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Share the Wealth -- and the Headache

June 1, 2000
Related Topics: Compensation Design and Communication, Variable Pay, Featured Article
So,which scenario strikes your fancy?

Crazedemployees are battering your door because their shares in the company -- so dizzily highyesterday -- have all but tanked. You lured most of them on board with promises of loftycompensation packages, which all but hinged on stock-market performance. The market’sstratospheric climb made you coolly sure you could deliver on all that your company hadpromised. A stomach-churning market correction comes along, and disgruntled workers areburning you in effigy.

Or,the powers-that-be, in a rare state of largess, decide that every employee, from the womanwho signs the checks to the guy who cleans the dumpster, deserves a public stake in thecompany. You are responsible for making it happen. And you do -- only to find yourselfchin-deep in paperwork because federal law dictates that any change in compensation forcertain employees demands a painstaking revisiting of overtime and comp-time calculations.

Andthen there’s the old corporate standby for nearly every occasion: The bigwigs simplysay, “Chuck it. Stock options are more trouble than they’re worth. We’resticking with the 401(k) plan. Nothing more.” They go back to their crosswordpuzzles, and you soon find that no amount of vision benefits, health-club perks, anddental plans will lure the talent through your company’s front door -- not when theycan go to that renegade Internet start-up down the street that’s promising scandalousreturns after its impending initial public offering.

Welcometo the wonderful world of stock options and the quandaries therein. If you haven’tyet pondered on any of the above potential melodramas, do so. If there is one aspect thatcan be considered a given with stock options, it’s that they are most certainly nolonger optional. Once reserved solely for chief executives, stock options are becoming ascommon a part of the employee compensation scene as the pay stub. A recent conservativeestimate by the National Center for Employee Ownership states that somewhere between 7million and 10 million employees in the United States participate in some sort of stockownership program. Companies ranging from Microsoft Corp. to Starbucks Corp. extend thecompensation vehicle to most -- if not all -- of their employees, according to the center.

“Stockoptions have become a popular way to attract and retain not just top people, but allemployees. While this is especially true among knowledge-based companies, a growing anddiverse group of other types of companies also has become interested in broad-based stockoptions,” stated Ed Carberry, a researcher for the Oakland, California-based center,shortly after the figures were released.

Stockoptions give employees the right to buy shares in their employer at a fixed price over acertain number of years. Employees with stock options bank on the notion that the shareprice will go up by the deadline, and that they will reap the benefits when they exercisetheir options. Fans of stock options insist the compensation device gives employees awell-deserved stake in their place of employment -- ownership, if you will. A smalldissenting faction, however, says that stock options do nothing more than imbuestarry-eyed employees with dreams of Wall Street windfalls; employees could not care lessabout the well-being of a company, just so long as its stock value doesn’t go south.

Forwhat it’s worth, a new study by the San Francisco-based online research indicates that a growing number of college graduates are putting more storein career advancement and training opportunities than in stock options. (In a listing ofthe eight economic benefits valued most by those surveyed, stock options came in sixth,behind health care and year-end bonuses.)

Still,love them or hate them, most human resources professionals and consultants agree thatstock options are here to stay. Moreover, even if corporations forgo extending stockoptions to every class of employee, many HR industry observers believe that more companiesthan ever are at least pondering the option. “Stock options have become a permanentfixture in compensation programs because part of the American ideal is ownership incorporate enterprise, and stock options are the absolute best way to put ownership in thehands of the employees,” says Heidi Toppel, eastern region practice leader of WatsonWyatt & Co.’s executive compensation practice. “Employers are looking foralternative ways to deliver compensation. You’re going to see stock options take amore prominent place in employees’ total compensation package.”

Weknow they’re good, but how do they work?

Tobe sure, stock options are but one of the equities-based compensation packages availableto employees: 401(k) plans are a mainstay in many retirement packages, and companies alsohave the option of offering restricted stock awards, which are shares granted to ensurelong-term commitments from employees. However, restricted stock awards will never gain theprominence of stock options, consultants believe, because employees do enjoy lower riskwith stock options if their company’s shares tank.

“Alot more folks, because of their 401(k) plans or whatever their defined contribution planis, are participants in the stock market. And there are millions more who are a littlemore attentive to the market and its fluctuations. It’s not like this is a strangedevice anymore,” says John Danpico, a managing principal with the Illinois corporateconsulting firm James & Scott Associates. “But if you ask any older worker, theywould not understand what an option really is. You’ve got to explain it to them.”

Which,of course, means companies have to do their homework. Stock options have gained steadypopularity in the compensation packages of most employees -- but there is prep workinvolved. For their part, employers need to know how to deal with the different classes ofemployees who may potentially be receiving stakes in the company. The employees -- as theyshould with every compensation package -- must take it on themselves to learn all they canabout the new compensation structure, and their human resources department can play avital role.

Amongthe areas companies must explore before they grant stock options are:

  • Who gets it? It’s okay to be generous; your employees probably deserve it.However, depending on who you decide should receive stock options, the consequences couldbe somewhat sticky, according to experts in corporate benefits and compensation packages.

    Ifyou decide to offer stock options to employees who receive hourly wages, federalregulators may insist that the options automatically become part of the employee’spay, and therefore must be taken into account when the company calculates the base ratefor the employee’s overtime pay.

    “Itgets mighty, mighty complicated. So much so that some companies say, ‘Let’s justforget it,’ ” Danpico says. “If it takes $150,000 worth of programming justto get people a well-deserved piece of the action, nobody’s going to win.”

    Congressis considering revisions to the Fair Labor Standards Act, which conceivably could make iteasier for employers to offer stock options to non-exempt employees. So for thosecompanies that want to offer stock options to everybody but want to forgo bureaucraticheadaches, write your congressman.

  • How much? How much of your company do you want in the hands of the employees? Ifyour number is too high, the board of directors will never go for it -- and neither willshareholders. The typical amount of overhang -- the total amount of options that could begranted as a percentage of outstanding shares -- runs between 10 percent and 12 percentfor most companies. Executives have to figure out their own company’s tolerancelevel.

    Earlierthis year, the United States Securities and Exchange Commission approved a regulation thatincreases the amount of stocks that companies can offer their workers before they have tocomply with federal securities registration requirements. Prior to the action, companiescouldn’t issue more than $5 million in securities a year to employees or directorswithout complying with the requirements. They can now exceed the $5 million mark, providedthey disclose risk factors, plan outlines, and other financial statements. Some executivesmay laud the change as less restrictive. Others, however, may find the disclosurerequirements somewhat cost-prohibitive.

  • Which kind? Employers may choose between incentive stock options and nonqualifiedstock options. With incentive stock options, an employee often does not pay taxes on thedifference between the grant and the exercise price until the shares are sold, at whichpoint the employee pays capital -gains taxes. The potential downside for employers is thatthey would not get a tax deduction for the spread. With nonqualified stock options, anemployee pays taxes on the spread, and the company is eligible for a tax deduction.

  • Talk it up. Stock options sound attractive, but most workers have only a vague ideaof how they actually work. Most workers mistakenly regard stock options as a part of theircompany’s benefits package, rather than as a compensation vehicle subject to thevagaries of the equities market.

“Theproblem is now that companies have issued stock options, they will grant options at thecurrent fair-market value, and now the stock has tanked,” says Janice DiMarco, a taxpartner in the technical group of PricewaterhouseCoopers LLP. “A lot of employeesknow they’re going to get ordinary income. They’re happy with that. But some tryto achieve capital gains and it involves planning. Most companies don’t like to betax advisors for individuals. They leave it up to the individual to understand, just likeany other benefit they’re entitled to receive.”

Youcan work around the problems

Humanresources officers would do well to make sure there are plenty of learning materialswithin easy reach of the employees, and that the resources cover everything from the typeof option offered to the tax issues that arise once an option is exercised. The Internethas given rise to a host of resources, including the NationalCenter for Employee Ownership.

TheNational Center for Employee Ownership recently published a book called Stock Options:Beyond the Basics, in which they give their own thoughts about what a company shouldconsider before it offers stock options. Among other things, the book addresses:

  • Initial public offerings. To head off regulatory concerns, the NCEO urges companiesto keep track of the methods they use to value their stock option grants during the18-month period before an IPO. The SEC pays close attention to the number of monthsbetween the stock option grant and the initial public offering, the difference between theexercise price and the offering price, and whether the company has gone through majorchanges. Essentially, regulators want to make sure that all securities a company issuesare valued correctly.

  • Divorce. For the most part, nonqualified stock options cannot be transferred in theevent of a divorce. However, some states allow for this. In most of these states, the IRShas ruled that the non-employee spouse should receive ordinary income upon exercisemeasured by the difference between the market value of the stock on the date of theexercise, and the exercise price. The employer is entitled to a tax deduction, so long asthe income in question is reported to the IRS. Current laws indicate that the employermust withhold with respect to nonqualified stock options exercised by the non-employeespouse, although it is unclear exactly how to go about this.

Recentdrops in the technology-laden NASDAQ Composite Index have caused many market observers towonder if the public’s fascination with all things dot-com is finally coming to anend. More broadly, the recent wild rides of both the Nasdaq and the Dow Jones IndustrialAverage are leaving a lot of people counting the days until a real correction sendsportfolios into free-fall.

Marketwatchers agree that the next big correction will have a sobering effect on how investorsview the stock market and their investment vehicles. However, most observers believe thattolerance for the pitches and falls of Wall Street is on the rise.

“Lookat 401(k)s. People try to grow their wealth through equities,” says Jerry Mattern,chairman of the compensation benefits committee for the nonprofit Society for HumanResource Management. “I don’t think people are as afraid of swings today. They’resaying, ‘I need to save, and this is a way to save, another vehicle for me.’”

Workforce,June 2000, Vol. 79, No. 6, pp. 118-126 -- Subscribe now!

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