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New York Times, September 21, 1997
Copyright 1997 The New York Times Company
The New York Times
September 21, 1997, Sunday, Late Edition - Final
SECTION: Section 3; Page 1; Column 1; Money and Business/Financial Desk
LENGTH: 3416 words
EARNING IT;
Some Second Thoughts On Options
BYLINE: By ADAM BRYANT
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 mega-grants 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 share-repurchase 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
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 enjoy 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, pro-active 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 DuPont.
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 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 so-called
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 limits already," Mr. Wagner said. "What are they
going to do for an encore?"
GRAPHIC: Photos: Emily Nelson, a consultant to high-tech start-ups, has amassed
about 60,000 options in lieu of fees. Roger L. Thornton has received so many
worthless options over the years that he now prefers to be paid in cash.
(Photographs by Jenny Thomas for The New York Times)(pg. 12)
Charts: "Beginning Of a Backlash?"
For years, shareholders rarely voted against management. But of 1,072
stock-option proposals before stockholders from July 1, 1996, to May 31, 1997, a
total of 256 drew a "no"vote from more than a fifth of those voting. (Source:
SCRA Database)
"A Tough Sell" lists companies at which proposed stock-option plans received the
most shareholder "no" votes or abstentions in 1996, and the potential dilution
of their stocks under the plans. (Source: Investor Responsibility Research
Center)(pg. 13)
Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 865-3271
(814) 863-8393 fax
huddart@psu.edu
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