Reviewing Your Repricing Options
from Winter 1998
by Marcia Berss
With the stock market tanking and the labor market tight, stock option repricing is spreading like—well, some would say, the plague. The practice of lowering the exercise price, usually to the current market value, on underwater options is under attack from accounting rule makers and a growing chorus of institutional investors. Directors face a damned-if-you-do, damned-if-you-don’t dilemma: You can abstain and risk losing employees, or reprice and invite the wrath of shareholders. Still, boards are not without, ahem, their options.
Stock options, once the exclusive domain of top management, are now so ubiquitous they make the comic pages of daily newspapers. Drug maker Pfizer is one of the pioneers, granting options to many employees for over 40 years. Says Bruce Ellig, Pfizer’s now-retired corporate vice president for employee resources, “Shareholders like stock options because they tie optionees’ income to the future stock price. Properly designed stock option plans are an excellent vehicle for compensating all employees, not just executives.”
That’s the way it’s supposed to work, but increasingly, it doesn’t. There are key differences between option holders and shareholders. First, until options are exercised, employees don’t put cash at risk like shareholders. If the stock rises, shareholders see their earnings diluted as options are exercised; they subsidize employee stock purchases at below-market prices. And remember, most options don’t require superior performance by the employee for vesting—such as beating a market index or meeting an internal goal or peer group standard; they merely require staying on the job. In the bull market of the 1990s, the rising tide lifted even leaky boats. Whoever said “90% of life is just showing up” must have held stock options.
And what if the stock price falls? Option holders are not out-of-pocket like shareholders. In fact, options can be repriced down, and increasingly they are.
A typical repricing trigger, according to compensation consultants, is a 50% stock drop over a sustained period, say, three months. Reebok International, for example, repriced in October after its stock dropped to the low teens, off 73% from its year-earlier high. The shoe maker explained: “As a result of Reebok’s stock price being down significantly, due in large part to unfavorable industry conditions, as well as the recent downturn in the stock market generally…the company has decided to adopt its stock option exchange and restructuring program as a means of restoring the incentive and retention objectives of its stock option plan.” The practice is particularly common among heavy issuers of options like high-tech companies. Apple Computer repriced four times in a five-year period. WestWard Pay Strategies, a San Francisco-based compensation consultant for high-tech firms, examined the 250 largest high-tech companies and found 14% had repriced in fiscal 1996.
The defense is always the same: Repricing is necessary to retain and motivate employees, particularly in the current labor market. Earlier this year, the unemployment rate hit a 28-year low.
Options have gained importance in pay packages. A 1997 compensation study by KPMG Peat Marwick of 133 companies (with median revenue of $4.1 billion) in manufacturing, financial services, and other industries found that long-term equity incentives such as stock options represent 40% to 60% of senior executive compensation, and 22% to 37% of middle manager pay.
Even the lowest-level employees get 13% of compensation from long-term incentives, according to KPMG. Silicon Valley startups like Intel were among the first to give options to most, if not all, employees, as a device to attract talent to their emerging companies. In their early days, of course, these outfits couldn’t offer pension plans, not to mention job security. As the stock market surged, the use of broad-based option programs spread to mature companies, such as Eli Lilly, Procter & Gamble, and Warner-Lambert. According to a 1997 survey by ShareData, 45% of firms with over 5,000 employees give options to all workers, up from 10% in 1994.
Another measure: Compensation consultants once used a rule of thumb that no more than a 10% overhang (options outstanding plus shares available for grant as a percentage of shares outstanding) should be allocated for employee options at mature companies. But compensation firm Pearl Meyer & Partners looked at the 200 largest companies and found that, in 1997, the average allocation at these mature firms was 13.1%, nearly double the 6.9% allocated in 1989. And, by the rule of thumb, a 15% overhang was the outer limit for high-tech or growth firms. A survey done by WestWard Pay found that the median overhang at high-tech firms is 15%.
Why is corporate America so addicted to stock options? It’s the closest thing companies have to a free lunch.
All agree options are a form of compensation, but under Financial Accounting Standards Board Statement No. 123, fixed-price options (and most are fixed) are not expensed. Proponents of this accounting practice note companies incur no cash cost in granting options, so why should they incur an expense? Moreover, they add, not all options may be exercised. Another plus: Even though the company doesn’t expense option grants, it can take a tax deduction when the optioned stock is sold. The savings can be significant. In 1997, PepsiCo reported that option deductions cut its tax bill by 17%; at Adobe Systems it was 21%. The net result, say critics, is that options understate compensation costs and inflate earnings.
As option use blossomed in the 1980s, the FASB proposed that companies recognize options as a compensation expense. Corporate managers howled that such treatment would damage earnings and send stocks tumbling. And even if companies did expense options, how accurately could they be valued? Critics noted that methods for valuing options, such as the Black-Scholes model, are most accurate when the option is freely traded (employee options are not) and the option term is measured in months (not years, like most employee options). In March 1994, during the FASB comment period, there was a “Rally in the Valley”—so named by local organizers—when Silicon Valley workers protested the FASB proposal.
The FASB examined the issue for a mind-numbing 11 years, then backed down. Beginning in 1996, it required disclosure of the impact of stock options on net income and earnings per share only in financial footnotes. In 1997, a bill was introduced in Congress requiring companies to expense stock options or lose their favored tax treatment. The bill died.
Now, however, the FASB is back again, this time seeking to require companies to expense repriced options. In August, it proposed that repriced options be considered variable plans under FASB 123; the changed (lower) price means the plan is no longer fixed, from the FASB’s perspective. Like the earlier FASB proposal, the recommendation is meeting protest, but this time companies don’t want to appear too visible in their opposition, relying instead on their accountants and compensation consultants to voice their displeasure. Jokes Matt Ward of WestWard Pay: “It’s like standing up in support of wife beating.”
Given the FASB’s track record on options accounting, this trial balloon, too, may fizzle. But even if the FASB doesn’t rein in repricing, investors might. Some institutional investors have made it their policy to vote against option plans when the company has a history of repricing. Proxy voting guidelines issued by the AFL-CIO for union pension funds discourage adoption of plans with repricing features. The $61 billion pension fund of the Teamsters union has pressed for corporate bylaws or policies that ban repricing executive options without shareholder approval. Last year, it won such an agreement from RJR Nabisco and this year was successful at Guidant Corp. But at Sprint, a proxy resolution to ban repricing was defeated last spring, as the company argued “such a limitation would severely limit Sprint’s ability to attract and retain key employees.” The Teamsters’ Rosanna Landis Weaver says the pension fund will be back next proxy season with more attempts to restrict repricing and this time, she points out, the union’s odds should improve, thanks to the troubled stock market.
Last year, the $50 billion State of Wisconsin Investment Board, the nation’s 10th-largest public pension fund, sought commitments not to reprice from 22 companies, mostly small, high-tech and biotech firms. It got agreements with 18, including Exide Corp. and Matrix Pharmaceutical, and filed proxy resolutions to amend corporate bylaws at the four others to put repricing to a shareholder vote. One of the companies that balked, Massachusetts-based Shiva Corp., challenged Wisconsin, arguing that option repricing is a general compensation issue and, therefore, isn’t subject to shareholder input under federal securities regulations. Last spring, the Securities and Exchange Commission sided with Shiva. So Wisconsin went to court. In August, the U.S. Court of Appeals vacated the SEC’s decision and now Wisconsin is going back to the SEC for round two. “Option repricing is clearly not a general compensation matter,” declares Wisconsin’s Investment Director John Nelson. “The amount of so-called compensation is virtually open-ended. The FASB doesn’t require it to be expensed as compensation, and shareholders approve most option plans. Repricing saddles the public owners with the entire loss in stock value, rewards the ones in control of the company for a stock price drop, and avoids shareholder approval,” he says.
Given investor revulsion to the practice, what steps can board members take to minimize the pain if forced to reprice? Most compensation experts agree top executives should be excluded from repricing; after all, they are the ones who have the most direct influence on the stock price and have the financial cushion to suffer along with shareholders. At Apple Computer, for example, options held by employees over the level of vice president were excluded from its 1996 repricing. At Oracle, “executive officers and directors” were excluded in a 1997 repricing. The WestWard Pay study found 31% of high-tech firms excluded officers’ options in repricing.
Companies also should resist the temptation to issue more options than originally granted to compensate employees for lost gains, which can ultimately yield more earnings dilution, pouring salt on shareholders’ wounds. Indeed, when companies reprice, they should issue fewer options. According to Ward of WestWard Pay: “Only consider a true economic value exchange, never a one-for-one share swap.” For example, he says, assume that 100 options granted at $10, are worth a targeted $30 per share at vesting for a $2,000 gain ($3,000 minus $1,000 option-exercise cost) for the employee. Repricing the options at $5 in a one-for-one swap yields a $2,500 gain ($3,000 minus $500). But repricing at $5 and granting 80 options gives the employee the original $2,000 ($2,400 minus $400) gain. In 1996, option holders at Adobe Systems gave up three options for every two received at a lower price. In 1993, IBM repriced options in a 2.4-for-1 exchange and excluded executive officers, in a model cited by industry experts as the best way to structure a repricing. But those swaps are exceptions. In its repricing survey, WestWard Pay found 83% of high-tech companies did a one-for-one trade.
Compensation experts also suggest other moves to make repricing more tolerable to shareholders, such as extending the vesting terms or delaying exercise of the option via a blackout period. In its repricing last year, Cirrus Logic maintained its vesting schedule but imposed a one-year blackout on exercise beginning at the repricing date. WestWard Pay found 51% of high-tech repricers adjusted vesting terms, and 20% imposed a blackout on exercising options or vesting. Concludes Matt Ward, “There has to be some quid pro quo for shareholders.”
These are short-term responses. One long-term solution is to reduce repricing by weaning corporate America off options. How? It might be easier than directors think, because there’s growing evidence that options don’t necessarily motivate employees to boost shareholder value. For every Microsoft, which is a heavy user of options and has stunningly outperformed the stock market and its peer group, there’s a Cirrus Logic, which also has a broad-based option program and has lagged both the market and its peers. Chase Manhattan, DuPont, General Mills, and PepsiCo all have given stock options to many of their employees for years—and all have posted subpar cumulative total shareholder returns against peer groups. “The academic evidence linking current option grants to future performance is, frankly, rather flimsy,” according to Kevin Murphy, a University of Southern California economist and a member of the National Association of Corporate Directors’ blue-ribbon commission on executive compensation.
Part of the reason may be that many option holders never really think like owners—a core purpose of options. They take the money and run. A 1996 study by accounting professors Steven Huddart of Duke University and Mark Lang of the University of North Carolina found that, among lower-level employees, about two-thirds of option exercising activity took place within just six months of vesting. Among senior executives, one-third of option exercising occurred within six months of vesting. About 90% of employees surveyed unloaded their stock immediately after exercise, in a basically cashless transaction.
Economists also note that options are a pricey way to pay people. Why? Outside investors are well diversified, holding shares in many companies. Company employees are not diversified; their “human capital” is linked to one firm. As a result, they rightly place a lower value on options than outside investors do on the stock. How much lower? USC’s Murphy looked at economic modeling of executive stock options and analyzed exchanges of cash for options. He figures that for every $100 in cash pay given up, executives demand $200 to $300 of options in Black-Scholes values. “The bottom line is that the cost to shareholders of granting an option is much higher than the value to executives of receiving the option,” he concludes.
If options are not delivering bang for the buck, the obvious place to start cutting is lower-level employees, where the incentive of stock options has a negligible impact. Even proponents of options, like George Paulin, president of compensation consultant Frederic W. Cook & Co., notes that “below the executive level, companies usually concede options have limited effectiveness as an ownership device.” Another option fan, Jude Rich, chairman of management consultant Sibson & Co., believes boards should reconsider “grants to all employees. The average factory worker or team has little impact on a multibillion-dollar company’s stock price.” Eliminating middle-manager and rank-and-file options cuts the need for much repricing, since the savviest companies reprice only lower-level options.
There’s still a question as to whether executive options are even effective. Some academics believe options have adverse effects, such as encouraging acquisitions and divestitures as option holders try to quickly boost the stock price while incurring no downside risk. On the other hand, a 1998 study by compensation consultant Watson Wyatt found that high levels of stock ownership by top management are linked to better financial performance. Even option skeptics like USC’s Murphy concede executives who have significant equity produce better results. Since directors and shareholders generally want to link pay with performance, executive options seem like a reasonable device.
The problem is, today, most executive options are structured to reward tenure, not performance. That structure is changing as some companies implement performance-based plans. A good example would be indexed stock options, where the exercise price is linked to a benchmark like the Standard & Poor’s 500 or a peer-group stock index. If the index and exercise price rises 5% but the optioned stock is up 10%, shareholders are richer and executives are rewarded for their superior performance. If the benchmark drops 10% but the optioned stock is down only 5%, that’s still considered superior performance and executives are still rewarded. Indexing reduces pressure on directors to reprice executive options, so it is another long-term solution. The Council of Institutional Investors, which includes more than 100 pension funds managing total assets of over $1 trillion, has called for indexing options.
But few companies do it. The 1997 study of long-term incentives by KPMG found only 1% of companies had indexed or other formula stock options. Institutional Shareholder Services annually reviews over 8,000 proxies and reports it has yet to find one that fully indexes options in up and down markets, though a few companies have tried a limited form of indexing. Why is there such little interest? Because, unlike fixed-price options based on service, indexed options are variably priced and must be expensed by the company.
There’s more interest in other performance-based option plans, such as those that permit options to vest when earnings per share grow 10% a year, for instance. Or plans that allow, for example, 25% vesting for each $20 increase in stock price. Some notable companies, like Monsanto and Transamerica, have performance-based option plans for top management. Consulting firm Strategic Compensation Associates estimates that in the last five years, about 10% of the Fortune 200 have granted these types of performance-linked options. More companies have opted for this approach over indexed options because they have found a way to avoid the earnings hit: Accelerate vesting if there’s superior performance but otherwise permit the options to vest near expiration, say in year nine. Because vesting may still be based on tenure, companies don’t have to expense the options.
But companies that go for such performance-based plans may still have to face repricing and the difficult choices that accompany it. The only way out of that dilemma is the high road: Forsake earnings and opt for indexed options or, like Warren Buffett, substitute other forms of compensation. When Berkshire Hathaway acquires companies that issue options, it replaces them with cash compensation. These companies, said the chairman of the board in his 1997 letter to shareholders, “have followed the standard—but, in our view, dead wrong—accounting practice of ignoring the cost to a business of issuing options.”
