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Stock Option Overhang Blues

New research may make stock option compensation for executive pay look even more unpalatable.
Lisa YoonNovember 21, 2002

As the debate over executive pay continues, those in favor of doing away with stock options have new fuel for their fire.

A new research report by Watson Wyatt shows that companies with high stock ownership by senior management financially outperform companies with lower executive ownership, as measured by total returns to shareholders, return on equity, earnings per share growth, and other metrics. The same goes for top executives who receive higher levels of cash pay.

Stock option overhang, however, does not get nearly as favorable reviews in the study. To that end, Watson’s link between excessive stock-option overhang and low shareholder returns may put CFOs — already in hot water over their executive pay — in a position of being the bearer of more bad news.

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According to Watson Wyatt’s “Corporate Goverance in Crisis: Executive Pay/Stock Option Overhang 2003,” stock-option overhang is a growing problem that few companies have been able to reverse. Overhang refers to the number of stock options granted plus stock options remaining to be granted as a percent of total shares outstanding.

Watson continues to find that high levels of stock overhang contribute to low shareholder returns at those companies. And the report, which studied 1,219 publicly traded companies, found that overhang increased well beyond optimal levels at many companies in 2001, as employees and executives exercised fewer options.

What’s more, overhang levels increased from 13.8 percent in 2000 to 14.7 percent in 2001, despite management at the studied companies making efforts to reduce them. “Shareholders, through their buying and selling patterns, are looking for companies to cut back on their overhang levels,” says Ira Kay, Ph.D., national director of compensation consulting at Watson Wyatt, in a research note.

“As a result, companies have become increasingly concerned about managing their stock option programs closer to the optimal overhang level,” Kay explains. “Companies with high overhang tended to lower their overhang levels in 2001, while those with low overhang levels significantly increased their levels.”

But that optimal level — what Watson calls the “sweet spot” — can be quite difficult. The term refers to achieving that delicate balance of employee incentive and share dilution that keep both employees and shareholders happy. The trouble is that the study found that lower shareholder returns from companies that exceed their optimal overhang levels happens in both bull and bear markets.

For example, technology companies closest to their sweet spots (generally 15 percent for the tech industry) only lost 12 percent of their shareholder value in 2001. On the other hand, those with higher or lower overhang levels lost more than 20 percent of their value.

Which companies increased their overhang the most? No surprises here: Tech companies overall increased their overhang levels from an average 21.3 percent in 2000 to 24.9 percent in 2001. “This change — the biggest for any of the major industry groups in the study — occurred primarily because of the large number of unexercised stock options,” says Kay.

He also believes that shareholder losses tied to stock option overhang will lead many companies to rethink their compensation plans. “With the current economic climate and the push for new stock option accounting requirements,” Kay says, “we expect some companies will begin to shift from stock options toward other compensation programs, especially those that encourage direct stock ownership.”

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