Market turmoil tarnishes luster of stock options

The CEO of BeyondWork knew that he could woo workers to his 75-person start-up if he offered more generous option grants. As the job market around the e-commerce company's Santa Clara, Calif., headquarters tightened in 1999 and the first half of 2000, Niv doubled the number of total shares to 20 million and sweetened option packages for new recruits.

But as the job market for technology workers in Silicon Valley and elsewhere cools, Niv feels less pressure to dole out large grants. Although stock options have become a core part of modern compensation, Niv says that the generous and nearly universal option packages of the late '90s may be replaced by smaller packages that are given only to relatively senior managers.

"It was a good idea," Niv said of stock options. "But like all good ideas, it went too far."

Niv isn't the only executive--or options-holding employee--scaling back his enthusiasm for the hottest compensation trend of the last decade. As the job market and the economy cools, experts say, 2001 is likely to see a major refocusing on core salaries, performance-based bonuses and lifestyle-oriented benefits instead of stock options.

"We came into the millennium believing there was only upside in the start-up world; low cash, high options were the norm, and lots of folks left their secure jobs to pursue the dream, to pursue the stock option lottery," said Linda Amuso, principal and co-founder of San Francisco-based iQuantic, a compensation consulting firm. "Folks who made that shift are now questioning that. It has really brought into question the risk-reward profile of a lot of people: Do you really want to be in a start-up, or do you want a more secure and established employer?"

Experts say the lottery-like nature of stock options is precisely why they are falling out of favor with employees. Their value is largely a matter of luck and timing, especially for workers who spend only a few years at a company. Although they create wealth in consistently rising markets, they are worthless in bear markets.

Formerly a sure thing
Stock options, an alternative form of compensation pioneered by Old Economy stalwarts in the '60s but popularized by the tech industry in the '90s, weren't always considered so risky. Many technology companies, short on cash but long on ideas, doled out options to compensate employees willing to settle for smaller salaries.

Typically, stock options have a strike price that is based on the day the employee joins a company, and they vest over a period of several years. For example, an employee might receive 4,000 shares with a strike price of $20 that vest in equal amounts over four years. After one year on the job, this employee would be allowed to buy 1,000 shares at $20 per share and immediately sell the shares at a higher price. If the shares are trading below $20, then the options are worthless.

Many workers perceived stock options and the wealth that they created during the late '90s bull run as the ticket to vast fortunes--or at least early retirement. The average option grant to a senior executive tripled from 1988 to 1998, according to iQuantic. The average grant increased at least 30 percent in 1999 alone.

Tech companies extended grants from the executive suite to the mailroom, typically offering several thousand options to mid-level employees--and more than 1 million options to senior executives. Last year, Jack Welch's unexercised options at General Electric were valued at more than $260 million, while Intel CEO Craig Barrett's were worth more than $100 million.

The media fueled America's fascination with options. A front-page article in The Wall Street Journal explained how Netscape Communications co-founder James Clark's secretary, D'Anne Schjerning, reaped $1.2 million in options while living in a San Jose, Calif., trailer park. Other newspapers reported on a decision by Cisco Systems CEO John Chambers to grant 1,300 summer college interns options for 500 shares if they returned after graduation.

At the height of the frenzy, workers around the nation came to believe that they, too, were entitled to membership in the stock-option millionaire club. If secretaries and interns were getting rich, why shouldn't every middle manager or sales associate?

The raging stock market inflated the hype surrounding options, and the reality was always quite different from the public perception. In fact, examples of overnight stock-option millionaires have always been relatively isolated.

The typical stock option vesting schedule of four years or more, combined with the particularly high turnover in the tech sector, means that relatively few workers ever exercise all of their options. The average tech worker stays on the job for only 13 months, according to Chicago headhunting firm Roy Talman & Associates. Meanwhile, a typical vesting schedule allows workers to cash out a quarter of their options after 12 months.

And with the stock market in a sustained slump, the reality is that the vast majority of companies' stock is trading below the strike price of their employees' options.

Underwater
According to the preliminary results of a survey conducted in November by data researchers at iQuantic, 50 percent of the option grants at 85 percent of companies are worthless because the company's current stock price is below the strike price. With the Nasdaq composite index down nearly half since its March peak, most options granted this year are deeply underwater.

In addition, many workers tend to inflate the perceived value of their options, said employee benefits specialist Brad Elman of the San Jose chapter of the Million Dollar Round Table, an insurance and financial services organization. In real dollar amounts, stock options are not worth anything until they vest and are cashed out--a point that many paper millionaires may gloss over.

"People have a tendency psychologically to look at it over four years and multiply it by the highest price per share," Elman said. "That's what they feel is their net worth, and they make decisions based on that. They go out and buy Porsche Boxsters based on the idea that they have these stock options that could be worth a certain amount at some point...It's rarely that easy to calculate."

Stock options have also become an increasingly prickly issue for employers. What started as a low-cost way to recruit workers has dragged many companies into a financial morass. At many Silicon Valley start-ups and newly public companies, stock options represent up to one-half of the outstanding shares--putting the company in the hands of a relatively small group of owners, diluting the stock, and riling institutional investors.

And now that the bull market has become a sustained bear market, many companies are feeling pressure to reprice existing options or supplement them with big new grants at depressed prices. They are also realizing that options, though inexpensive in the short term, cost dearly over the long term.

Re-pricing shares essentially erases underwater options and replaces them with an equal number of new ones at a lower price. Apple Computer, Oracle, Iomega and Barnes&Noble.com have all used the strategy. The Financial Accounting Standards Board (FASB) enacted a new rule in March that made repriced options a costly expense that is immediately tacked onto balance sheets.

Supplementing options is another possibility, and no less a tech titan than Microsoft has resorted to the tactic. In April, Microsoft granted a total of 70 million options to its 34,000 employees. In the iQuantic survey, 69 percent of companies surveyed in November said they were considering giving workers an additional options grant to increase retention.

But Wall Street hates both strategies because they dilute shares available on the open market. Investment banks also loathe repricing and supplementing options because they see it as unfair: If the banks can't jigger the price to be more favorable, why should the employees?

"It's very tempting to go the route of repricing or reissuing to take that extra value for employees," said Cris Banks, principal of Terranova Consulting and a senior lecturer at the Haas Business School at the University of California at Berkeley. "But my feeling is that you need to play by the rules of the game...Some people win and some people lose. I know we're trying to create opportunities for wealth, but we need some consistency if we want to play the game."

Some institutional investors dislike stock options so much that they are calling for a change in how they are recorded.

Today, stock options are considered a capital transaction, appearing on the balance sheet as a sale of stock. Anti-options groups argue that they should be considered an expense, no different from salaries and bonuses. Others want options to be recorded on the balance sheet as human capital so that when they're exercised the company is charged for the "spread," or opportunity cost, to the company.

No easy answer
But stock options face more problems than cantankerous investors. Options don't provide any long-term solutions to the fundamental challenge of recruitment and retention in a full-employment economy--a band-aid solution to get employees to stay.

So companies face a bind: Do they alienate Wall Street with diluted shares, or do they spark turnover by not granting options-hungry employees more stock?

Many experts say the tech sector has settled for a solution that combines the worst of both worlds: They continue to give out new options, increasing the number of outstanding shares, and they have started awarding higher salaries in case the options turn worthless.

"It's sort of like an addiction," said Kevin Murphy, professor of finance and business economics at the Marshall School of Business at the University of Southern California in Los Angeles. "Once you start granting them, it's hard to get off the cycle. People start wanting them and craving them, and the company can't stop giving them."

In many cases, both the company and the employee lose the options lottery.

"The greater cash compensation is putting a further cash drain on New Economy companies," said Jim Hughes, a partner with Arthur Andersen consultants, who heads the Pacific Southwest Human Capital Practice in Los Angeles. "Sometimes that's why companies fold. They just can't get their compensation strategy together."

The earliest signs that Corporate America is straying from stock options are already apparent. When former Amazon.com chief operating officer Joseph Galli negotiated his contract with the giant e-tailer, he secured an enormous option grant but also secured a protection clause that required Amazon to pay him up to $20 million if his options didn't pay off.

And when asked why qualified workers should come to Microsoft--the poster child for the stock-option millionaire employee throughout the late '90s--Microsoft senior technical recruiter David Pritchard took pains not to emphasize the prospect of wealth through Microsoft options.

"Yes, all of us have been very fortunate in the stock options we've received, but what really gets people excited is the work they can be doing here," Pritchard said. "Yes, compensation, base salary, stock options and benefits are all very important. But equally important is the job they're going to be doing, the person they're going to be working with, how much responsibility and authority and autonomy do they have to do great things. All those things are super important to people."

Of course, Microsoft stock is down roughly 60 percent since the beginning of the year, so all employees who received options with a market strike price this year are holding options that are underwater. And the 70 million stock options given out in April with a strike price of $66.63 also are worthless.

Although the Microsoft recruiter didn't want to discuss options, it is clearly a hot-button morale and retention issue inside the company. In a memo to managers last week, CEO Steve Ballmer acknowledged bluntly that the steep drop in the Microsoft stock price "makes employees, new and old, more sensitive to cash compensation.

"Stock options remain a great long-term opportunity," he wrote, but "reality has set in--here and industrywide."

Here to stay?
Although the options trend is cooling, experts say they will continue to be an integral part of compensation for years, if not decades--at least for certain workers.

Dimitri Boylan, chief operating officer of online recruitment firm HotJobs.com, said companies that just began experimenting with larger option grants in the past year--especially Old Economy companies that prided themselves on high salaries and juicy benefits--are likely to ditch options. But they will remain a key form of compensation in the tech sector, he said.

"The idea that companies give out options and drive the value of the company up is an American phenomenon that has taken hold over the last decade and is never going away," Boylan said. "People who aren't used to options may be liking their salaries right now, but there's no one in the Silicon Valley who would say no to options."

To be sure, Corporate America and its workers' fascination with options could easily be revived if the stock market takes a sustained turn for the better. But whether it makes sense to base long-term recruitment and retention plans around swings in the stock market is another issue.

"The question isn't whether people's opinions on options have changed in the past year," the Million Dollar Round Table's Elman said, "but whether people's opinions have changed in the past 15 minutes. You can't base anything on that."