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Microsoft Leads the Way in Opting Out of Options

July 31, 2003
Related Topics: Variable Pay, Compensation Design and Communication, Featured Article, Benefits

Throughout the technology boom of the 1990s, scores of companies sought to attract talented workers and motivate them to new heights of productivity. They offered grants of stock options, a financial incentive that, because of accounting technicalities, had the added allure of not showing up as an expense on the corporate balance sheet. "It got to the point where companies almost had to use options because everyone else was doing it," says Diane Doubleday, a compensation expert in the San Francisco office of Mercer Human Resource Consulting. "Employees wanted the chance to get rich and were comfortable speculating on a company’s upside. Companies could hand out what seemed like free money."

But the free ride soon will be over. In June, the Financial Accounting Standards Board, a professional group that sets rules for how companies keep their books, stated that in 2004, it most likely will begin requiring that options be counted as an expense, so that companies that issue them will put a dent in their profits. Then, in July, Microsoft--which in 2002 gave employees options worth an estimated $3.6 billion, nearly a third of its pretax income--announced that it was ending the practice altogether. While some other technology companies that still favor option grants are lobbying Congress to pass a law blocking or delaying the new accounting rule, human resources consultants who specialize in compensation issues say Microsoft’s move puts an exclamation point on what is already obvious: in corporate America, options are no longer the vogue. In a recent study of 134 companies, Mercer Human Resource Consulting found that 63 percent of them have scaled back or eliminated option grants.

Some in the technology sector are long-faced about the demise of options as an incentive, saying that future start-ups will be hard-pressed to attract talent without them, and that giving employees a chance to become owners in exchange for productivity is a proven route to success. But human resources consultants who specialize in compensation issues say that in the long run, the major stakeholders--management, workers and investors--all actually stand to benefit from the end of options’ dominance as a compensation device. Companies now can design incentive compensation plans more closely tailored to their own specific circumstances--whether it’s a need to retain an existing talent base or a volatile share price that might reduce the allure of options. They even can create hybrid plans that utilize several different types of compensation--various combinations of restricted stock, options and cash bonuses--to give them more flexibility in dealing with future economic ups and downs.

"This is actually a great opportunity," Doubleday says. "What it’s doing is giving companies a clean slate, and allowing them to take a fresh look at how they provide incentives to employees."

Even though some companies--most notably Intel, whose shareholders in May rejected a proposal to expense options--still cling to the practice, nearly 200 companies are now expensing options, according to Ted Buyniski, principal with Buck Consultants, a New York-based human resources firm. Unless Congress intervenes, Buyniski expects that the rest of the corporate world will rapidly fall in line behind the FASB. One reason, he says, is a technicality that would allow companies that make the change quickly to avoid the risk of having to take charges for past years’ option grants, which would force them to restate earnings. (A Buck study of 28 technology companies found that if they waited too long to expense options, the median charge against earnings would rise from 2 cents to 31 cents per share.)

But even if new accounting rules didn’t necessitate a shift away from options, consultants say, other new realities eventually would compel companies to change. When options became popular in the 1990s, everyone from investors to politicians lauded them as the near perfect way to reward employees for helping companies grow. But the luster faded quickly, and after financial scandals at Enron and WorldCom, investors began to suspect that other companies might be playing similar accounting tricks to allow executives to make a killing on their piles of options. But even at honest companies, the dramatic plunge in stock prices over the last several years rendered many rank-and-file employees’ options essentially worthless because the exercise price is now higher than the market value of the shares.

"The big problem with options is that they’re really only effective as a motivational tool in a bull market," says Brent Longnecker, president of Houston-based Resources Consulting Group. "Today, when you have people holding billions of dollars in options that are underwater, the idea isn’t so appealing. This isn’t 1995, when people were willing to take a chance at getting rich. In 2003, what they want is to get paid." (According to a recent Wall Street Journal story, Microsoft sought to placate unhappy employees by offering an unusual deal in which they could sell their worthless options, though the payout most likely was far less than they would have hoped.)

That’s one reason why Longnecker favors direct grants of restricted stock, which the employee actually receives after staying at the company for a set number of years. Microsoft chose such a plan to replace options, and in the recent Mercer study, 60 percent of the companies that had abandoned or cut back on options went with restricted stock instead. Longnecker sees restricted stock as the No. 1 vehicle for most companies because it offers a more powerful incentive for retention. Unlike options, actual shares are guaranteed to provide some value to employees, as long as the company doesn’t go under. And at mature companies that pay dividends, employees can make money off their equity without having to sell off shares. That makes it desirable for employees to hold on to their equity, which restricted-stock advocates say builds a sense of connection to the company and its fortunes.

Buyniski says that a slower, steady benefit is a better fit with the typical employee’s mind-set today. "Even as the market seems to be recovering, people are taking a much more sober view of their equity," he says. "They’re not in a rush to turn it over so they can buy a bigger house or a flashy car."

Restricted-stock plans, however, have their critics. "Basically, it’s pay for pulse," says Rick White, chairman of the International Employee Stock Options Coalition, a technology industry group that opposes option expensing. "You’re rewarded as long as you stay around, no matter whether the company prospers as the result of your efforts or not. With options, for you to benefit, the company has to appreciate in value. If your object is to get employees to think and feel like owners, they’ve got to have some risk." That problem can be remedied easily, advocates of restricted stock contend, by tying the size of the grant to corporate performance.

Another compensation alternative favored by Longnecker is the performance-unit grant plan, which he says gives companies the flexibility to reward employees in whatever fashion turns out to suit economic conditions down the road. The concept isn’t a new one. Longnecker says that it was developed by PepsiCo in the early 1970s during a long stagnant spell in the stock market--though paradoxically, he notes, it works just as well in times of volatility. "Basically, if the company is growing and generating profits, but the stock market, for whatever reason, isn’t paying attention to that, you make the grants in cash. But when the market starts to take off, you switch and give out stock. It’s a nice hedge for employees, but it also injects some reality back into the situation because really, at the end of the day, not everything should be driven by share price. You’re refocusing attention on selling products and succeeding at the business itself."

Doubleday thinks the future most likely lies in such flexible plans, which she sees as including custom combinations of stock and cash--and possibly options as well. Instead of spreading options throughout the rank and file, she says, a company may want to give them some other compensation incentive and reserve options for top performers, or for employees whose technical skills have the most critical strategic value.

Longnecker says it will be critical for human resources to educate employees about the new compensation plans. "We’ve got a lot of work to do because people are more skeptical in the current climate," he says. "But at the same time, they’re also sick of just looking at those options and hoping for the market to go up. They’re ready for a change, and now companies can give that to them."

Workforce Management, August 2003, p. 74-76 -- Subscribe Now!

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