Stock Options: Overused and Underwater

HR professionals face major challenges with this once-attractive recruiting and compensation tool. But there are remedies.

December 23, 2002
Employees once viewed hefty stock-option grants as a fast lane on the road toriches. Companies embraced the distinct advantages of using options to attractand keep top talent. In today’s economy, however, with the market price ofmany stocks dipping well below the exercise price, millions of options aresolidly underwater and unprofitable--at least in the short term.

Human resource professionals face major challenges in coping with the falloutfrom this weakened compensation and retention strategy. But there are remedialsteps that can be taken both to address the current dilemma and to implementmore effective solutions for the future.

Attempts to recognize and resolve the option quandary actually began nearly adecade ago. In 1993 and 1994, the Financial Accounting Standards Board launcheda quest to require an expense for stock options. The response from corporateAmerica was swift and primarily negative. Clinging to a comfortable status quo,companies claimed that unfettered access to free options would align executiveand employee interests with those of shareholders and would propel America’sthen fledgling tech economy to new heights.

Remember the saying, be careful what you wish for? Bowing to intense publicpressure, the FASB backed off. It allowed businesses to continue granting stockoptions as freely as they wished--without any real checks and balances on thesystem. Unrestrained, the practice spread and accelerated like wildfire, andoption grants expanded in size by more than 400 percent in seven years. Seeingonly the upside in the proposition, companies also began to widen the practice,including more lower-level employees in option plans. These enormous andwidespread grants definitely helped to drive growth in the tech sector as wellas the "old" economy. On the other hand, some argue that lavish optiongrants were also partially responsible for unrealistically inflating andultimately puncturing the market bubble.

The result is that our nation’s incentive system is seriously broken, witha huge percentage of the options that were intended to attract, retain, andmotivate employees now underwater and ineffective.

Where does this leave HR executives? In many cases, they’re holding the bagand scrambling for solutions. It’s a problem replicated across the corporatelandscape, as a growing number of companies find themselves strapped withunderwater options and high overhangs, or options as a percentage of sharesoutstanding. In effect, HR has lost the almighty magnetic field they’d reliedon to attract, retain, and motivate their best people. When stock options losetheir lucrative luster amid a downturn in the market, valued managers andexecutives can quickly start to feel unappreciated and uncompensated--and mayconsider un-employing themselves with the company.

Given the substantial size of option grant packages within most companies,executives may stand to lose 50 percent or more of their total pay package whenthe stock price drops significantly. Human resource executives can temporarilyreassure themselves that their competitors for talent are in the same boat. Butif the boat is sinking, does it really help to know you’re not alone in it?

If stock options have been included as part of your pay package, and yourstock price has plunged 30 to 50 percent or more, it is imperative that youconsider all of the alternatives available to you:

  1. Do nothing at all.

  2. Grant additional options.

  3. Grant restricted shares (may be tied to performance), or replaceunderwater options with restricted shares on a value-for-value basis.

  4. Cancel and reissue underwater options, with a six-month window.

  5. Reprice underwater options.

Creating solid plans for the future
    Underwater options are a big problem in part because so many have beengranted to so many people. The reason they were granted makes the problem worse.For many employees and executives, options were a primary reason they accepted ajob at the company in the first place. And for a great many companies, optionswere the competitive edge needed to attract people, and the "glue" used tokeep them. So, when a company’s options go underwater, the "deal" or "contract"made with its employees and executives begins to crumble. What is worse, thedeal was flawed in the first place, based on an implicit promise that couldn’tbe kept of relatively quick and easy wealth.

Though well intentioned, large option grants didn’t succeed in makingexecutives think and act like shareholders. It made them think and act likeoption holders, with a higher risk and shorter-term perspective thanshareholders. On their own, options don’t provide balanced incentives, andthey’re not a valid reason to go to work for a company in the first place. Formutual benefit, employment should be based on a variety of stable andsubstantive factors such as corporate culture, suitable career path, belief inthe product or service, and alignment with the company’s vision andphilosophy. Joining a company on the basis of the number of options granted(with hopes of getting rich quick and retiring early) creates an ill-conceivedcontract for all concerned.

Digging ourselves out of today’s swamp is only half the battle. Goingforward, it’s important to decrease our lopsided reliance on options anddevelop better plans that combine a variety of cogent and creative strategies.We need to consider flexible, tailored compensation vehicles that are clearlyaligned with the company’s organizational objectives and desired risk profile.

This shift in strategy does not have to dilute executive pay. However,executive pay must become more balanced and directly aligned with the goals andstrategy of the company--part of what we call a Balanced Incentive Portfolio.Packages may include a combination of options and long-term cash and stockincentives tied to core financial and non-financial goals. The options that aregranted should be more performance-based, with the exercise price increasing ata given percentage rate or fluctuating with the market. Such provisions wouldrequire the company to earn a minimum rate of return for shareholders beforeproviding a return to executives and employees.

While there isn’t a magic incantation to make the current problem ofunderwater stock options disappear, management can cope through measured actionssuch as a value-for-value cancel/re-issue, or replacing underwater options withrestricted stock (in far fewer numbers). Looking ahead, companies must takeprudent steps to avoid this problem in the future by developing and implementingmore balanced incentives based on business fundamentals and measurable,controllable performance.

The chart attached can help you see the pros and cons of various strategies for dealing with underwater options. Once you have opened this PDF file, you may need to enlarge it by "zooming in."

Workforce, January 2003, pp. 50-54 -- Subscribe Now!