Investment Banking

To Have and Have Not

Companies have long had it both ways on stock options. But now they must show what these incentives cost and how much dilution they cause
Michelle CelarierMarch 1, 1998
To Have and Have Not

After all, options have little or no value when they’re “out of the money”–that is, when the underlying stock’s price is below the option’s exercise price. Only when the stock rises above that exercise price can the option be converted to stock. But when the value of a company’s stock rises above that level, in the words of one CFO, “everyone is happy.” And the bull market has made for more and more such mutual joy.

But shareholders may not be so happy if they look at the footnotes buried at the bottom of some 1996 annual reports. Consider Westinghouse Electric Corp., as CBS Corp. was known until last year. Under a new rule imposed by the Financial Accounting Standards Board (FASB), Westinghouse disclosed that it would be forced to report a loss of $8 million in 1996, instead of net income of $30 million, were it to consider the cost of its employee options exposure. In other words, it would have taken 126.7 percent of Westinghouse’s income to finance options granted to executives and other employees in 1996 and some of those that were granted earlier that could be exercised.

CBS shareholders are hardly alone. Other companies that would take big hits include software giant Microsoft Corp., which did more than any company to popularize stock options when it became evident a few years ago that scores of employees had become multimillionaires as a result of exercising their options. At the end of September, Microsoft reported that covering its total options exposure would eat up 30 percent of its annual earnings, based on the previous 12 months’ numbers.

For such disclosures, FASB requires companies to use the so-called Black-Scholes model to determine fair value. But they need count only those options granted during the reporting period and those vesting during that time frame that were granted after December 15, 1995. Of course, companies can go further if they want. Microsoft says it also counts options that were granted earlier, as well as those that are not yet vested.

“Stock options are our largest financial obligation outstanding,” says Greg Maffei, Microsoft’s CFO. “They are an enormous part of how we motivate and retain employees.”

Using Microsoft’s approach, Sun Microsystems Inc. vice president of corporate resources, CFO, and chief information officer Michael Lehman estimates the expense of its options would absorb 10 percent to 20 percent of the Palo Alto, California, network computer products maker’s annual earnings. According to a consulting firm that asked not to be identified, others whose 1996 annual reports show big hits include computer retailer Best Buy, where the cost of covering options would reduce net income of $1.7 million to a loss of $1.2 million, Goodyear Tire and Rubber (from a plus $101.7 million to a plus $91 million), Humana ($12 million to $4 million), Monsanto ($89 million to $79 million), and Texas Instruments ($385 million to $305 million).

Until now, options have been shrouded in market mystique, defended by corporate executives and employees alike, and largely ignored by analysts and investors. But the numbers suggest that stock options are not free, as many have claimed, but cost real money, and that may finally raise some eyebrows.

The big question, of course, is whether the cost is justified. While proponents claim options are necessary incentives, the grants have not only overstated corporate earnings, but have also added to dilution, forcing companies to spend cash to buy back shares–often at higher prices than the option’s exercise price.

Finally, stock options may not be as effective an incentive as proponents have claimed. Some critics charge that options lure companies into risky ventures that temporarily boost the stock price. Indeed, several studies suggest that long-term stock performance at companies that pay executives in options doesn’t match those where stock ownership by executives is the norm. So perhaps it is not surprising that the tax breaks companies get for stock options have come under attack in Congress.

What complicates the issue is that the cost of options is difficult to measure with any precision.


Clearly, however, the impact of options extends beyond earnings. No one denies that they have created substantial–and rising–dilution. A 1997 study of executive compensation at the top 200 U.S. industrial and service corporations, conducted by Pearl Meyer & Partners Inc., an executive compensation consulting firm in New York, found that for the first time, over half the companies surveyed had more than 10 percent of total shares allocated for potential exercise of options.

A 1997 study by human-resources consulting firm Watson Wyatt Worldwide found the average overhang at 13 percent. And according to Pearl Meyer, 14 companies allocated more than 25 percent as of June 30, 1997, the latest numbers available (see table, above).

The combination of overstated earnings and dilution from currently exercisable options distorts actual earnings per share. As Thomas McManus, a Katonah, New York- based independent U.S. equity strategist, puts it, “Reported earnings are fantasyland compared to these real obligations.”

But the yardstick may become marginally more accurate as a result of a different rule from FASB, which requires companies to shed more light on the impact of dilution. Previously, companies didn’t have to report their EPS both with and without the effect of options, warrants, and certain convertible securities, if the difference amounted to less than 3 percent. Because FASB claims many companies failed to show both when they should have, it eliminated the 3 percent test starting last December 15.

Indeed, fear of dilution from the exercise of options has driven much of the huge stock buyback of recent years. Yet that drive has diminished the positive impact buyback programs have had on companies’ market value. “For a lot of companies, the share buybacks are just fleeting purchases of common stocks due to come onto the market at a later date,” explains McManus. “It’s not a permanent antidilutive strategy.” He estimates that at least half of the buybacks were for options plans.

McManus says his position on stock buybacks has changed dramatically since 1994, when he was one of the first equity strategists to argue that low dividend yields on U.S. stocks weren’t going to keep the stock market from soaring, because companies were changing the way they pay shareholders by buying back stock. Instead of using cash to raise dividends paid out to shareholders, companies began buying back stock, ramping up the stock price by limiting supply. Buybacks were also seen as a psychological boost to the company, because it indicated a company’s confidence in the future. But McManus and others promoting buybacks didn’t anticipate then how heavily companies would eventually depend on them to finance the oversized options packages, which were just beginning to be granted on a wide scale.

Now, however, many firms are being forced to buy back shares in the market at high prices to finance the options. At Microsoft, for example, Maffei says employees have options to purchase 258 million shares at an average strike price of $35, while the stock price is about $130. In its latest fiscal year, ended June 30, Microsoft spent $3.1 billion to buy shares to offset its options exposure, amounting to two-thirds of its reported earnings. And it estimated its options liability at $26 billion–a big number compared with the $9.6 billion in cash on its balance sheet and with a stock-market valuation of $175 billion.

“Everybody who owns the stock in these companies is having the wool pulled over their eyes by a very large issuance of options, because the more the stock goes up, the more it will cost the other shareholders,” says McManus.


As for the incentives options provide, critics contend that companies run by managers whose compensation depends more heavily on options than on stock may engage in riskier activities that will momentarily pump up the stock price, while ignoring other responsibilities. Their reasoning: Unlike stock ownership, options pose no downside risk. If the stock price never rises above the option’s exercise price, the option expires worthless.

“When an executive owns stock, he becomes like an outside owner of stock, in terms of risk exposure,” theorizes Gerry Sanders, a professor of strategic management at Brigham Young University. “If a company makes money and the market responds positively, he’s rewarded. If his actions have negative consequences, he takes a hit in the bank account.”

Not so for the executive with stock options. He gets a huge windfall when the stock rises, because of the leverage involved in options. On the other hand, if the value of the stock drops, he’s out only the price of the option. Sanders isn’t alone in criticizing options on this basis. University of Texas management professor James Westphal claims that too many executives are bolstering the stock price in ways “that don’t reflect what’s happening on an operational level at the company” and ignoring other measures of operational performance, such as operating margins, that “get closer to how the organization is run.”

Consider the case of Oxford Health Plans Inc., which granted options to all employees (and huge packages to top executives). Oxford, once the darling of Wall Street, pursued an aggressive high-growth strategy based on signing up more and more customers who posed higher risk, such as Medicare recipients, but ignored the basics.

Anne Anderson, an analyst at Atlantis Investment Co., in Parsippany, New Jersey, attributes part of the blame to Oxford’s options culture. “There’s an incentive to maximize the upside and not spend the money on things to give you support,” says Anderson, citing Oxford’s notoriously inadequate computer infrastructure and lack of controls over its financial arrangements with physicians.

Sanders can marshal other evidence to support the thesis. In a random sample of 250 firms in the Standard & Poor’s 500 stock index between 1990 and 1995, he found that those that offered fewer options to executives outperformed those that offered more. Firms in the top quartile of options pay generated stock returns of 12.9 percent a year, almost 300 basis points lower than the 15.7 percent that those in the bottom quartile produced.

In addition, his preliminary research shows that as options pay increases, companies spend more on acquisitions and less on internal investments such as research and development. Just the opposite holds for stock ownership. The more stock ownership, the less companies pay for acquisitions and the more they spend on internal investments. For firms in the top quartile of stock pay, the rate is 12.94 percent.

And options “very rarely create actual stock ownership,” says Ira Kay, practice director, compensation consulting, at Watson Wyatt. Instead, Kay notes that a confidential survey of brokerages from the early 1990s by a major brokerage firm indicated that more than 90 percent of the shares received through an option exercise are sold the same day.


It may be too late to put the stock-option genie back in the bottle. The bull market has made options the prime incentive for management and even lower-level employees in many U.S. industries, especially in technology and finance. By 1996, some $600 billion in shares had been set aside for options grants, a 10-fold increase since 1985, according to Sanford C. Bernstein & Co., a New York investment firm.

Sun Microsystems’s Lehman, who says the company monitors how many options are granted by the competition, argues that options are a requisite for growth. “What fuels our growth is the people,” he says. “It’s an investment that’s required.” The company, whose total options liability is about $1 billion, now has 13 percent of its 378 million shares, or about 49 million shares, tied up in options grants.

“Stock options are the most common and the most powerful long-term incentive plan in use at publicly traded American corporations,” says Kay of Watson Wyatt. “They are so powerful that a number of our economic competitors–Germany, Japan, Canada, and the U.K.–are emulating the U.S. in terms of putting in stock options.” (Japan just changed its laws to allow the practice.) At the same time, however, Kay says the risk they pose is starting to mount.

But the potential for trouble has been masked by growth. Until now, many of the companies with the heaviest overhang have had the highest growth rates–specifically technology firms. “I look at the real earnings growth generated by the company, and as long as we have sufficient cash and resources to grow, we feel like we’re making the right trade-off,” says Lehman. But growth at the high-tech giant is starting to slow. In a report released shortly after third-quarter 1997 earnings, Goldman, Sachs & Co. analyst Laura Conigliaro wrote that “results were disappointing, with revenues coming in at 13 percent growth, well below our 20 percent estimate.”


Microsoft’s Maffei disputes the idea that companies will have to pull back on options grants if growth slows. “We don’t decide how many options we can grant based on what we think the growth is. It’s the other way around. The employees will make the growth.” At the same time, Maffei admits that in recent years Microsoft has reduced option grants as a percentage of total shares outstanding. But the total allocation stands at a whopping 44.8 percent, according to Pearl Meyer. And earnings are beginning to slow by a significant amount. Goldman, Sachs analyst Richard Sherlund projects earnings growth of only 10 percent for Microsoft during the second half of fiscal 1998, which ends June 30. In previous years, Microsoft reported earnings growth of more than 50 percent.

Maffei says that “we have done things other than options,” but still sticks by them. “We think options are a good program for the majority of employees.”

Other companies are now encouraging executives to buy stock or trying to reconfigure their options compensation to avoid some of the pitfalls. At Sun Microsystems, for example, employees are encouraged to buy stock up to a certain percentage of their salary at 85 percent of the stock’s fair value. But the reason why companies don’t just issue stock, instead of options, is simple: Options have been viewed as free. And that is what the FASB-required disclosures may change.

Says Sanders: “If you read proxy statements, you’ll find that when boards have to report what they’ve given their executives, or in justification of stock options, they will say things like, ‘This is a win-win governance mechanism.’ The executive will win only if the shareholders do well. And there’s no cost to the firm unless there’s a corresponding benefit. Moreover, there’s no cash expense to them.” Indeed, while companies don’t have to expense the cost of their options, they are able to gain a tax benefit from them.

It is the tax gimmick that makes options doubly attractive. When the options are exercised, the company is able to deduct as an expense for tax purposes the gain realized by the option holder, even though it hasn’t charged the cost to income. A bill has been introduced in Congress to bar such tax deductions. And it has bipartisan support, although the lobbying pressure brought to bear on FASB’s rulemaking in this arena raises doubts about its prospects.

As for Wall Street analysts, some are more concerned about the possibility of companies paying executives real money instead of options. Alex Kotlyar, an analyst who follows Microsoft for Donaldson, Lufkin & Jenrette Securities Corp., fears that a reduction in stock option incentives would lead to greater turnover. Maffei would not say whether fewer options are being handed out, or whether the decline in the rate at which they are being granted, as a percentage of Microsoft’s outstanding shares, is a result of its aggressive buyback program. But there have been reports that the company has become less generous in granting options to lower-level employees.

In addition, Kotlyar contends that contrary to Maffei’s assertions, “If its growth rate slows down, it will have to replace options grants with higher cash compensation.” In the end, the risk inherent in stock options depends on whether a company’s fundamental growth rate–as opposed to its earnings per share–can be sustained. If options exposure forces a company to spend money to buy back stock that is better spent on its business, that will eventually hurt. “If a company is putting a majority ofcash into stock buybacks and the top-line revenues are not growing, then you’ll start to see the impact of it,” cautions Sun Microsystems’s Lehman.

Until recently, investors ignored that risk, in part because there was little way to gauge it. In 1993, FASB proposed that corporations expense options at the time they are granted, using the Black-Scholes or similar models to determine their value. But under pressure from corporations, FASB backed down. And although the watered-down rule sheds some light on the issue, few analysts are paying attention. “There’s virtually no focus on it right now,” says Goldman’s Conigliaro.


Corporate executives also tend to downplay the importance of these new disclosures. “It’s the accounting rules, and we are obligated to disclose it,” says Fredric Reynolds, CFO of CBS, adding that, “I’m not sure I’m as keen on what the new practices find. If the stock goes up, I’m not so sure it’s really a cost, as it’s beingportrayed. And if the stock goes down, then the options have no value.”

Yet corporate executives battled FASB ferociously when it proposed the more extensive accounting change. As Dennis Beresford, the former FASB chairman who drew the brunt of corporate displeasure at the time and is now a professor of accounting at the University of Georgia, puts it: “If it doesn’t mean much, why did people fight FASB over so many years? It was a life-or-death issue.”

Michelle Celarier is a writer in Croton-on-Hudson, New York.