The lavish
use of stock-option grants that once made millionaires out of
ordinary tech workers is now producing legions of dissatisfied
shareholders. The reason is dilution. The number of options granted
and shares available for future grants - the overhang - has risen,
putting a bigger dent in per-share earnings and slicing employees
a bigger share of the company's future value. At the same time,
exchange-listing rules adopted earlier this year give shareholders
the power to block new plans or changes in existing ones. We would
expect that the bigger the overhang, the greater the chance that
a new stock-based compensation plan will be voted down by shareholders.
What Companies Can Do
At first glance it appears that options, the preferred stock-plan
model up to now, are on the way out. They are, indeed, under attack
on multiple fronts. The Financial Accounting Standards Board (FASB)
is moving to require that they be expensed at fair market value,
thus taking away their current accounting edge over other forms
of compensation. Several high-profile companies have recently
dropped them in favor of restricted stock units. Consider the
overhang concerns and rising shareholder activism, and one might
wonder if options have any future at all.
But that's far too simple a view of stock-based compensation.
Options are not really the problem, nor are widely touted alternatives
such as restricted stock units really the solution. A form of
compensation that works very much like options - stock-settled
stock appreciation rights - may, in fact, be an appropriate way
to share the rewards for future performance between shareholders
and employees.
The real issue for both companies and investors is how closely
the rewards, whatever their form, follow performance. One thing
that hasn't changed about stock-based compensation is its bedrock
aim of aligning the interests of owners, managers, and workers.
If a plan meets this goal, discarding it just to keep overhang
under an arbitrary dilution rule would be unwise - from both the
employees' and shareholders' points of view.
What Does Dilution Really Cost?
One arbitrary rule for measuring dilution is the widely used overhang
limit of 10 to 15 percent as a test for the adoption of new stock
plans. Even if institutional investors treat that figure more
as a guideline than as a rigid standard for every proxy vote,
they're missing the real target, which is the actual value of
the overhang rather than the number of shares.
Take the case of two companies: one with a 15 percent overhang
of options in or near the money, and the other with the same percentage
of options, most of which are far out of the money. In terms of
fair market value, one of the underwater options would be worth
much less than any option that's in the money. The low market
value is due to the low probability that the option will ever
be exercised to purchase company shares. Because the option is
unlikely to be exercised, it's also unlikely to dilute EPS by
raising the number of shares outstanding. A realistic dilution
standard should reflect that fact.
Stock Option Alternatives
Some might have second thoughts about getting on the restricted-stock
bandwagon.
But restricted stock or restricted stock units - the latter an
unsecured promise to issue shares at a later date - have caught
on lately as an option alternative for several reasons. First,
the pending FASB requirement for fair-market options expensing
would eliminate the biggest accounting advantage of options over
stock grants. The rule levels the playing field, at least in accounting
terms. Second, restricted stock is easy to value and requires
no cash outlay. Finally, it retains at least some value even if
share prices drop. In return for giving up the leverage of options,
employees get a cushion.
Those who are wary of restricted stock options see them as an
expensive way to attract or motivate employees and reward performance.
Also, as investors grow more sophisticated about dilution and
its real impact, they'll focus more on the overall value of the
share overhang rather than the number of shares.
Companies can cut its overhang by swapping a large number of options
for a much smaller number of restricted stock shares or units.
But swapping big baskets of options for smaller bundles of shares
comes with an obvious price: less potential for appreciation.
Because options-for-shares swaps are designed to reduce the number
of shares and not to raise the total value of the overhang, the
number of shares or units offered to the employee has to be much
less than the options being turned in.
Restricted stock that vests solely based on continuing service
has a further disadvantage - one that should be a major objection
for any savvy shareholder. Though it may be popular with employees
and function as an adequate equity compensation placeholder if
a company stops granting options, it's no motivator. Moreover,
it misaligns the economic interests of employees and outside shareholders.
Time-vested grants of restricted stock or stock units are, thus,
probably the least logical way to encourage or reward performance,
though they do encourage retention. The employees win even when
the shareholders lose.
Pay
for Performance
Like any other form of equity compensation, including options,
restricted stock can always be tied in some way to performance.
Vesting could be linked to some measure of corporate, team, or
personal performance.
The California Public Employees Retirement System (CalPERS) already
makes its wishes clear in this regard. Its policy guidelines for
executive compensation state, among other things, that "In
the case of option plans and restricted stock, a significant portion
of the overall program should consist of performance-based plans.
Time-accelerated vesting is not considered a meaningful performance-based
hurdle."
But here, too, there's a price to be paid. Performance-based vesting
makes stock-based awards more expensive to the company because,
share for share, they're worth less to the employee than awards
that vest with time. The latter are a sure thing if the employee
simply sticks around long enough. When the vesting is contingent
on meeting some objective, especially if the employee has little
power to influence the outcome, the award is going to be seen
as less valuable. More such awards have to be granted to achieve
the same level of employee satisfaction. That could end up making
the overhang and dilution problem even worse, especially if the
performance targets are set low enough that the company and individual
workers are likely to hit them.
Stock Appreciation Rights
So if stock grants have their problems and stock options aren't
really so bad after all, where does this leave the company trying
to deal with its dilution problem? The answer is with options
of the right kind, i.e., performance-based, or with something
even better - stock-settled stock appreciation rights, or what
I like to call "super SARs." These awards give employees
the right to receive shares of stock equal in value to the appreciation
of the company's stock from the grant date to the exercise date.
If 1,000 super SARs are granted with the stock at $30 and the
share price rises to $60 at exercise time, the super SARs will
be worth $30,000 and the employee can cash them in for the equivalent
amount of stock - in this case, $30,000 divided by $60, or 500
shares.
Super SARs have been little used up to now, but their day is coming
soon. Under the current and proposed FASB rules on option expensing,
super SARs would be expensed (like options) based on their fair
value on the date of the grant. And once they're granted, they
have distinct advantages over both options and stock shares or
units.
For employees, they offer options-style leverage from price appreciation
(though of course they can also end up underwater) and give employees
some control over tax timing because they are only taxed when
exercised. For shareholders, super SARs are a way to offer option-style
rewards without having to put as many shares into play. In other
words, they produce the same impact at the cost of less dilution.
And super SARs can be indexed or tied to other performance metrics,
just as options can.
In considering drawbacks, super SARs don't have the éclat
of options at Silicon Valley watering holes. Compared to options,
they also may be harder to explain to employees. Options have
the advantage, at this point, of both familiarity and cultural
currency; they're a badge of achievement that won't easily be
dislodged from the tech world's consciousness.
Conclusion
All this means that, after all the current controversies over
options have passed and suitable replacements have been found,
the new form of compensation won't be radically different from
the option-based plans of old. It will be an improvement, but
it will still embody the core option principle of giving workers
a chance at rewards ranging from nothing at all to the truly eye-popping,
depending on the success of the company and its reception on Wall
Street. Employees still will get their shot, however long, at
real riches. The difference, if companies design their plans properly,
will be a lower dilution cost to shareholders. "More bang
for less overhang" will be the catch phrase from now on.
Tim
Lovoy is a partner with the Technology, Media & Telecommunications
practice of Deloitte & Touche LLP. He can be reached at 213-688-6543.
