeat, will pull back a stock-plan proposal before putting it to a vote. Five years ago, any opposition was rare, he said.

In another measure of shareholder discontent, the Investor Responsibility Research Center said that the average proportion of stockholders voting against stock-option plans climbed to 19 percent in 1996 from 3.5 percent in 1988, a more than fivefold increase.

As much as stock options appear to be free when they are issued, the cost is no longer so well-hidden. It is now commonplace for companies to report that they must spend money to buy back shares to offset dilution from stock options - meaning that with more shares outstanding, earnings per share automatically dwindle. The Microsoft Corporation, for example, said in July that it repurchased 37 million shares for $3.1 billion in its most recent fiscal year. The average price of the repurchased stock was $84, compared with an average exercise price of $31 for all outstanding options. In the past, when a company announced a sharerepurchase program, its stock price typically jumped. But these days, buybacks are less likely to get such a positive reaction.

"Companies have been literally buying shares at all-time highs to pay for the options they have issued," said Patrick S. McGurn, director of corporate programs for Institutional Shareholder Services.

Such programs are not only transferring large sums of wealth from shareholders to insiders, said Nell Minow, a principal at Lens Inc., an investment management firm. They are also shifting the voting power that goes with those shares to insiders, giving them greater ability to drown out dissident voices in proxy votes.

"These very extensive stock-option programs are hostile takeovers from the inside," she said.

There are also growing questions about precisely what shareholders are getting for their money when companies grant stock options to top executives and employees.

Some complaints are familiar, including the observation that stock options reward mediocre performance in a bull market, and that employees who are given stock options enoy far less risk if the stock falls in price than do outside investors, who pay for their shares.

But many side effects of stock option plans are less well-known.

At the annual meeting in Boston last month of the Academy of Management, for example, William Gerard Sanders, a professor of strategic management at Brigham Young University, said he found statistical evidence that big stock-option packages for top executives tended to increase the frequency of acquisitions and divestitures.

This "symbolic churning," as Mr. Sanders called it, is a means to signal that the company is making "positive, proactive change" that companies hope will be reflected in a jump in their underperforming stock. After all, because there is plenty to gain and little to lose with stock options, a chief executive can act like a slugger ahead on the count, swinging for the fences.

In his study of 250 large United States companies from 1991 to 1995, Mr. Sanders also found that at companies where top executives already owned significant blocks of stock, there were comparatively few acquisitions and divestitures.

"When top executives get options, the evidence suggests they start experimenting," Mr. Sanders said.

"We know that most of the time when they churn, they do not create value. But if the options gain considerable value from an escalating stock price, then they churn less."

At the same meeting in Boston, two management professors - Edward J. Zajac of Northwestern University and James D. Westphal of the University of Texas at Austin - said they found that a narrow focus on a single indicator of performance, like the stock price, tended to result in tunnel vision that sacrificed other measures of performance, like sales, net earnings, return on assets or return on equity.

The timing of option awards to executives is also intriguing, according to a report by David Yermack, a professor of finance at New York University, in the June issue of the Journal of Finance. In a survey of 620 option awards among Fortune 500 companies from 1992 to 1994, he found a pattern of chief executives' receiving option awards shortly before favorable corporate news was announced.

For example, Mr. Yermack cites as one example the fact that K. Grahame Walker, chief executive of the Dexter Corporation, a maker of specialty coatings and adhesives in Windsor Locks, Conn., was awarded options on April 24, 1992. Over the next three months, the company announced that its quarterly earnings had more than doubled and that it planned to sell a division. A spokeswoman for Dexter said that the timing of Mr. Walker's option award was dictated by its annual meeting.

Perhaps the most trenchant criticism of most stock-option plans has come from one of corporate America's elite. In a speech last year to Wall Street analysts, Robert B. Hoffman, chief financial officer of the Monsanto Company, said that conventional options "tend to reward attendance, not performance."

At the time, Monsanto had surpassed its goal of a 20 percent return on equity, the threshold at which its previous options package took effect. Executives wanted to set a new, more challenging target.

At the meeting, Mr. Hoffman announced a new, two-pronged incentive program that he said would reward shareholders before it rewarded top executives.

One was for four sets of options that would become valuable only when the company's stock surpassed price targets of $150, $175, $200 and $225. Monsanto's stock is now trading at $38.75, or the equivalent of $193.75 before a five-for-one split last year.

The second aspect of Monsanto's incentive package is that top executives are required to buy stock in the company with money lent them by the company. If they do not reach certain targets, like performing better than the 75th percentile of the Standard & Poor's industrials through the year 2000, the executives will have to pay the company back.

"Our management will be subject to both the upward opportunities and the downward risks inherent in stock ownership," said Robert B. Shapiro, chairman and chief executive of Monsanto.

Although companies like Transamerica and Bank of America have also adopted option packages that require some kind of premium performance, such incentives are not commonplace. Frederick W. Cook & Company, a compensation consulting firm, said in a report last year that 14 percent of the country's largest 250 companies tied options to specific performance criteria, up from 6 percent in 1993.

Why don't more companies have programs like Monsanto's? Part of the answer may be that companies in different industries have varying opportunities for growth. But Charles M. Elson, a professor at the Stetson College of Law in St. Petersburg, Fla., offered a simpler explanation.

"It's a board dominated by the manager," he said. "Overcompensation is basically the fault of passive boards that agree to salary packages on demand, without spirited negotiations."

Many companies are willing to move the threshold at which stock options can be exercised, but typically they engage in the heads-I-win, tails-I-still-win strategy of repricing stock options downward, not upward, thereby making it easier to reach a point where the options become valuable. While such generosity to executives of companies with poorly performing stock is not so common in the current bull market, the practice could well return in a bear market.

"The repricing of underwater options has the perverse effect of rewarding poor stock performance," said Kurt Schacht, general counsel of the State of Wisconsin Investment Board.

Stock-option programs for lower-level employees have, in general, come under less criticism. Although there is scant evidence suggesting that such programs help improve corporate performance, more companies are adopting them, including the Chase Manhattan Corporation and Du Pont.

The chairman and directors of the Coram Healthcare Corporation even took the unusual step last year of returning stock options representing about 10 percent of the company's shares and, trying to accelerate a turnaround of the company, used them instead as an incentive for employees. (The company's stock has remained flat since the program was announced.)

For all its criticisms of conventional stock options, Monsanto said last year that it would give them to its 27,000 lower-level employees to foster a sense of ownership. "Intuitively, it makes sense," A. Nicholas Filippello, the company's chief economist, said in a recent interview.

While stock options may make workers feel more like owners, that feeling may not be lasting. When options are In the money after the exercise date - trading above the price at which they were issued - workers tend to cash them in fairly quickly, according to a study published last year of 50,000 employees at eight corporations.

Two professors, Steven Huddart of Duke University and Mark Lang of the University of North Carolina, found that the employees typically exercised their options years before the expiration date, effectively surrendering about half their potential long-term value. Such option plans may also backfire on a company in a bear market.

"It works really well as long as the stock price is going up," said Professor Saly of the University of Minnesota. "But if a major part of an employee's compensation is based on the stock price, and you take someone who is making $40,000 and make $10,000 disappear, what happens to employee morale?"

Second thoughts on stock options tend to encounter the strongest head winds in Silicon Valley, a place where options have been hailed as a key to the area's booming economy, a way to attract talent to ideas while also keeping salaries low in a company's fragile start-up phase. Options, touted as a refreshingly egalitarian approach to compensating workers, have created enough young millionaires driving expensive cars for a respectable traffic jam, even by California standards.

By all accounts, workers in Silicon Valley have grown quite sophisticated about stock options. Young, talented engineers who years ago were surprised to learn that they received something called stock options now hold out until their demands for sizable options packages are met.

In Silicon Valley, options have even become a kind of currency to pay for outside help. A company called Talentwave in Larkspur, Calif., often takes options as payment when it helps start-ups find top executives.

"If I'm the person who has some of the responsibility for assembling the technical team, why can't I price myself in the same way?" said Jim Trattner, president of Talentwave.

One of Talentwave's principals, Emily Nelson, does management consulting and headhunting work for a number of fledgling technology firms, and has decided to take most of her pay (a percentage of which goes to Talentwave) in the form of stock options, rather than cash.

At first, she said, it was a way to lower her fees without feeling as if she had lowered her fees. But she now has about 60,000 options and expects to get another 40,000 in about three months. Most of the companies she works with have not yet gone public.

"I have a great portfolio, but my bank account is empty," said Ms. Nelson, who adds that she regularly works 100-hour weeks. "But I decided that this is how I'm going to make it."

Her vision of making it includes doing business consulting from a home on the Oregon coast while having more time to play with her toys. (She's serious about the toy part - her rare time off is spent at Toys "R" Us, she said.)

"Next year, I may be a millionaire, but it will depend on the market," Ms. Nelson added. "People consider me revolutionary or foolish."

In a sense, though, Ms. Nelson is pursuing a more diversified and less risky strategy than many others in Silicon Valley, who job-hop from one start-up to another in the hope of striking it rich.

And although the number of start-up companies continues to grow in Silicon Valley, the likelihood of joining another Apple or Microsoft in its infancy is not getting better. If companies develop a promising technology, they are often quickly bought out by larger competitors, thereby accelerating option packages for top executives of the smaller concern, but not necessarily the options held by lower-level employees.

Sometimes young companies are not bought out at all, and instead are simply overtaken by a competitor with more marketing heft. That is what happened to a Seattle company called Intermind, which developed technology that automatically sends customized information over the Internet to a computer user. But it was soon eclipsed by similar offerings from Microsoft and Netscape. Intermind has shrunk considerably from its peak of about 80 employees, but company officials say it will soon make an important announcement about its next move.

Some have experienced hands in the valley have seen so many start-ups sputter that they have largely sworn off stock options.

After Roger L. Thornton went to work for Cypress Semiconductor 10 years ago at age 23, he found himself sitting on almost $100,000 in proceeds from stock options. An early convert to options, he then spent many years accumulating options from a number of fledgling firms that ultimately proved worthless.

Now a consultant at 33, he typically takes his pay the old-fashioned way. He and the three other partners in his firm set aside 20 percent of their revenues each year for investing, typically in more mature technology companies that they know well.

"As an investor, you can cover your odds on a lot of bets," said Mr. Thornton, whose firm is Medialane, in Cupertino, Calif. "But when you are an employee, you can only make that bet so many times in your career."

"There's this perception that you come to Silicon Valley and get rich quick. It makes good folklore, but the fact of the matter is that most people get rich very slowly," he added. "By working hard, I can guarantee that it will happen if you do it that way."

While he recognizes that stock options have helped make Silicon Valley so successful, he also said that some companies abuse them as a way to underpay people in the face of long odds that the options will pay off.

"I'd like to say that while people are getting more sophisticated about stock options, they can also be used to play on an individual's greed," he said.

What is clear, though, is that employees and executives, particularly talented ones who are in demand, want more options, and companies are giving them as signing bonuses and using them as tools to retain the people they want to keep.

And what if the stock market flattens out for a long period? The widespread use of options has raised at many companies an expectation, even a sense of entitlement, that the options will always pay off.

As it is, options have led to a number of legal spats. A former executive with the Parametric Technology Corporation recently won $1.6 million after a Los Angeles jury decided that his company dismissed him mainly because he would soon be eligible to cash in valuable options. Many companies also insist on socalled bad-boy clauses in their options packages for senior executives, giving them the right to demand that departing executives give up their options, or repay recent profits from exercising them, if they do something considered harmful to their former employer.

In a flat stock market, companies may feel pressure to reprice options or issue more of them to satisfy demands of employees who have come to expect a payoff. Either way, said Mr. Wagner of Strategic Compensation Research, companies are going to find that shareholders are likely to grow increasingly intolerant of overly generous stock-option grants.

"Many companies are at their limit already," Mr. Wagner said. "What are they going to do for an encore?"

Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
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