How To Salvage Stock Options
Forbes
Blair Jones and Seymour Burchman
30 July 2002

Forbes


Stock options are a case of good intentions gone bad. Remember, from the middle 1980s to the early 1990s, many companies replaced restricted-stock and long-term performance bonus plans with stock options in the belief that they were a better way to link shareholder and executive interests. Executives would gain only if shareholders did.

Options also offered an added benefit--no charge to earnings. They received a further boost when Congress passed the $1 million cap legislation in 1993, which placed a cap on tax deductions for nonperformance-based pay to a company's top five executives. Stock options with an exercise price of fair market value or higher on the grant date qualified as cap-exempt performance-based compensation, while service-vested restricted stock did not.

By the mid-1990s, more than nine out of ten U.S. companies were granting stock options. Most options were plain vanilla, with an exercise price equal to fair market value on the date of grant, ten-year terms and a three- to four-year vesting period. The market bubble of the 1990s and the dot-com-driven war for talent accelerated increases in the size of option grants. By the end of the decade, average annual grant sizes were growing at a rate of 10% to 15% per year.

That was then; this is now. Stock options are at the center of political and investor controversy. New questions have been raised about the influence stock options have over executive actions and decisions. The sheer size of some stock-option packages has been eye-catching (see "Big Bosses & Paychecks"). Individuals as influential as Federal Reserve Chairman Alan Greenspan single out stock options as a key contributor to "the infectious greed" that has swept America. Have stock options had their day?

There is no question that in many companies, stock options have been overused and abused. But before we discard them, we should consider the useful role they can still play in most executive-compensation programs. The current controversy is a wake-up call to salvage what is good about stock options.

In their traditional form, stock options haven't delivered on the promise to align shareholder and executive long-term interests because of three important limitations.

First, a rising tide raises all ships. So even executives in average and poor performing companies can do quite well. Stock option mega-grants have exacerbated this outcome in some instances. Executives have been able to realize huge gains from even small increases in share price, purely based on the number of option shares they held.

Second, timing can mean everything. Companies tend to grant stock options once a year. Executives are free to exercise vested stock options at almost any time during the option term. Canny timing can make stock options seem more like a lottery than a true reward for performance.

Third, the potential rewards from stock options have significantly exceeded their inherent risks. Executives so minded could be tempted to make huge bets or, worse, to drive up their company's stock price, with limited personal risk if the bet fails.

In addition, stock options' favorable accounting has often become the dominant factor in their adoption, rather than a side benefit. Alternative long-term incentive vehicles rarely receive a fair hearing by board compensation committees, even if alternatives are better aligned with a company's long-term business needs and shareholder interests.

The limitations mentioned above can be overcome. Start by addressing each of the terms of stock-option programs--exercise price, vesting, time to exercise, eligibility and grant size. This is a serious task for board compensation committees, which, like their audit committee counterparts, will need to ensure their members have the skills to evaluate alternatives to traditional options and the independence to act on behalf of shareholders, not like rubber stamps for executives.

One reasonable response to the rising-tide-raises-all-ships issue is to index options. Indexed options work similarly to traditional stock options, with one exception: Rather than having the exercise price fixed at the market price on the date of grant, the exercise price varies based on the change in an appropriate stock market index, e.g., the S&P 500 or a narrower industry index.

Assume a company granted an indexed option when the stock price was $10 and chose to index against the S&P 500, which grew at a rate of 10% per year. The option would have an exercise price of $14.64 four years later when vested. This exercise price would continue to rise for the life of the option. Executives would only realize gains to the extent they outperformed the chosen index.

Indexed options balance a company's relative stock market performance against its absolute gains. In practice, companies are likely to weight the extent of out performance against their chosen benchmark, which would give them flexibility in dealing with up and down markets.

Because indexed stock options pay primarily for out performance, they are highly leveraged. This means they require more shares to deliver the same value as traditional stock options. Explaining the mechanics of indexed options can also be complex. Therefore, they may be best suited for the most senior executives, who are most accountable for shareholder returns.

For lower-level executives, it may be more appropriate to grant restricted stock that vests based on performance relative to an index. In this case, the value of restricted stock is based on the absolute performance of the stock. How much an individual earns is based on indexed performance.

The timing-is-everything and risk/reward limitations can be addressed by instituting mandatory holding periods--say, two to three years--for a certain portion of shares acquired upon option exercise (once the exercise price and taxes are paid). Grants could also be made more frequently throughout the year--for example, quarterly. Vesting for at least a portion of shares could be lengthened. Companies could also vary grants more based on individual performance.

As the momentum for companies to expense stock options increases, many think that the use of stock options will be cut back. But before we dismiss options out of hand, we should remember that they were introduced for good reasons and that their shortfalls are not fatal.

Instead of abandoning them, we should reinvent stock options in a way that furthers the original vision for them. A combination of the fixes discussed above can go a long way toward addressing current criticisms of traditional stock options.

Switching from plain vanilla to indexed stock options, in particular, focuses top executives on making their company outperform competitors and the market as a whole, which would better serve to align executive and shareholder interests. Requiring executives to hold some of the shares they get through exercising stock options would be a severe disincentive to manipulating their company's stock price in the short term to their own advantage.



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