The Rise of Restricted-Stock Grants

A 2003 PricewaterhouseCoopers human resource services survey shows that 15 percent more companies use restricted stock than in 2002. Switching from options to restricted stock is not necessarily all that easy to pull off.

January 5, 2004

Progressive Corp.’s top 650 employees get annual restricted-stock awards of 20 percent of pay. Until last year, mid- to senior-level employees of the holding company for the Progressive Insurer Group got annual stock-option grants. Microsoft and, both broad-based options pioneers, also now give restricted stock rather than options. In fact, dropping options in favor of restricted stock is becoming a popular move.

    A 2003 PricewaterhouseCoopers human resource services survey shows that 15 percent more companies use restricted stock than in 2002. But switching from options to restricted stock is not necessarily all that easy to pull off. "The problem is that companies tend to look to what everyone else is doing," says Blair Jones, senior vice president of Sibson Consulting in New York. The reality is that, for some companies, restricted stock is not an appropriate compensation tool, she says. While restricted stock may be the right thing for Microsoft--a mature, established company that pays dividends--it may not be the right move for a start-up company in a high-growth industry. The impact on employees and the strategic goals and objectives of the stock-compensation program must be fully assessed before a change is made, experts say.

    Progressive, which has 25,000 employees and is located in Cleveland, likes to have entrepreneurial managers who are not afraid to take risks. But senior management also has felt that option holders might take unnecessarily excessive risks to drive up stock prices. "We did our own study of corporate governance in the wake of accounting scandals and concluded that restricted-stock awards better align employee interests with those of shareholders," says Progressive treasurer Tom King, noting that the change is not a defensive move to salvage underwater options. All outstanding options are still "in the money," with share prices above strike prices.

    Employees have not objected to the change. "They understand the trade-offs," including less risk for less gain, King says. In addition, restricted stockholders share in Progressive’s $.10 per share annual dividend and have voting rights--two things they did not have with options. Furthermore, the value of equity compensation remains the same. For example, if Progressive stock trades at $75 per share, then, under the old plan, an employee making $100,000 would have received approximately 500 options with a market value of $20,000, King says. Today, that employee would receive approximately 250 shares still worth $20,000. After three years, the new awards vest at a rate of one-third a year, with the 30 most senior level employees’ awards vesting only after the attainment of corporate growth targets. All awards are fully expensed in the company’s financial statements over the life of the grant.

    A spokesperson for Microsoft says that restricted stock is now a better way of attracting and retaining the best employees and aligning the interests of its 50,000 employees with those of shareholders. "Employees all have the opportunity to receive stock awards, be an owner, and share in the success of the company," he says. The company would not discuss further information about the plan.

    Whether restricted stock is right for employees depends on age and risk tolerance, experts say. For risk-averse employees, restricted stock has notable advantages now that holdings of underwater options are common. "Restricted stock is always worth something," says William Gerek, global director for the Hay Group’s executive compensation practice in Chicago. When share price drops below option strike price, options are worthless to employees. But if restricted stock is worth $30 on grant date, and share price drops to $22, the stock is still worth $22, says Scott Olsen, a principal and head of PricewaterhouseCoopers’ human resource services compensation practice in New York. Unlike options, restricted-stock awards require no employee cash outlays, Gerek says. Employees can get dividend income, even prior to vesting. The dividends are taxed at ordinary income tax rates until vesting, and thereafter at 15 percent.

    But while restricted stock has less risk, it also has fewer opportunities than stock options, Olsen points out. There is less chance of becoming an overnight multimillionaire, the very thing that appealed to thousands of innovative, entrepreneurial individuals during the technology boom. The smaller size of restricted-stock grants may also lead to misunderstandings. "Some employees focus on the numbers and see that where they once got 10,000 options, they are now getting 1,500 restricted shares," Jones says. But restricted stock is a sure thing and less speculative than options, and thus is worth more. This fact must be communicated to employees before a switch, she says.

    Employees also are in less control of their tax destiny. They don’t pay taxes on options until they are exercised, so there is control. But restricted stock is a tax certainty that is included in income on vesting, Olsen says. Some overseas jurisdictions even tax restricted stock upon grant. Employers can delay taxation by issuing "restricted-stock units," a contractual promise to issue shares at some future date after they are vested. Microsoft uses restricted-stock units, Jones says. Employees can also elect to be taxed within 30 days of grant date under Internal Revenue Code section 83(b). The theory is that taxes will be lower at that time than they will be after vesting, Jones says. But, she warns, employees cannot get taxes back if the stock falls in value or is forfeited.

    Restricted stock is also more appropriate for certain types of firms and certain industries. In high-turnover industries, it is more effective in retaining rank-and-file workers. "Stock options were never much of a retention tool; they basically retained employees until they vested, then they’d cash in and leave," Gerek says. Until vested, employees are disinclined to leave a firm and leave restricted stock behind even if stock prices have fallen, Olsen says. But stock options are better for start-up firms and companies where cash flow is a problem. "Stock options are much more motivating than restricted stock," Olsen says. And whether restricted stock or stock options should be granted depends on the level of the employee as well. Restricted-stock awards may be a better form of motivational equity compensation for the rank and file, Olsen says, but senior management still should have a component of their compensation based on performance.

    While investors generally favor restricted stock, they will scrutinize any switch. Institutional Shareholder Services recommended that its 700 clients vote yes on the Microsoft change, but the California Public Employees Retirement System voted its proxy shares against it, stating that the company did not provide enough information about the plan. The plan passed anyway. The AFL-CIO’s office of investment management, which oversees more than $400 billion in union pension funds across the country, says that restricted stock is an appropriate compensation tool for senior executives only if vesting is performance based.

    Depending on corporate strategic goals and employee level, a compensation package can have both restricted stock and stock options, Olsen says. The Financial Accounting Standards Board’s proposal to expense stock options beginning in 2005 can, in a sense, be considered a good thing, experts say. "One reason that stock options pulled out ahead of the pack was their favorable accounting treatment," Gerek says. Options were granted primarily because they were viewed as "free," Jones says. Once expensing becomes mandatory, however, then the comparison becomes one of "apples to apples," Gerek says, and the decision can be based on what is truly the best compensation strategy for the company.

    There is no one-size-fits-all approach to equity-based compensation, experts say. "Look at all equity compensation vehicles and see which makes the most sense for your company, your employees and your investors," Gerek says. While overall levels of pay are relevant in comparing yourself to peers, how that compensation is delivered should vary from company to company. Factors such as employee age and corporate culture should be taken into consideration.

    One company that is going its own way is Dell Inc., which intends to grant 50 percent fewer stock options to its approximately 44,000 employees than it did last year. It has no plans to replace the options with restricted stock or anything else. For the year ended January 31, 2003, the company granted 84 million stock options. It plans to issue approximately 44 million for the year ending January 31, 2004. Senior management believes that stock options are less effective than they were in the late 1990s, says spokesman Michael Maher. "We found that, given the marketplace for hiring and retaining employees, we aren’t required to issue as many options to hire people or keep them," he says.

Workforce Management, January 2004, pp. 60-62 -- Subscribe Now!