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December 2000
Vol. 9, No. 12, pp. 41–42.
Personal Business
Are Stock Options Getting Un-Bearable?

Market corrections and rising costs to employers imperil this form of compensation.

Some compensation experts are concerned that the practice of granting employee stock options is out of control. They fear that it could be working against its intended purpose of motivating employees and could possibly be endangering the economy.

Technology start-ups and new management philosophies have helped turn employee stock options into a much more common element in broad-based employee compensation packages. But this is not totally good news because the actual cost of offering stock options has been steadily increasing over the past three years.

Stock options are a great idea in theory. They bind an employee’s compensation to the long-term future of the company, bringing their interests into parallel. A new study of 63 Fortune 100 U.S. companies by management consulting firm Hewitt Associates LLC showed that the cost of options has gone up 200% in the past three years. Although 52% of companies expressed a moderate or high level of concern over the cost of stock options, few are taking major steps to alleviate or control these costs. For start-up companies seeking to recruit scarce workers with little cash to offer, stock options have become a virtual necessity. Stock options—often referred to as the new currency—are now a necessity at any new company and are considered the best weapon to attract workers from the “old” economy. No CEO worth his or her salt would dream of taking a new job without the prospect of millions of dollars of stock option profits.

Why All the Fuss?
So why have the Industry Standard and The New York Times recently panned stock options? The $300 billion Teachers Insurance and Annuity Association–College Retirement Equities Fund has criticized megagrants of stock options to chief executives because they, and others, believe this compensation concept has evolved into a case of too much of a good thing. Whereas Internet start-ups used to offer stock options with incremental vesting over five years, increasingly, the trend is that companies, desperate for talent, are shortening the waiting period. In some cases, outright gifts of stock are being made, taking away much of the risk and incentive. Other companies, clearly intent on short-term horizons, are providing options that vest immediately at 50 or 100% if the outfit goes public or is acquired.

The strong earnings and stock price performance in recent years had allowed companies to put the issue of stock option cost on the back burner. Compensation experts had been saying that if we had a market correction, or if earnings and stock prices declined, many shareholders could become more concerned about the whole stock option cost issue and pressure boards to do something about it.

Web Site Is All About Options
A new Web site, myStockOptions.com, features original articles, calculators, an online options record-keeper, modeling tools, a discussion forum, and an "Ask the Experts" column in an intuitive interface. The modeling tools are specific to stock options, and the record-keeper includes option expiration and vesting dates. The calculators tell users their net gains after taxes, personalized by state. An "I Need the Money" calculator lets a user fill in the amount of money needed and see which options to exercise to obtain it. The modeling tools help users determine when to exercise options by looking at comparisons to alternative investments.

"This site is an absolute knockout," says Charles Christian, a Johnson & Johnson executive.

Well, we had stock market corrections in March–April and October–November 2000 that put billions of dollars of options “under water” (hopelessly below the current stock price), and it also called into question the risk of leaving the old economy. Recruiters for established companies may find it much easier to attract key employees as the financial troubles at new economy companies mount—and workers realize that attributes like stability have some value after all. Nonetheless, we really haven’t seen any attitudinal change at the corporate level. Stock options continue to be the coin of the realm. Forty-two percent of companies surveyed say that they expect the overall size of their stock option grants to increase over the next three years. Vesting schedules among surveyed companies varied from one to five years, with 45% of companies vesting options over three years and 26% vesting over four years. The study uncovered a moderate trend toward increasing vesting schedules to four years.

The Tax Issues
One of the worst scenarios for an employee who exercises a stock option is for the value of the stock to fall dramatically in a year after the option is exercised and the stock has been acquired. That’s because the employee must pay taxes on noncash income during the year of acquisition. The employee may have to raise the cash from other sources to pay the tax. For example, say an employee—a single person with wages of $100,000—claims one personal exemption and the standard deduction. In 1999, the employee exercises a stock option and realizes a paper profit of $200,000 and pays taxes on this profit. In 2000, the stock plunges and the employee sells the stock, suffering a loss. The market has erased the appreciation that he or she realized in 1999. Because the loss occurred in a year after the gain was reported, the loss can’t be offset against the gain. Capital losses can only be offset against that year’s capital gains. Otherwise, capital losses can only be used to offset up to $3000 in regular income each year. If the employee only reported wage incomes of $100,000 for 1999 and 2000, his or her total federal income tax for the two years would be approximately $47,400. But since the employee exercised a profitable stock option, the total federal income tax liability for 1999 and 2000 is about $80,500. The employee is left with about $33,000 in capital losses that can be carried forward to reduce regular tax liabilities in later years at the rate of $3000 per year.

A one-year “cliff”, or waiting period, means that the employee can’t use any of the options for one year, and then he or she can only sell that stock or options that have been vested. Take away the cliff and shorten the vesting period, and critics charge that you have also taken away most of the risk (to the employee) and the long-term incentive. Why shouldn’t an employee “take the money and run”? In short, many believe companies are giving away a lot while getting little in return. Stock options have the potential to deliver tremendous gains to an individual whose performance is not tremendous or even above average but simply good enough to keep around. Conversely, options have similar potential to deliver no gain to an individual whose performance was tremendous. This latter situation is not as uncommon as one might imagine, and yet can frequently be the case in companies with highly volatile stock prices that grant meaningful amounts of stock options to broad groups of individuals.

However, some experts say that given the job-hopping orientation of many new media employees, vesting schedules have become meaningless as a retention tool. Still, an employee ownership stock index, made up of public companies with more than 10% employee ownership, has beaten most market averages since 1992 when the index’s publisher started computing it and publishing the results. This index is published by an employee-owned investment bank, American Capital Strategies of Bethesda, MD.

Compensation experts and regulatory groups also worry about what happens when the stock price goes down or never appreciates enough to be exercised. For example, if an employee is issued options to buy the company’s stock at $30 and the price of the stock never goes above $25 during the time it could be exercised, the employee gets nothing. There is no darker side to stock options than when the exercise/purchase price is above the current fair market value of the shares. For essential nonexecutive employees, the continuing meaningful value of this large portion of their total compensation package is a key incentive to stay with the company.

Few observers who take the time to analyze the issues are totally opposed to the possibility of canceling the old options and regranting them at a lower price (i.e., “repricing” the options). However, there has to be some shareholder-palatable quid pro quo such as less than a one-for-one exchange on the number of shares and a restart of vesting or an exercise blackout period. Critics attack the repricing practice (and the IRS imposes tax implications in certain circumstances), saying that the idea was to get the employee to tie his or her fortune to the company’s stock price and that repricing removes the employee’s risk and the incentive.

The Outlook
Stock options appear to be such a popular tool that they may stay around for a while. Look for shorter vesting schedules, deeper penetration into the company, and possibly increased government regulation in the short term. In the long term, the marketplace will decide. If stock prices tank or we enter a recession, count on some corrections to current excesses.

Milton Zall is a freelance writer based in Silver Spring, MD. Comments and questions for the author can be addressed to the Editorial Office by e-mail at tcaw@acs.org, by fax at 202-776-8166 or by post at 1155 16th Street, NW; Washington, DC 20036.

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