Microsoft's move to ditch stock options in favor of
restricted-stock grants, combined with a FASB ruling, could push the
rest of techdom to abandon them,
too
A year ago, Microsoft Chief Executive Steven
A. Ballmer was asked why the company didn't take a leadership role in
reforming tech-industry accounting. Why, an analyst asked, didn't the tech
giant deduct the cost of stock options from its earnings? Ballmer's
response: Others in the tech world say the fallout would be "very, very
gloomy." As a leader, Microsoft stood by its industry.
No more. On
July 8, Microsoft (MSFT ) did the
unthinkable: It scrapped stock options, eliminating a form of pay that
made thousands of Microsoft employees millionaires and helped define the
culture of the tech industry. Instead, starting in September, the company
will pay its 54,000 employees with restricted stock, a move that will let
employees make money even if the company's share price declines. Like
stock options, the restricted stock will vest gradually over a five-year
period from the issue date. Under accounting rules, grants of restricted
stock are counted as expenses and charged against earnings.
"A SMARTER WAY"? Microsoft's explanation for the
switch was the "angst" it faced from employees whose stock options were
worthless. "We asked: Is there a smarter way to compensate our people, a
way that would make them feel even more excited about their financial deal
at Microsoft and at the same time be something that was at least as good
for the shareholders as today's compensation package?" says Ballmer.
More than just altering one company's pay program, the move
promises to change forever a perk that is as closely linked with
technology as the assembly line is with the auto business. "This marks the
beginning of the end of the options compensation era," says Robert B.
Austrian, an analyst with Banc of America Securities.
Stock
options paved techdom with gold, making millionaires out of top execs and
rank-and-file software programmers alike. But critics argue that they
distorted company earnings, camouflaging an expense that never showed up
on the bottom line. In response, the Financial Accounting Standards Board
is preparing a rule that would require expensing of stock options. Here's
how Microsoft's move will affect employees, investors, and the tech
industry.
What does this move say about Microsoft? No
company has been more of an icon of the tech boom over the past
quarter-century than this software giant. But as the company nears its
third decade, its financial performance has become staid. Sales, which
climbed an average 36% a year through the 1990s, haven't cracked 16%
growth this decade. In the 1990s, Microsoft shares grew nearly 100-fold,
from a split-adjusted 60 cents to $59.19. Share prices have been halved
since the 1999 peak.
The new pay plan is a tacit admission that
Microsoft isn't the growth stock it used to be. Microsoft shares haven't
kept pace with others in the industry. Its stock is up 6.3% this year,
compared with a 43.6% rise in the Merrill Lynch 100 Tech index.
What does the change mean for Microsoft employees? The
biggest shift is that employees can get some value from their stock even
if the price doesn't climb. That may not seem like much of a motivational
force. But with shares well off their 1999 high, virtually all the options
granted since then are worthless. That means the 20,000 employees who
joined Microsoft in the past three years have seen little or no benefit
from their stock compensation.
Now, employees will still have a
strong incentive to improve the performance of the company and its stock
price. But they don't have to wait for the gargantuan price jumps of the
past decade -- jumps that aren't likely to come from a mature company,
anyway.
Their existing stock options won't be worthless, either.
Under the new plan, which needs regulatory approval, employees can elect
to sell their options to J.P. Morgan. In an e-mail to employees, Ballmer
wrote that at a Microsoft stock price of $25, the company expects that
options with a grant price ranging from $33 to $34 could be sold for
approximately $1.80 to $2.10 each. Not much, but it's better than
nothing.
What's the effect on earnings and
accounting? Microsoft will announce on July 17 the impact on its
earnings. With its report for its first fiscal-year quarter ending in
September, the company will begin to account for the expense of new stock
awards and for stock options that are vesting. The hit from the fresh
expense could be as much as 23% of earnings, according to analysts at
Goldman, Sachs & Co., who looked at the cost of past Microsoft
stock-option payments.
But the company probably won't have to hand
out as many dollars' worth of stock as it did of stock options in order to
satisfy employees. If it can cut its costs for stock-based compensation by
one-fourth, its newly reported expenses would be about 17% of earnings.
Microsoft is choosing to account conservatively for the ongoing vesting of
options it has granted in the past. That means the potential advantage of
switching to stock awards will phase in gradually.
What's in it
for Microsoft shareholders? Investors aren't too rattled. The day
after the announcement, Microsoft shares fell 23 cents, or 0.8%, to $27.47
in a trading session in which the Dow Jones industrial average dropped
0.7%. Over the longer term, its stock price could go up, notes analyst
David Bianco of brokerage UBS. Investors could be encouraged if Microsoft
gets more output from employees because its stock compensation provides
stronger incentives without extra cost. Plus, since Microsoft plans to
hand out fewer restricted shares than it did stock options, it may not
need to buy back as many shares, which could conserve cash and minimize
dilution.
What does Microsoft's move mean for other tech
titans? Intel (INTC ), Cisco Systems
(CSCO ), and others
have vowed to keep issuing options. They argue that there is no accurate
way to account for options and it would be a disaster, they say, if tech
companies had to expense them. Unlike Microsoft, most tech outfits face
fierce competitors in the U.S. and overseas. They believe stock options
are a good way to keep competition from poaching key employees.
These are legitimate concerns, but Microsoft's move and the
expected ruling from FASB mean it's probably only a matter of time before
the day of reckoning comes for the rest of the industry. There's already
momentum in that direction in all types of corporations. According to
Mercer Human Resources Consulting, a compensation consultancy, 220
companies have announced plans to expense options this year. And on July
9, DaimlerChrysler (DCX ) revealed that it
is considering scrapping stock options.
Won't expensing of
options crimp innovative startups? Indeed it may. The FASB ruling
will apply to private companies as well as public ones. Startups typically
offer recruits generous grants of stock options because they can't afford
the salaries that more established companies offer. They also say they
need a come-on to convince talented people to give up secure positions and
risk their careers on unproven companies. If these businesses have to
expense stock options, it may take longer for them to achieve
profitability, delaying an initial public offering and requiring them to
raise additional venture-capital funds.
With mandatory expensing,
"it will be very hard to have a successful startup company in Silicon
Valley or in the U.S.," warns Marc Benioff, CEO of Salesforce.com, a
software company that is expected to go public next year. He may be
overstating the case, but in a world that is increasingly hostile to
startups, any additional burden makes it even more difficult for these
innovators to thrive.
What does this mean for executive
compensation? With Microsoft as their trailblazer, expect many
other companies to reexamine their compensation programs. Under the
Microsoft plan, its top 600 executives and managers will receive most of
their compensation in the form of restricted stock. The amounts will
depend on growth in the company's customer base and improved customer
satisfaction.
Many other businesses will likely be persuaded by
the Microsoft example to replace some option grants with restricted stock.
But no one expects options to disappear entirely, whatever the cost.
Compensation consultants say that options -- with their promise of a big
payoff -- will remain an important, albeit smaller, part of the executive
compensation landscape.
By Jay Greene in Seattle, with Cliff Edwards in San
Mateo, Calif., and Steve Hamm, David Henry, and Louis Lavelle in New York