(The Right) Stock Options Are Still the Way to Go
from
September/October 2002
by Rob Norton
The bear
market in stocks over the past two years and the recent spate of
accounting scandals have raised questions about the use and abuse of
stock options as a method of executive compensation. Critics ranging
from Warren Buffett to Senator Joseph Lieberman have rightly complained
that options programs are often poorly designed, leading to perverse
incentives and confusion about the quality of reported earnings.
Today's pressing question is whether the value of options should be
deducted from corporate profits at the time they're granted to
employees. Recently Standard & Poor's changed its method of
calculating "core" corporate earnings to include options as an expense,
and many experts, including Federal Reserve chairman Alan Greenspan,
have urged that generally accepted accounting principles be changed in
the same way.
Such reformers get no argument from Gregory V. Milano, a partner and president of the North American division at the consulting firm Stern Stewart & Co. in New York City, which is best known for promoting EVA (economic value added), a measure of financial performance that some people believe is directly linked to the creation of shareholder wealth over time. Milano speaks and writes often about corporate financial reporting and executive compensation, and he is convinced that options remain an efficient way to compensate executives and encourage excellence—provided that they're the right kind of options. He spoke with Corporate Board Member's Rob Norton.
Should the value of options be deducted from profits in financial statements? There's absolutely no question about it. At the time you grant stock options, they have a value. Even when they're out of the money, you'd be willing to pay something to own them. It's the equivalent of issuing the securities to somebody else, getting the cash, and paying that cash to the employee. To the extent that the options vest over time, that cost should be amortized against profit over that period of time.
Should directors be concerned about the possibility that companies may be required to expense options? They shouldn't allow the accounting treatment to influence their decisions. Directors should try to design and implement a compensation system that will attract and motivate the best human capital they can, given the nature of their business, and whether it's charged or not charged to earnings shouldn't make any difference.
Their companies are already disclosing the nature of compensation plans in detail, so nothing new is happening. Anybody who thinks companies are hiding something from investors by not having to expense options is just fooling himself. In the past, little was known publicly about executive compensation. But today practically the entire option agreement has to be revealed in the footnotes to the financial statements. Sophisticated investors understand this. They get the information, they analyze it, and they recast the numbers, with the costs of the options laid out properly, when they evaluate a company's share price.
What are the most common types of options programs in use today? The most common is the basic, plain-vanilla incentive stock option. It gives you the right but not the obligation to purchase shares at a preset price, known as the exercise or strike price. If the stock goes up you have an opportunity to make money, and if it goes down you basically forfeit that element of your compensation. Typically, you can exercise these options at any time over 10 years—sometimes five—and usually you have the right to exercise them after one year, although sometimes there's a restricted period for a number of years.
Are there problems with that plain-vanilla approach? Yes. The complaint of many investors—and our complaint for many years—is that if the stock price is up 10% over 10 years, the chief executive or other options-holder still makes something. Yet if your stock price is up by only 10% over 10 years, you should have been fired a long time ago instead of being rewarded. Plain-vanilla options have no requirement that you produce some pre-specified return before you get anything. Also, allowing employees to exercise options after a year or less is a mistake. Options, after all, are supposed to be long-term compensation.
What can you do to correct that problem? The best way would be to structure the options so the exercise price rises every year at some pre-specified rate related to the expected return to shareholders, which we call leveraged options. You would tend to give people a greater number, since the options would each be worth less on the issue date because they have a tougher hurdle. But if your shares do very well over an extended period, you stand to make a lot of money, and if you perform below expectations, you get nothing.
The problem with that approach is that under present accounting rules, if the stock price rises above the exercise price the company must recognize the difference as a cost, unlike plain-vanilla options. This is why companies have shied away from them, even though they're better for the shareholder, better for the company, and a much better reward program.
What's the next-best solution? What some of our clients and other companies have done is to grant options that are out of the money: If the share price is $20 now, you might set the exercise price at $25, $35, or higher. These are sometimes called premium stock options. The share price has to rise to some higher level before the recipient gets anything, and as long as that's a fixed higher level, you're not subject to the same accounting penalty of having to show them as an expense. A number of companies have done that, and have wound up with a much more effective pay program.
What lessons can directors learn about options from the boom and bust of the dot-coms? Options as a means of trying to motivate people can be very effective. But if you're at a point where your shortage of cash leads you to give options because you can't pay people any other way, you're asking for trouble. You tend to give too many options, putting people at too much personal risk for the outcome of the company. And as soon as things go badly, the employee realizes the options are worthless and gets a job somewhere else. A real owner is in a different position, because he has capital at risk.
Another problem, which existed earlier but was a serious problem for a lot of the high-tech companies at the end of the '90s, is that they gave far too many options to too many people. If you're one of a thousand people affecting the share price of the company, the other 999 people as a group have a lot more of an effect than you do. It's not like you can see some direct relationship between what you do and what you get. So although it can be an attractive form of compensation, and one that can make employees happy if it pays off, it doesn't really drive a particular type of behavior. It would have been much better to design an incentive around something that each employee had a greater degree of influence over, so they could see the cause and effect.
What lessons can directors learn about options from the dismal performance of the stock market over the past few years? After the high-tech bubble burst and the market declined, people started to become less interested in stock options, which is unfortunate. They're still an important way of motivating behavior for very senior executives with strategic oversight and influence over a whole company. If anything, since the market fell and the economy stumbled, investors and directors should want senior executives to have good exposure to the share price going forward. As an investor, I'd like to know that if a recovery plan has to be put in place, the executives have a real stake in its success. And from the executives' point of view, if you were happy to take stock options when the share price was $20, how can you not be happy to take them when it's $12? Now is the time they should be asking for stock options.
What about the outrage expressed in some quarters, notably in Washington, about abuses of options? Washington should have an opinion on this, but I think it should worry about issues of legality, such as alleged fraud. Investors are the ones who should discipline companies that have poor reward programs. I challenge you to look through 100 random reports from Wall Street and find one that talks intelligently about compensation as a tool for trying to drive better performance. If Wall Street cared about it, perhaps that would have an impact on companies, but I don't think it should be regulated.
Putting aside the fact that Enron may have booked more profits than they had and may have done all sorts of other very bad things, there are stories, albeit secondhand, that suggest the company's compensation plans were seriously flawed. In some cases, it seems, people were collecting pay that was based on the present value of the future profits of a deal. That's crazy. It encourages an excessively short-term time horizon, in a business where you want people thinking about the longer term and about risks and exposures.
There's also outrage about the repricing of options. What do you think of that practice? We're definitely against it. The whole idea of pay-for-performance compensation, of which stock options are one type, is that if you do well you're supposed to get more, and if you do poorly you get less. So when things go badly, why should we reprice the options and basically forgive that bad performance? Companies say they do it for retention reasons, that if they don't reprice the options, the employees will leave. Unfortunately, repricing has become so commonplace that that's probably true. The fear becomes the reality once it becomes the norm. But I think repricing is a horrible idea.
What are the key factors that directors, and especially members of compensation committees, need to keep in mind when they're designing executive-compensation packages? The very first thing they should worry about is how they pay, not how much. Calibrating the right amount should be a secondary criterion. First they should consider such things as, What's your strategy? What's your time horizon? How much risk do you want the executive to take? Those kinds of things should influence the pay package.
An executive-compensation package should have three elements. First, executives should have an adequate salary and near-term bonus to make them feel they're being treated fairly. Second, to provide a good link between ownership and results, you should offer a long-term incentive plan, paid in cash or stock, that's based purely on internal performance measures, not on the stock price. That way you know that something's happening inside the company, and that it's not just the overall stock market driving things. In addition to this, you can offer what's called restricted stock, granting shares that will belong to the executives after they stay some period of time. At Stern Stewart, we modify that to call it performance-based restricted stock, where the number of shares you eventually get is driven by your internal performance—again, so it doesn't just depend on the share price going up.
Only then do you tack on the third element: the stock-option plan. I wouldn't grant any options at the current share prices. I would grant the options with exercise prices well out of the money—30%, 50%, 75% higher. The higher you set that price, the lower the value of the options and the more you have to give the person. It's a trade-off that each company should make based on the nature of its business. If you have a very aggressive strategy in a volatile business, you might want to give people more options at a higher exercise price so there's a big payoff for stretch performance. If it's a more mature business, you might want to use a lower exercise price and give the person fewer options, because the likelihood of reaching a very high level is low.
What does that kind of compensation plan accomplish in practice? With three components like that, you've paid adequate attention to internal performance, no matter what the stock price does. There's adequate payoff for a really big-bang performance, like Wal-Mart in the '80s. And by having the different components packaged together, you get away from one of the main problems with stock options by themselves, which is that they become an on-off switch. When the stock price is almost the same as the exercise price, and you're near the expiration date of those options, you run the risk that someone is going to take a flagrant short-term action in order to make the share price bump before he loses the options completely. This needn't be the extreme of Enron's people saying that everything was dandy while the world burned around them, but there are always little things that CEOs, CFOs, and investor-relations people communicate to the market, which can influence the perception people have and the share price in the short term.
Could you give some examples? We've seen all sorts of crazy things. Squeezing internal training money and R&D spending, pushing deals back, pulling them forward, giving customers discounts to buy in this year's fourth quarter instead of next year's first quarter—all sorts of stuff to try to jack the share price up in the short term. And if someone has half a million stock options outstanding, and if they can get $5 on the share price, even morally sound people take actions, sometimes subconsciously, that aren't good for the company.
Should companies use options to encourage and compensate directors?
Some companies do, and it's a great idea. Though directors have responsibilities to many constituents, their No. 1 responsibility is to shareholders, so it's appropriate that they receive all or part of their retainer in stock options. Unfortunately, too many directors are more worried about making sure they don't look bad than they are about trying to look good. Directors usually have a lot more downside risk than upside potential. Who are the directors of Microsoft? Do you know? Nobody knows. [They do now. See the box at right. —Ed.] But there was real downside if you were a director of Enron. So there's a tendency to be overly conservative, and giving directors a nice bundle of out-of-the-money or premium stock options is a way to give them a potentially large upside to counteract that natural conservatism.
