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Are stock options in your future?

With employers and employees alike looking more skeptically at stock options, experts at Wharton debate the future of this once-popular form of compensation.

Given the recent turmoil surrounding stock options--including well-publicized abuses of executive stock options, the depressed market, and anticipated new rules on the expensing of options--has this once-popular form of compensation lost its appeal?

Also, how effective are stock options these days in achieving what has always been their stated goal--aligning the interests of managers with the interests of shareholders? Does company performance improve because of stock options? Should companies be required to include stock option compensation as an expense on their income statements, or is that issue, as Corey Rosen, executive director of the National Center for Employee Ownership, puts it, "going to be the Y2K of stock options?"

Finally, what are the advantages of broad-based options programs versus those offered only to top management?

The dilution effect
Up until three years ago, stock options were the currency of high-tech start-ups in Silicon Valley during a boom period that created a whole new class of wealthy owner/employees. These days, stock options suggest out-of-control executives at large corporations who made millions cashing in options as their companies were sinking into bankruptcy.

A recent paper by Wharton accounting professors John Core and Wayne Guay entitled, "Stock Option Plans for Non-Executive Employees," concludes that by the late 1990s, employee stock options at large corporations averaged 7 percent of total outstanding shares. Approximately one-third of all the options were held by top executives.

"Most knowledgeable people, including the heads of compensation committees, directors of human resources, board members and CEOs, were well aware that the aggressiveness of options grants couldn't go on," says one Silicon Valley compensation consultant. He cites research showing that over the past five years, the median stock option burn rate at publicly traded technology companies exceeded 6 percent.

"This means a company has to increase in value by at least 6 percent for the pre-existing shareholders to break even. That was fine when stock prices were increasing at 20 percent, 40 percent, or 80 percent a year, but for the last two and a half years the market has been losing a great deal of money. To add insult to injury, the shareholders were further diluted by overly generous executive stock option programs," the consultant said.

Indeed, last week Thomas Siebel, chairman and CEO of Siebel Systems, announced that he was voluntarily canceling the approximately 26 million stock options granted to him since 1998. His gesture comes at a time when revenue at Siebel Systems is down and 15 percent of the work force has been laid off.

For Wharton accounting professor David Larcker Siebel's decision raises an important question about large stock option awards. "One of the big mysteries out there is why people who are founders, or who already own a ton of equity, continue to get options. What incentives could these options possibly provide? There have to be superdiminishing returns to having a few more stock options if you already own millions of shares."

These days, stock options suggest out-of-control executives at large corporations who made millions cashing in options as their companies were sinking into bankruptcy.

In the meantime, companies are not likely to discontinue stock options, even if the recent bad press means they will come under increasing scrutiny from regulators and investors. "I seriously doubt that these plans will stop altogether, although I do think companies will use them a little less," says Guay. "The best way of aligning the interests of managers with those of shareholders is still through the stock price. That can be accomplished in two ways, through stock options and stock ownership. Both are tied directly to stock price performance."

Rosen of the National Center for Employee Ownership suggests that "options appear to have leveled off. Companies aren't disbanding their programs, but we don't see a lot of new ones being established or existing ones being expanded. People are waiting to see what happens."

One of the big issues, observers note, is how employees perceive the value of these options. Typically firms choose to use the Black-Scholes option-pricing model, which according to Larcker, "is an excellent starting point to figure out the cost to the firm of granting an option. But the method was developed to value publicly traded options typically over a three-to-six-month horizon." Various adjustments have to be made in order to get close to the real cost of the options, especially when they have longer vesting periods or if the model lacks the necessary forecasting information. The bigger point, Larcker suggests, "is that fundamentally people don't want to value options because they don't want to have to disclose what the options are costing them."

Some also question whether the Black-Scholes method ends up making options look more valuable than they are. "It's not clear whether a risk-averse employee will come up with the same" valuation as the Black-Scholes model does," says management professor Martin Conyon. In that case, the options might not be as appealing. It also depends on whether stock options are viewed "as an add-on or as part of the compensation package," he notes. An employer might make an offer that splits up the compensation between options and salary. A risk-averse person, however, might "prefer to have the certain equivalent of cash rather than options."

That could be a moot issue: In this economy, employees don't have much choice, or as much leverage, as they used to. "The heady days of options being everywhere, of people walking across the street for a slightly better options package, are long gone," says Conyon. "It's a war zone out there. There just aren't as many job opportunities available."

The case for broad-based options
Stock options, says Douglas Kruse, a professor at Rutgers University and co-author of a forthcoming book entitled, "In the Company of Owners: The Truth About Stock Options and Why Every Employee Should Have Them," have received "lots of bad press and much of it is deserved."

Kruse and his co-author, Rutgers professor Joseph Blasi, are especially critical of executive stock options. Using a sample of the 1,700 largest companies in the U.S., they found that the value of executive stock options increased by more than 1,000 percent in the 1990s whereas market value of all the companies only went up about 350 percent. According to Kruse, "there is no good evidence that executive stock options improve company performance."

But it's a different story when you look at broad-based stock options, adds Kruse, who defines broad-based plans as ones where "more than 50 percent of nonmanagerial employees regularly receive stock options grants." Companies with broad-based plans "do better in terms of productivity and total shareholder return because they are able to create and reinforce a participatory culture," he suggests.

Some research suggests that firms with stock options plans do outperform those without them.

According to Kruse, "stock options by themselves don't make a difference, but we argue that when you combine stock options with employee involvement, cash profit sharing and other incentives, and when you have policies that decrease status differences between executives and employees, that can improve performance. It's what high-tech companies have done over the past decade." Kruse and Blasi also analyzed 100 high-tech and 100 non-high-tech companies in Silicon Valley, and found that 98 of the 100 high-tech firms had broad-based options plans, while six of the 100 non-high-tech companies had such plans.

Indeed, broad-based stock options plans are common in the largest computer and high-tech companies ranging from Microsoft to Intel to Cisco Systems. But Starbucks, a decidedly non-high-tech company, was the first privately held company in the U.S. to offer a stock option program to all eligible full-time and part-time employees, or "partners," as they are called. That was in 1991. Today, Starbucks has 62,500 employees and sales of close to $3.3 billion.

According to Conyon, however, economists "have always been slightly suspicious about the use of stock options for lower-level employees. Their argument is, 'Can a maintenance worker really affect the stock price?' Economists would argue that options are not a good incentive device for that person." At the same time, some research suggests that firms with stock options plans do outperform those without them, but "the difference isn't really marked, and there is a debate about what the true driving factors of those differences are." Conyon's own position is that broad-based stock options can be effective. "Even if you give people lower down in the organization smaller amounts, it still creates a sense of 'everyone is in this together.' It's 'symbolic egalitarianism,'" he says.

In small start-ups, or even firms that are in a high-growth phase, options across the board may well help with employee retention, Guay adds. "Usually options can't be exercised for three to five years. So employees might be encouraged to stick around until those options vest."

Considering the current state of the stock market, of course, it's an academic discussion for now. "These days, most employees would prefer to have slightly more cash than slightly more options," says one observer, who describes lower-level stock options as "more of a recognition award than a wealth creator." On the other hand, he adds, "as soon as the market comes back, there will be a renewed clamor for options at all levels."

To expense, or not to expense
The National Center for Employee Ownership recently completed a survey of business school professors that asked about the impact of expensing stock options on company stock prices. According to Rosen, only five out of the 36 professors who responded think that expensing will have a significant effect on stock prices. The rest either think it will have no effect at all--which is the most common response--or that it might have a more substantial effect on a few companies.

And yet the perception is that expensing--i.e., requiring corporations to deduct the estimated value of stock options grants as a business expense in reported income--will "harm stock prices," says Rosen, adding that the Center recently completed a book titled "Equity Compensation in a Post-Expensing World." Rosen adds: "Generally economists say (stock prices won't be affected) because this information is already out there."

Others agree. The expensing of stock options must already be included in the footnotes of a company's financial statements. Therefore, a requirement that it now be included in the actual income statement won't--and shouldn't--have "a huge impact on anything," says Guay. "So it's not clear to me why there is so much lobbying against it" by, for example, option-dependent high-tech firms and the Nasdaq composite index.

Guay points out that the Financial Accounting Standards Board (FASB) failed 10 years ago in its bid to require expensing of stock options, "which means they probably won't touch it in the immediate future. I do think the International Accounting Standards Board will approve the requirement, and then the FASB will take its cues from them. Conformity of accounting rules across countries is going to be a big issue." Assuming an expensing requirement is approved, he adds, "it might have a minor effect on the amount of options that firms grant, but I don't think it will be massive." For its part, the FASB now requires quarterly, instead of annual, disclosures of companies' estimated option expenses in their footnotes. Chances are high that a rule requiring expensing of options--which several hundred companies already do voluntarily--may be passed in the next 12 to 18 months.

Guay does suggest that one reason executives in particular may be opposed to expensing stock options is that it could put their compensation under a brighter light. As he notes in a recent co-authored paper titled, "Accounting for Employee Stock Options," expensing options "would influence contracting arrangements by making stock option compensation to top executives more visible. This, in turn, would make it more difficult for top executives in firms characterized by poor corporate governance to justify awarding themselves excessively lucrative pay packages."

Kruse and Blasi, after wrestling with this issue, say options should not be expensed, but if they are, the requirement should include only executive options. Kruse, however, is concerned that a number of companies in the past year, worried that expensing will take place and that they will be slammed by the market, "have been cutting down their broad-based options--but not the executive options. So in a sense employees are being punished for the abuses of the executives."

In his opinion, from a technical standpoint, stock options resemble profit sharing plans. "When you establish a profit sharing plan, you don't have to count it as an expense. Rather you count it as an expense if and when you share profits. It should be the same with stock options. Why do we need to count them as an expense (when they are offered) rather than if and when employees exercise the options? It could be that options never pay off, so they end up never being an expense for the company."

The future of stock options
Because of the recent executive scandals, Rosen expects greater scrutiny of stock options across the board, regardless of how they are allocated. That means "less willingness to make them more broad-based, at least in the short run." But in the long run several things will help, he says. When the economy recovers and jobs pick up, especially for skilled workers, "employees can once again demand options." In addition, Rosen says, companies that claim "people are our most important asset" will increasingly be viewed negatively by employees if options are granted only to top executives.

If companies do start cutting back on stock options, they have other choices for performance-based compensation, both Rosen and Kruse note, citing employee ownership, profit sharing, stock purchase plans and so forth. Certainly because of the recent scandals, "you won't have people saying they don't care about anything else as long as they get options," Rosen says. "Instead people will be much more realistic about the role equity should play in their compensation. They shouldn't, for example, have most of their paycheck in options; they shouldn't have most of their retirement money in company stock."

Rather than just focusing on the tax and accounting treatments of stock options, Conyon suggests that companies look into more innovative ways of designing their options packages. In Europe, he says, especially in the U.K., stock options already have performance criteria attached to them. In addition to the standard vesting that occurs over time, "vesting occurs only if certain performance hurdles are met. Either earnings per share growth has to be at a particular rate, or it might be benchmarked against other firms. The point is, there are additional constraints attached to the options."

In addition to more performance-based options, Larcker also predicts an increase in relative-based options (where the exercise price moves up or down depending on the overall stock market) and premium-based options (those granted way out of the money). Some option holders may be required to hold stock longer after they exercise their options, or their ability to exercise the options may be restricted. "Also, because options are not dividend protected (i.e., the holders miss out on any cash dividends that are paid), it will be interesting to see whether companies decide to add dividend protection, or use less options. If it's the former, the dividend yield could start getting pretty high."

In general, Larcker says, he expects companies to do a better job of figuring out how options fit into their compensation programs. "There has been a lot of scrutiny of audit committees. Next in line should be compensation committees, which need to better justify what they do and why. Part of that is how they award options."

To read more articles like this one, visit Knowledge@Wharton.

All materials copyright © 2003 of the Wharton School of the University of Pennsylvania.