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The Fair Labor Standards Acts Gets An Update

WorkSpan, April 2004, Volume 47, Number 4

Get Out of Gluttony: Offering Shareholders a More Balanced Equity Diet

By Doug Sayed, CCP, SPHR, Applied HR Strategies Inc.

The accounting regulatory bodies likely will require the expensing of stock options beginning next year. Depending on the outcome, changes may highlight how companies have been gorging on a steady diet of options. Many of these companies will need to cut back on their feasting to get equity incentives back on track.

Quick Look

Despite all the grumbling, expensing is not too big an issue because it is not a cash cost.
Stock options have been especially great for cash-strapped companies because no cash is used when stock options are granted, but they still are effective at motivating employees.
It is important to remember that stock options are not "free" and do affect all shareholders to one degree or another.

It is common knowledge that the accounting regulatory bodies likely will require the expensing of stock options beginning in 2005. The high technology industry has been fighting the looming expensing requirement strenuously, but will likely lose this battle this time around (a move toward expensing in the mid-1990s was defeated).

Despite all the grumbling, the truth is that expensing is really no big deal because it's not a cash cost. It will, however, highlight how many companies - especially in the technology sector - have been gorging on a steady diet of options. Many of these companies will now need to go on a low-carb regimen or get back in the "Zone" to get their equity incentives diet back on track.

Why the backlash against stock options? Aren't they "free"?

Before tackling these questions, it's important to get some background settled first.

The Stock Options Value Proposition
Stock options have been a great deal for technology companies and other organizations with broad-based options programs. One big plus, especially for cash-strapped companies, is that when stock options are granted, no cash is used in the process, but they still can be an effective attraction, retention and motivation tool. So, they're "free," good at attracting and retaining key personnel, and often provide a very substantial upside. What's not to love?

And it gets even better.

In the future, when the options grants vest "in the money," employees exercise (purchase) their options, and the company receives another freebie - cash. In addition, the company often receives a tax deduction. So, there's no cash out the door, but the company received some "free" revenue and a shot at a tax deduction.

It's great from the company's perspective in most cases and it's largely a no-risk proposition for the option recipients, so again, what's not to love?

Well, nothing, unless you're unfortunate enough to be a real shareholder in a company that heavily issues stock options. Remember shareholders? Those prickly individuals and institutions that spend real money and take real risks investing in a company?

The Investment Community's Key Issues of Concern: Overhang
Overhang is the percentage of shares outstanding that have been granted (or are available to be granted) to employees. As companies continue to issue large quantities of options to executives and other workforce members, the build-up and potential dilution of options can escalate significantly.

While many public companies with more narrowly based options programs typically have overhang rates of less than 15 percent, the norm for technology companies is a bit over 20 percent, and it's not uncommon to see firms with more than 25 percent overhang. Essentially, 20-plus percent of the total shares outstanding are in the hands of people who have little or no real investment risk in the company, or no "skin in the game," as some might say.

Dilution
When large amounts of options are issued, the potential dilution of existing shareholders can become excessive. When options are exercised, the total pool of shares expands and the proportional ownership of all shareholders drops, along with earnings per share, and the likely future value of the shares.

Some firms have issued so many shares as options that current shareholders really only own the equivalent of 65 percent to 75 percent of their current proportional ownership, if most of the options granted are eventually exercised. Would you really want to be a shareholder in a company where what you own today will be significantly diluted by option grants? No one seemed to care in the late 1990s, when companies were growing rapidly and stocks were soaring, but what about today's slow-growth mode?

High Run Rates
The run rate is the percentage of shares outstanding that a company issues in options each year. Most prudently managed firms keep their run rates below 3 percent or so (and many are far less than that), but it's not uncommon for early stage and other technology firms with broad-based options programs to have run rates in excess of 5 percent annually. Translation: That's 5 percent-plus additional dilution every year, year after year.

Cash Cost of Options
While not a problem for pre-IPO firms and those with modest overhang and run rates, many public companies spend millions to repurchase stock to combat the dilutive impact of options grants. Microsoft, Adobe Systems and many others spend millions of dollars (sometimes hundreds of millions) buying back stock to hold down the dilutive impact of their broad-based options programs. Those millions could have gone to many better uses for shareholders. Excessive option granting practices essentially amount to a significant transfer of wealth from the company's shareholders to its employees.

A Real Life Example
Consider an article about the Adobe Systems stock option program that recently appeared in Barron's, the weekly financial publication. According to the article, over a three-year period from 2000 through 2002, Adobe issued options on more than 20 percent of its total shares outstanding. That's in addition to previously issued options.

On the plus side, the company did receive $288 million in options proceeds from the exercise of stock options during the same period.

But to combat the huge dilution being caused by its option granting practices, the company spent $830 million to buy back stock on the open market during that time. That money amounted to more than 50 percent of Adobe's cash flow over that same period. That same money could have been used in several ways that would have been far more advantageous to its shareholders.

The $830 million could have been used to pay dividends, invest in new products, make acquisitions or to provide the company a significant cash cushion. Instead, it was used to essentially buy its way out of an imprudent use of options. The company's shareholders effectively had to pay hundreds of millions of extra compensation dollars to the Adobe workforce, over and above base salaries, benefits and cash incentives that had already been paid.

That isn't to say the company shouldn't provide some additional incentives to key personnel and executives in the form of stock options or other long-term incentives. But more than $800 million worth of impact to the shareholders in three years?

What's even more vexing and ironic about the Adobe case study is that while the top five senior executives hold more than 4.5 million options, the actual shares owned (with their own money and dollars on the line) was less than 35,000 shares (2003 proxy).

Most telling is the CEO, who owned less than 2,000 shares outright, according to the 2003 proxy statement, but held more than 3 million options (even after previously cashing in millions of dollars in options). From 2000 through 2002, the CEO was issued 2.95 million option grants, or well over $100 million of face value at today's prices.

Building a Balanced Equity Diet
While often an effective and cash conservative strategy for attracting, retaining and motivating employees, stock options are not free and do affect all other shareholders to varying degrees. When used prudently and in moderation, options can be a highly effective tool. When used to excess, however, they can be detrimental to the interests of shareholders as a group.

Foot Notes
For more information related to this article:

Go to the "Info Finder" section of the home page, click on the blue "Power Search" button and then click on "Advanced Search."
Leave the "Rewards Category" and "Optional Filter" blank.
Type in this key word string on the search line: stock option expensing OR stock options and high tech OR dilution OR overhang.

About the Author
Doug Sayed, CCP, SPHR, is founder of Applied HR Strategies, a Seattle-area HR and compensation consulting firm, and has been a WorldatWork member since 1991. He can be reached at doug@appliedHRstrategies.com or 425/827-3881.

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