Stock Option Grants Smaller? Or Not?

Fred WhittleseyPay and Performance: The Compensation Blog0 Comments

If you saw the article in the Mercury News Thursday morning, “Stock Option Flow Slows” you might think that (a) this is news , (b) companies are giving out fewer stock options to employees, and (c) this has something to do with new accounting rules. I think (a) no, (b) somewhat and (c) no.I suppose it is news that Bear Stearns issued a report with data indicating that this is the case. Their report says that companies in 2005, compared to 2000, are issuing (a) fewer options and (b) less total “value”. I think (a) yes and (b) no. But that has been occurring for the past four or five years and it is old news.

If I was really drunk right now, but much less drunk than the time I was the drunkest I’ve ever been, the news might be that I’m not really all that drunk. In 2000, US companies were drunk on stock options. There was no accounting expense required for employee stock options and shareholders were giddy about the bull market (widely misinterpreted as their investing savvy) so they didn’t mind that they were being diluted. Employees in the US got lots of options. Employees outside the US in those same companies, where pay is a fraction of US pay, often got the same number of options. New hires got big option grants (even though we hardly knew those people) and continuing employees got grants every year – even the poor performers (we can’t give them zero, they might complain or leave). Today, companies are granting fewer options than they were in a time when many granted an absurdly high number of options. But that is not news.

Remember that then the market crashed and shareholders got mad. But a lot of those employee options got “repriced” or exchanged so that the employees weren’t penalized for the stock price decline, even though others may have gotten rich during the bubble. That irritated some investors. Since then, many of the companies that were granting an absurdly high number of options cut back to above average levels – less drunk now. Shareholders of some companies refused to approve more shares for employee stock plans. No more for you, sir, I’ll call you a taxi. Some companies didn’t even bother asking shareholders to approve more shares even though they had run out. Closing time, indeed. It’s important to note that several companies gave smaller grants, or no grants, because they ran out of shares and it wasn’t good timing to ask for more. But they’ll get more this year, and may have to do extra-large grants to make up for last year. I personally know a couple of companies that are doing this. So when is a zero not really a zero?

Reports like those issued by Bear Stearns are based on data from hundreds of companies and it takes a lot of work to pull all that data together. But those of us who study each company in detail know there is much more to the story. Microsoft, instead of granting stock options, now grants restricted stock units in a number about one-third of the number of options it used to grant. So, did they “reduce” their grants by two-thirds? Or did they reduce their “option grants” to zero? A few other companies like Amazon made a similar change. I have seen, and continue to see, these types of errors in reports issued by reputable firms. (This article, by the way, notes that restricted stock is now “popular” but I have no idea what the criterion for being popular is. I do know, however, that granting restricted stock is still a minority practice, like popular orange shoes, and is very unpopular with a lot of investors.)

What about the company that didn’t issue options last year because they allowed employees to exchange worthless underwater options for newly-priced options? Is that a zero too? And what about the company that moved its annual option grant date from December to January, and went 13 months between grants with none in calendar year 2005. Zero? As the mathematicians in the audience know, zeroes can bring down an average quite a bit.

Here’s a really deceiving part of the story. You might remember that stock prices were quite a bit higher in 2000 than in 2005. The NASDAQ was roughly double where it is now. Due to a bizarre but widely accepted belief that an option granted when a share of stock is at $100 is twice as valuable as an option granted when that same stock is at $50, we conclude that we are giving less value because stock prices are lower. In other words, those $100 options we gave you are worth much more compensation even though our stock price is now at $50. For those of you who understand stock options you probably noted the absurdity of that last sentence. That’s the “duh” part. Options granted when stock prices are a fraction of what they were in 2000 are of lower “value” because the Black-Scholes option pricing model says so. Not.

But wait, there’s more! Companies definitely took action in response to the new accounting rules for stock options. Few people know that US companies spent millions of dollars of shareholders’ money over the past two years on consultants who helped them to develop “better” estimates of the value of stock options granted to employees. (Did you miss the news story on that?) This became a compelling activity because of the need to start reporting that value as an expense reducing reported profit. In virtually every case, that “better” estimate was a lower one (surprise!). Don’t take my word for it, just read their 10-Ks. Thus the reported “value” of employee stock options went down because companies got “better” at low-balling the number. Did that reduce employee pay? Of course not. And of course there are those companies that accelerated vesting to avoid recognizing any expense at all, so those options will now require an accounting expense of zero and must therefore be worthless. Hmmm. How did you calculate those, Bear Stearns? Seems to me that those options just got a lot more valuable.

Amidst all of the smoke and mirrors, many companies have indeed started issuing stock-based compensation to employees on a more reasonable and thoughtful basis (I do not include the vesting accelerators in that group). But let’s not think that a massive reduction in option grants has occurred because some will take that as further evidence that the US worker has experienced a massive pay cut while executives have not and then introduce federal legislation to fix the problem. The real news is that companies are radically changing how they pay employees which is the big positive outcome of the new accounting rules and shareholder pressures. Many companies are taking the first fresh look at pay practices since a time before many business journalists had started learning their cursive. That is the really big news but the data won’t show up in reports issued by accounting analysts at investment banks who I happen to think should leave the compensation business to people who actually know something about compensation and go focus on investing.

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