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Options called into question

Some pay experts and watchdog groups are questioning whether stock option grants to CEOs actually translate into better performance and stronger loyalty.

Although stock options have come to play a more significant role in compensating high-tech CEOs, some pay experts and watchdog groups are questioning whether the practice actually translates into better performance and stronger loyalty.

"The biggest thing that is destroying the relationship between pay and performance is, ironically, stock options," said Graef "Bud" Crystal, editor of the Crystal Report.

Tech companies dole out stock options in hopes of retaining CEOs and making See special report:
Fat cats their compensation contingent on how successfully they run the company. The theory is that, the better a company performs in the long run, the higher its stock price will be and, consequently, the greater the reward for the CEO when it comes time to cash in his options.

But Crystal has found that there doesn't seem to be any correlation between the size of stock option grants and the success of a company.

"It seems like it has nothing to do with anything," Crystal said. "If you put [market value and compensation figures] on a graph, it looks just like a series of random numbers drawn from a machine."

Of the 59 companies analyzed by CNET News.com, the average number of stock options for fiscal 1997 awarded to CEOs was 377,000, with an average value of roughly $7 million.

IBM CEO Lou Gerstner received 2.2 million options with a value of $139.3 million in fiscal 1997, according to data complied by Standard & Poor's Compustat. Oracle CEO Larry Ellison received a grant of 1.6 million options valued at $41.5 million.

Stock option breadwinners
Company CEO Options
IBM Louis V. Gerstner, Jr. 2200 $139331
ORACLE Lawrence J. Ellison 1600 41546
COMPAQ Eckhard Pfeiffer 875 40345
DELL* Michael S. Dell 3200 33515
CISCO John T. Chambers 800 21088
NOVELL Eric E. Schmidt 2750 14802
BAY** David L. House 2000 13857
COMPUWARE Peter Karmanos Jr. 266 10497
INFORMIX*** Robert J. Finocchio, Jr. 1500 10200
SUN Scott G. McNealy 300 6403
*Based on Dell's fiscal 1998 proxy, given that 11 months of the company's fiscal year were accounted for in 1997.
**House became CEO of Bay in 10/96. Fiscal year ended 6/97.
***Finocchio became CEO of Informix in 7/97. Fiscal year ended 12/97.

Source: Standard & Poor's Compustat, a division of the McGraw-Hill Companies.


According to Big Blue's proxy, Gerstner was given a special grant of 2 million options as a reward for his performance. During his tenure, IBM saw its revenues grow 3 percent last year over the previous year, while its earnings rose 12 percent and its market capitalization grew by $23 billion.

One compensation expert noted that performance-based options such as those awarded to Gerstner are an increasingly common practice.

"Instead of being just a plain vanilla stock option [that vests over time], we're beginning to see more and more performance-based features put into those options," said Richard Norton, a compensation consultant at Towers Perrin of Northern California.

Norton noted that one common incentive arrangement offers executives stock options that don't vest for a certain number of years unless a particular goal is met. If the goal is met prior to the deadline, the options vest immediately.

As for a company's shareholders, many have reservations about the impact options grants can have on their returns. Among the issues associated with them that have raised the ire of investors are: dilution to earnings per share as options are exercised, the difficulty of determining the true cost of such grants to the company, and the inequity that goes along with reconfigured option strike prices.

Companies are not required to account for options--which otherwise would be charged against earnings--as part of their compensation expenses. But in 1996, the Financial Accounting Standards Board began requiring companies to at least include a footnote in their annual reports explaining how their earnings would have been affected had they factored options into compensation costs.

IBM's earnings, for example, would have been $5.87 billion, or $5.82 a share, in fiscal 1997, compared with the reported $6 billion, or $6.01 a share, according to the company's annual report.

Dell Computer CEO Michael Dell received 3.2 million option grants last year, making him the most generously rewarded high-tech CEO in terms of options granted, according to Compustat. In order for the company's shareholders to determine whether those options were well-deserved, however, they would have to take into consideration the fact that Dell's 1997 pretax earnings would have been reduced by $22 million, or 8 cents a share, if stock options had been taken into account, according to the company's annual regulatory filing.

"The reason Silicon Valley so bitterly fought the FASB is that they knew in their hearts that if they had to charge against earnings, the game would be over--that we'd have to cut way back on grants to senior executives because the costs would be astronomical," Crystal said. "But as it is now, it's like Alice in Wonderland. We give [executives] this huge option and we pretend it doesn't cost anything."

Repricing the strike price of options, or lowering the per-share price paid to exercise the options, is another contentious issue for investors. Advanced Micro Devices is one company that repeatedly has lowered the strike price of its options, in an effort to keep employees as its stock price plunged.

Repricing of options has long been a common practice, aimed at retaining executives as well as a company's rank-and-file employees, said Marty Katz, head of the Western office of William Mercer's executive compensation practice. He pointed out, however, that there has been a philosophical shift recently, with many companies now choosing to reprice options for all employees except their top five executives.

Although AMD chief executive Jerry Sanders did not receive any stock option grants in 1997, he did receive more than $15 million from cashing in previous grants.

"The issue is that Jerry Sanders cashed in options worth $15 million dollars last year, and, given that the stock price was $28 a share five years ago and it's [dropped below that] today, that's quite a feat," said Chris Bohner, research analyst for the AFL-CIO. "A lot of other shareholders didn't have that luxury, especially long-term investors."

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