Stock Options Under Fire
07/03/03
By : Paul R. Dorf, APD
Lessons from Microsoft and what it means for your Company
The latest news from Microsoft centered on its announcement to discontinue the practice of granting employee stock options and to use restricted stock in its place. Although this seems to have taken many people by surprise, it shouldn’t have, as all publicly traded companies wrestle with the realities of the recently enacted Sarbanes Oxley Act, the uncertainty caused by the debate on expensing options, and the continuing public outcry about compensation excesses.
Basically, Microsoft indicated that upon shareholder and SEC approval, it would discontinue granting any stock options to employees, and would only issue restricted stock with vesting requirements in the future. To entice employees currently holding stock options, many of which are “under water”, to give up the approximately 1.7 billion options, it has arranged to allow J. P. Morgan to purchase them at a nominal cash amount. It is assumed that the Company will continue to honor the exercise of stock options that are vested and “in the money”. They may even accelerate those unvested, but “in the money” options, however, that is strictly conjecture.
Obviously, this move is driven to a large degree by tax and accounting considerations, or at least anticipated changes affecting stock options. Since options have become such a significant portion of the total compensation package impacting employees at most levels, and amounting to as much as 50% or more of the senior executives’ package, it is critical that every company consider the impact of this move to restricted stock relative to their own situation.
The following table provides a comparison of stock option and restricted stock grants since 1998 as contained in the ECS Industry Report on Top Management Compensation Surveys. Non-Qualified Stock Options have increased over the period, while the grants of ISOs and Restricted Stock have basically stayed the same from year to year. The big question is how will the anticipated changes from granting of Stock Options to Restricted Stock change this picture in 2004 and beyond.
Year
| Non-Qualified
Stock Options
| Incentive
Stock Options
| Restricted
Stock
|
1998
| 56.7%
| 36.4%
| 26.0%
|
2000
| 57.7%
| 39.9%
| 26.4%
|
2002
| 63.1%
| 38.7%
| 25.2%
|
2004
|
|
|
|
What are the advantages?
- Fewer shares allocated for restricted shares means less dilution to shareholders.
- The potential negative accounting for options is avoided.
- Restricted stock has a fixed accounting charge.
- Vesting requirements can be tailored to meet company needs.
- Related cash-flow needs of employees are less and may encourage stock ownership.
- Restricted shares generally receive dividends (or equivalent) even before vesting.
What are the disadvantages?
- May reward employees who are “resting till vesting”.
- Restricted shares have an accounting charge; currently, there is no charge for options.
- Backend tax hit to employees when shares vest (can mitigate with 83(b) election).
- Motivation to increase stock price is lost.
- Does not require financial commitment by employees.
What does this mean for Public companies?
- The Compensation Committee needs to re-visit its Compensation Philosophy.
- Determine if stock options are still relevant as part of its total pay package for executives, employees, and board members.
- Consider how this impacts Stock Ownership Guidelines.
- Determine if restricted stock is better or worse, based on each company’s situation?
- Clarify who will receive stock grants of any type in the future.
What does this mean for Private companies?
- Long-term incentives and compensation will not go away; rather it will take new and creative forms.
- They will have to continue to compete for the best-qualified and talented employees.
- The total compensation package must remain competitive in order to attract, motivate, and retain key employees.
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The change in compensation strategy announced by Microsoft has re-ignited the controversy of which pay components, and in particular, which stock-based plans should be used. This will have an immediate impact on all companies as they continue to compete for top talent, and in their ability to motivate employees to strive for the profitable growth that is most common of all corporate goals.
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Compensation Resources, Inc. is a consulting firm dedicated to providing pragmatic solutions to meet its clients’ needs and to assist them to achieve their tactical and strategic objectives.
