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Business Week, July 22, 1996


OPTIONS FOR EVERYONE

Business Week: July 22, 1996
Department: Cover Story

Annie Hansley, a customer-service representative at Chemical Banking Corp., never owned stock or much cared about the market--until she received options, that is. In 1994, Chemical awarded Hansley and every other full-time employee ``success shares,'' or options to buy 500 shares of company stock at $40.50 each. When the stock hit 50, 55, and 60, and stayed there for three days running, employees could exercise a portion of the options and collect the cash. Suddenly, checking the quote in the newspaper became an early-morning ritual at Chemical. And as the stock reached its target exercise prices and employees could cash out for a profit, the excitement reached a fever pitch. ``I hadn't been watching the stock price before. But once it hit 50, it was all we talked about in the morning,'' says Hansley, who as a result of a 1996 merger now works in New York for Chase Manhattan Corp.

Like Hansley, millions of U.S. workers are learning for the first time what the options game is all about. That's because stock options--once reserved for top executives and workers at high-tech startups that couldn't afford to pay competitive salaries--are filtering down to an everincreasing number of rank-and-file corporate employees. Since 1989, when pioneer PepsiCo Inc. granted every employee bonus options worth 10% of their salary, an estimated 2,000 companies have instituted their own broad-based option plans. Options are a productivity incentive for booksellers at newly public Borders, tellers at NationsBank, box packers at Pfizer, chemical-plant operators at Monsanto, baggage handlers at Delta Air Lines, and part-time espresso servers at Starbucks.

NO CHARGE. Even more companies are likely to use this incentive now that the Financial Accounting Standards Board (FASB) has settled a decade-old debate that kept many interested employers on the sidelines. In October, 1995, FASB determined that corporations didn't have to take a charge against earnings for fixed-term options. In 1997, the projected cost of options need only be disclosed in a footnote to the annual report, allowing employers to expand their use of options with little direct impact on earnings.

In large part, the options boom is a product of downsizing and reengineering, which has compelled companies to rethink traditional compensation. Leaner companies rely on fewer employees to shoulder more of the work, while shareholders demand demonstrable links between pay and stock performance. So options are becoming a popular incentive in this new corporate culture that has left employees feeling disenfranchised because of mergers, acquisitions, and layoffs. ``Options are an antidote to the stress and demoralization caused by restructuring,'' says Robert Salwen, president of Executive Compensation Corp. in White Plains, N.Y. ``And they're a way for the company to acknowledge the greater role each of the survivors plays.''

Indeed, companies hope that tying everyone to the stock price will inspire them to do their best to raise it. ``We've been working for years to get the majority of our employees to hold company stock,'' says Sanford I. Weill, CEO of Travelers Group Inc., a diversified financial services company. The idea is to get everyone ``to think like owners and build our wealth beyond what we would get in cash compensation.'' Upon discovering late last year that 26,000 of his 60,000 employees owned no Travelers stock despite opportunities to do so through 401(k) and employee stock-purchase plans, Weill announced in March that everyone with one year of service would receive an additional 10% of their compensation--up to $40,000--in options starting in 1997.

...AS EMPLOYEES
BECOME SHAREHOLDERS

Worker ownership of employers' stock, March, 1996

PLANS EMPLOYEES PLAN ASSETS (MILLIONS) (BILLIONS)

ESOPS AND 10 $225 STOCK BONUS

401(k)S (MAINLY 2-3 200 HOLDING COMPANY STOCK)

STOCK 3 100 OPTIONS*

* For plans that include most full-time employees

DATA: THE NATIONAL CENTER FOR EMPLOYEE OWNERSHIP


Yet critics debate whether options are for everyone. How much impact can the average worker really have on the stock price? While companies with broad-based plans defend the growing number of shares set aside for option grants, it's still management that gets the lion's share. Hard numbers are sketchy so far, but even at companies that are sharing the wealth with more employees, few workers will enjoy gains anywhere near the $41 million Weill's options reaped last year alone.

When the market's rise seems to be on auto pilot, and it's easy to make money, options appear to be a no-lose venture. But what happens when stocks inevitably cool? Many employees are market neophytes who have never bought and sold stock, much less experienced a correction. Companies argue employees have little to lose in a downturn since people only exercise if the stock price increases. And the risk of demoralization is tempered since most companies--for now, at least--have not reduced salary compensation when they debut broad-based plans. Yet countless new options holders may be in for a rude awakening when they realize the paper profits upon which they planned to retire have gone up in smoke.

That's what happened to Wal-Mart Stores Inc. employees who depended on company stock--through profit sharing, a stock ownership plan, and options--for a large portion of their pay. When the stock tanked in 1994, those close to retirement cashed out at a fraction of what they had anticipated. The stagnant stock price caused morale to suffer among the rest of the workers, too. ``It will be extremely interesting how companies explain to employees that all this money they thought they had disappeared in a bear market,'' says Richard Semler, principal in the Los Angeles office of management consultant Sibson & Co.

Indeed, if companies don't educate their workforces about options risk, what looks like a magnanimous corporate gesture today could turn into a major employee-relations problem down the road--especially if workers ever forgo some of their salary for the perk. That's a big challenge when many workers are still grappling with how to invest their retirement savings through 401(k) plans. And there's an equally tortuous learning curve ahead for the growing number of options novices, who must acquire market savvy and self-discipline.

To be sure, many companies have been giving workers stock for decades, beginning with employee stock-ownership plans (ESOPs) and more recently through 401(k)s. However, ESOPs and 401(k)s usually must be held until retirement. Options are so alluring because they can be readily converted to cash, offering the prospect--and danger--of immediate gratification. This often proves tempting for people who view options as a quick money source instead of a long-term wealth builder, says Paul Allen, director of Smith Barney Inc.'s stock plan services.

PANIC TIME. A 1996 study by two associate accounting professors, Steven Huddart of Duke University and Mark Lang of the University of North Carolina at Chapel Hill, found that two-thirds of the exercise activity of lower-level employees occurs just six months after they are vested and the options are ``in the money,'' that is, when the market price is higher than the grant price. Senior executives exercised at half that rate. Overall, 90% of employees in the study sold their stock right after exercise. By doing so, the typical employee at the eight corporations in the sample sacrificed $1 of expected value for every $2 realized, Huddart and Lang estimate.

The experience of Chase's Hansley bears out those findings. Swept up in the excitement, she cashed out as many options as possible at the first two exercise prices. She figured she'd sit tight when the stock reached 60 and wait for it to move higher before exercising her last options. But when the price dipped slightly, she panicked and bailed out as soon as it inched back up to the low 60s. Since then, thanks to strong earnings, the bull market, and the merger, the stock has been as high as 74--and Hansley rues exercising early. ``If I had a chance to do it again, I'd just hold onto them all,'' she sighs. It would have been worth the wait: Those options would now be worth more than $16,000 per employee, almost as much as a typical New York bank teller's annual salary.

So far, the gains employees have collected on options have been a valuable retention tool for companies. ``When the market corrects itself, we'll see the value of options come back down to earth, but right now, they're an incentive for staying,'' says Ray Harrison, senior information-systems manager at Network Equipment Technologies in Redwood City, Calif. ``If you get a nice grant at review time, you think, `I might as well stick around till I'm vested.'''

Such thinking has benefited fast-food giant Wendy's International Inc. Before the launch of its We Share stock-option plan in 1989, restaurant crew turnover was almost 300% annually. ``The main reason they left was frequent changes in management,'' says Wendy's spokesman Denny Lynch. ``So we had to do something to keep the managers to keep the crew.'' Each year, everyone from assistant manager up gets options equal to 10% of their previous year's earnings. Since 1989, turnover among assistant managers has dropped from 60% to 38%, and crew turnover has been cut almost in half.

Thomas Lee, 25, is one of those who stayed. An eight-year Wendy's veteran, he worked his way up from cook and cashier to assistant manager at Wendy's in Lebanon, Pa. Lee plans to use any options profits for the downpayment on a house. Wendy's assistant manager Sonia Murphy, 29, says the options she and her husband, a McDonald's Corp. assistant manager, receive have taught them the importance of saving.

But for executives whose net worth has dramatically increased thanks to the rapid appreciation of their options, the benefit can be ``tantamount to a bad marriage, since it can cost you too much to leave,'' says New York accountant Stuart Becker. Dave Hill, 40, a former senior manager at Reliastar Financial in Minneapolis, knows people who would like to leave their jobs but don't because they have too many unvested options. Five years ago, Hill passed up a great job offer for just those reasons. ``It's very hard to look at your wife and say: `I'm walking away from a six-figure amount,' knowing that all I'd have to do is stay there to get the money,'' he says.

The equity options generate can be a double-edged sword for employers. Thanks to patience and planning, Mike Greer, 45, was able to quit his job as the head of small-business banking at Cleveland's Society Corp. (now KeyCorp) and use the $250,000 his options produced as the seed capital for his own business. Greer exercised his options incrementally as they reached target prices he set. When he resigned in 1991, he left behind thousands of options. In the years following, the bank merged twice and the stock went from the low teens to as high as 80. ``I'm sure I gave up a substantial amount of money in continued appreciation to start my own business, but there was also no guarantee that I would have survived either of the bank's mergers,'' he says.

Some companies learn the hard way that distributing options broadly is no panacea, even in a bull market. When Houston-based Lyondell Petrochemical Co. went public in 1989, all employees received a one-time option issue equal to 20% of their salary to buy the stock at $30 a share. They could use payments from a profit-sharing plan to exercise the options. But for the past seven years, the stock has been trading mainly in the 20s, and the options have been underwater.

Lyondell CEO Bob G. Gower attributes the stock's poor performance to the cyclical nature of the industry. Although earnings have been relatively good--employees have received profit-sharing payments of 4% to 5% annually since 1989--the stock has been out of favor. ``So many things can affect stock-price performance that have nothing to do with the individual employee,'' Gower says. ``Employees may actually be de-motivated upon realizing that it can be like a lottery.'' That's why Gower prefers profit-sharing plans, which keep workers focused on earnings instead of the share price. ``We should only ask employees to control things they can influence, like earnings,'' he says.

Some companies, such as Owens Corning, are looking for ways to use broad-based option plans but link them more closely to good performance. As the current bull market has shown, even companies with mediocre results have seen big jumps in share prices and options values. (Since early 1989, the total return of the Standard & Poor's 500-stock index has been 181%.) So some activist shareholders argue that the exercise prices for options should be pegged only to ambitious increases in the stock price or other benchmarks. Such premium-priced or indexed options would ensure that employees benefit only to the extent that the stock outperforms the market or its peers.

BACKLASH? Some sophisticated shareholders question if options are really the ``free money'' that many executives claim they are. They fret that setting aside massive amounts of outstanding shares will dilute earnings, hurting existing stockholders. Today, about 10% of shares outstanding are reserved for option grants at companies such as Toys `R' Us Inc. and Pfizer Inc. But it can be much higher: Morgan Stanley & Co. requested shareholders' approval to allocate 55% of outstanding shares for its 1996 stock-option plan, bringing total potential dilution from employee options to 73%, according to the Investor Responsibility Research Center (IRRC) in Washington. Morgan Stanley shareholders had little trouble supporting the plan: Current and former employees own 33% of the company.

The potential for increased dilution may be fueling a backlash. The percent of shares voting against new stock-option plans was 17.3% as of 1995, a fivefold increase since 1988, the IRRC reports. ``I'm absolutely convinced that number will increase as shareholders understand the issue better,'' says Nell Minow, managing director of LENS, an activist money manager in Washington. With shareholders sensitive to dilution, one of the most delicate balancing acts companies face is determining eligibility, says Peter T. Chingos, head of compensation consulting at KPMG Peat Marwick. Supermarket chain Safeway Inc. issues stock-option grants primarily to store managers and above. ``With 114,000 employees and only 240 million shares outstanding, it's very difficult to give a meaningful amount of stock to everyone,'' explains CEO Steven A. Burd. ``You have to make some choices about how far down in the organization you take it.''

Proponents contend that fears of excessive dilution are unfounded. First, the number of options exercised each year is small relative to total shares outstanding. Dilution at PepsiCo and DuPont Co. is around 1% of outstanding shares, says Matt Ward, a stock-compensation expert at Watson Wyatt in San Francisco. And options are exercised only if the stock price has gone up. Besides, they argue, the income gained from the exercise of options and the corporate tax deductions from nonqualified options can be plowed into repurchasing shares to neutralize dilution. General Mills Inc. repurchases shares at prices lower than the ultimate exercise price, which helps control costs, claims Alan J. Ritchie, vice-president for compensation and benefits at General Mills in Golden Valley, Minn.

FEW NUMBERS. Many companies believe sharing options wealth is a good first step toward bridging the gap between shareholder returns and growth in employee wages and benefits. In 1995, return to shareholders was above 37%, while employees got less than a 3% increase in pay and benefits, says compensation consultant Frederic W. Cook. To combat the ire this might generate, he suggests increasing the amount of acceptable dilution to 20% from 10%, and the number of employees eligible to participate in options plans.

Surprisingly, many companies don't seem to keep hard numbers quantifying options plans' successes. ``We knew going into it there was no way to prove the benefit to the company, but we believed very strongly it was a good idea,'' says PepsiCo spokesman Richard Detwiler. Adds Ward: ``The benefits are so obvious, it's hardly worth the time and money to calculate them.''

Luckily, today's corporations pushing options well down into the organization can take some cues from long-time options users in the high-tech industries, notes Salwen. First, keep the broad-based plan simpler than that for executives. Use only plain-vanilla options and clearly defined vesting periods. Second, don't issue token grants: Make sure the awards are financially significant to the recipients. Third, he says, it's not enough to make employees stock owners. Companies need to create an environment that allows people to act like owners, too.

If properly implemented and communicated, options can be a great equalizer, says General Mills' Ritchie. But if companies and workers don't plan for both the risk and reward, there won't be any real winners in the options game.

By Kerry Capell in New York


Copyright 1996 The McGraw-Hill Companies. All rights reserved.

This page was updated by the Webmaster on July 15, 1996



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