Stock Options: The End of the Affair?
Some reports say there are
as many as 9,000 gMicrosoft Millionaires,h others say the number isnft
quite so high. But all attribute the vast wealth accumulated by managers
and workers to one source: stock options.
So it was front-page news
when Microsoft announced early in July that it was shutting down its
options program and planning instead to award employees shares of stock,
which do not offer the same potential for stupendous
gains.
gThere are a handful of
companies like Cisco, Microsoft and Intel that are the high-profile, big,
successful pacesetters,h said Wharton accounting professor David F.
Larcker. gMicrosoft has historically been a big user of options. So if
they are changing their program, itfs the kind of thing that a lot of
other companies will look at.h
To many corporations,
especially technology firms, the move smacks of heresy. Options, their
defenders say, are the best way to motivate employees to boost shareholder
value and a low-cost way for cash-strapped startups to lure top talent. As
many as 10 million Americans are thought to be holding employee
options.
But options critics, among
them many shareholders groups, cheered. They believe options fueled the
corporate scandals of the past few years and argue that options actually
undermine corporate performance.
For whatever reasons, more
and more companies seem to be backing off of their love affair with
options. A report in the July 30 Wall Street Journal noted that
companies – ranging from Dell, Yahoo and Siebel Systems to Citigroup,
Jones Apparel Group and Rohm & Haas – are cutting back the number of
employees who are eligible to receive options. The Journal also cited a Mercer Human
Resource Consulting study this month reporting that three-quarters of 33
large companies surveyed gare making changes in their stock-option and
other long-term incentive plans. Of those, 64% are reducing the number of
options granted and more than half are cutting the number of employees
eligible to receive options.h
Stock Options vs. Stock
Awards
Microsoft Chairman Bill
Gates and Chief Executive Steve Ballmer are among the rare breed of
American executives who have never received options. They argue that their
enormous holdings of Microsoft shares already give them sufficient
incentive to work on shareholdersf behalf.
But the company, which
currently employs about 55,000, has given options to all ordinary
employees and most managers since its founding in 1975, and the enormous
run-up in share prices made thousands rich. Adjusted for splits, shares
went from 7.3 cents at the initial public offering in 1986 to a peak near
$60 at the end of 1999. The stock is currently around
$26.50.
At a typical company, an
options grant gives an employee the right to buy a set number of shares at
a specified price at any time over a 10-year period after the options
gvesth or become exercisable. If the share price rises from $50 to $100,
for example, the employee can exercise the option to buy shares for $50
and then immediately sell them to realize a $50-per-share
profit.
Under the new program,
employees will receive shares of stock in blocks that will gradually vest
over five years – that is, the employee gets a fifth of the shares each
year. Employees will still
realize profits if the share price rises. (Technically, these are called
stock awards or restricted stock units, since the shares are acquired over
time but can be sold as soon as they are received. In another form, called
restricted stock, all shares are acquired at once but the owner can only
sell some of them each year. Restricted stock programs for managers
sometimes issue shares only when performance targets are
met.)
For Microsoft, whatfs the
difference between options and stock awards? Wharton accounting professor
Mary Ellen
Carter said one key difference is that fewer shares need be devoted to
the program if stocks are used instead of options. gWith stock, you donft
have to give as many to get the same value.h
The ultimate value of each
approach depends on share price gains. If a company wanted to give an
employee an options grant worth $5,000, it might assume, for example, that
the share price would rise from $75 to $100 over the optionfs 10-year
life. It would thus take 200 options to create a $5,000 benefit over the
decade. Since the employee would have to spend $75 a share to exercise the
option, all of the benefit would come from the rising share
price.
But if the company awarded
stock, it would take just 50 shares to provide $5,000 in value. At a price
of $75 when awarded, the 50 shares would be worth $3,750 immediately, and
there would be $1,250 in gains as the price rose to
$100.
But suppose the price rose
to $200 over the decade instead of $100. In that case the 200 options
would be worth $25,000, while the 50 shares would be worth just $10,000.
Options are more profitable in a rapidly rising market. On the other hand,
if the price fell to $50, options giving the right to buy at $75 would be
worthless – gunderwaterh or gout of the money.h The 50 shares of stock,
however, would be worth $2,500. Stock is better in a falling
market.
Microsoft, Larcker said,
appears to have concluded that the geometric price gains of the 1980s and
1990s are not likely to be repeated. With the shares trading at half their
peak price, all the options granted during the past five years are
worthless – the exercise prices are higher than the current market price.
By switching to share awards, the company assures employees their holdings
will retain some value even if the price sinks, though they would not make
as much if the price soars.
gI think itfs a pretty overt
statement,h Larcker noted. gMicrosoft is saying, eHey, look, wefre no
longer a super-high-growth c super-innovative company. Wefre a mature
company.f In a mature company restricted stock is probably a better
incentive vehicle.h
(Employees will also be
allowed to make small gains by selling their underwater options to
JPMorgan Chase. An underwater option with a $33 strike price might fetch
$2, the company said. The securities firm will resell the options or use
them in hedging and derivatives strategies.)
Counting Options as
Expenses
The options-to-awards switch
was probably also influenced by widely expected changes in accounting
rules, Carter said. Currently, employee options do not have to be counted
as an expense, which is one reason they have been so popular with
executives, directors and even shareholders. Critics have long argued this
is misleading, since options inevitably represent a cost one way or
another. To provide shares for options programs, many companies use cash
to buy shares on the open market. Others issue new blocks of shares,
diluting the value of shares previously outstanding.
Reformers say options
motivate executives to cook the books to drive up share prices. Pressure
to count options as an expense has mounted in the wake of the Enron,
WorldCom and other corporate scandals, which many critics attribute in
part to options abuse.
Within the next few years,
regulators are likely to force companies to count options as expenses –
just as stock grants already are, says Carter. Microsoft said it will
begin expensing its existing options now, estimating that the move would
reduce reported earnings by about 27% this year.
Without their accounting
edge, options would then lose their luster and stock programs would become
more attractive. Since stock awards typically involve fewer shares, it
costs less if shares are bought on the market, and it causes less dilution
if new shares are issued. With the soaring use of options in the past
decade, dilution has become a serious problem. At many companies, existing
shares would lose 5-20% of their value if all employee and executive
options were exercised.
Wayne R. Guay,
accounting professor at Wharton, noted that Microsoft may also have been
motivated by the recent cut in federal taxes on dividends, to 15% from as
high as 38.6%. The cut makes dividends more attractive to shareholders,
giving companies more reason to pay dividends. Microsoft initiated its
first dividend payment this year.
Dividends are of no value to
people who hold stock options, since one must own actual shares to receive
dividends. In fact, people who hold options oppose dividend payments
because they undermine share prices. All else being equal, the share price
drops by the amount of the dividend, because the dividend payout drains
money from the corporation.
When the tax cut gave
companies more incentive to pay dividends, it made stock grants more
attractive to recipients than options.
Dreams of Staggering Wealth
Since companies have long
argued options encourage employees to work harder, a key question is
whether stock awards will work as well.
Microsoft employees holding
underwater options are better off now than they were before. They will get
a small payment for their worthless options and will look forward to stock
awards that will have real value even in a weak
market.
Because options generally
offer greater value than stocks in a rapidly rising market, options in
theory should thus provide employees a stronger incentive to work hard
than shares will. But the research does not clearly show that companies
with big options programs do better than those with stock award programs,
or that either do better than companies that have
neither.
Recent work by four
Larcker, Guay and their
colleague John E.
Core did a broad survey of academic research and could not find
compelling evidence that employee ownership, through options or shares,
boosts shareholder returns. gWhether it translates to the bottom line is
totally unclear,h Larcker said.
If employee ownership does
make people work harder, that effect is probably more pronounced at small
firms where an individual employee may feel he or she can really make a
difference, Guay said. gMost of those Microsoft employees own a tiny
fraction of the company. The typical employee will ask himself, eIf I work
really hard, can I increase the stock price and increase the value of my
stock options?f The answer is usually no.h Nonetheless, he said, options
or stock awards can boost employee morale, which can benefit the company
and its shareholders.
To boost the incentive for
its top people, Microsoft will grant 600 managers stock on the basis of
employee satisfaction and revenue growth.
Carter said employee
ownership can serve as a useful tool for retaining valued employees.
Options usually must be exercised or lost when an employee resigns, so a
departing employee misses any future gains. Employees who get stock awards
will be able to keep them when they leave the company, but they will have
to stay with Microsoft to get any shares that have not yet vested on the
five-year schedule.
Carter and Launn J. Lynch,
of the Darden Graduate School of Business at the
So far there has not been a
rush of companies emulating Microsoftfs switch from options to stock.
Intel and several tech-industry associations followed Microsoftfs
announcement with a statement defending the value of options and opposing
expensing requirements.
Carter said she expects more
companies to offer stock, simply because they believe options will lose
their accounting edge.
But at many companies, the hope of staggering wealth will keep options programs alive, Guay said. He predicted that not many will switch to stock. gI would be very surprised if you saw this sweeping through the tech industry.h