Human Capital & Careers

In the Journals: Fading Options

Microsoft's conversion to restricted stock provided a peek at what may be compensation's next wave: transferable stock options.
Lisa YoonDecember 22, 2004

While increasing numbers companies are moving away from stock options, their departure is just the beginning of a full-scale exodus, according to Harvard Business School professor Brian J. Hall. “There is a revolution coming in stock-based compensation,” says Hall. “By the end of this decade, the standard equity pay plan will be dramatically different from what is customary today.”

The ingredients of the “near-perfect storm headed directly for stock option pay” are familiar to finance executives. The bleak menu includes the questionable effectiveness of employee stock options (ESOs) as a retention and motivational tool when options are underwater and falling stock prices that led to a backlash against excessive executive pay.

The wave of corporate scandals starting with Enron also caused many to view options as a lure for executives to run afoul of proper accounting. Finally, the near-certainty that the Financial Accounting Standards Board (FASB) will require companies to expense options creates a tipping point — “a ‘blank slate’ and thus an opportunity for companies to reexamine their equity-based pay programs as never before.”

Many compensation experts say restricted stock will replace options as the dominant form of equity-based pay. In fact, some companies have already made the switch, including Microsoft. But Hall believes transferable stock options (TSOs) have advantages that trump both restricted stock and ESOs.

Microsoft’s conversion to restricted stock provided a glimpse of how TSOs work. In partnership with investment bank J.P. Morgan, the company created a one-time TSO program that enabled holders of underwater Microsoft options to sell their options to J.P. Morgan.

The Microsoft employees who sold their underwater options to the investment bank did so even though they received less than the full market value of their options. While J.P. Morgan paid the market price for the options (at Black-Scholes values), the maturity of any options sold was shortened by about two years. That reduced the price paid to employees for the options, in turn reducing the liability and cost to shareholders of the underwater options sold to J.P. Morgan.

“The most important outcome of the Microsoft-J.P. Morgan tender offer is not the shift toward restricted stock but rather the effect of the transaction in clearing away uncertainty about the tax, accounting, and regulatory treatment of ongoing TSO programs,” maintains Hall.

Like ESOs, TSOs have tax advantages in comparison to restricted stock. In both programs, the tax rate is applied to the amount of the option holder’s gain, while the company gets a parallel deduction for the same amount. In contrast, restricted stock is taxed as the stock vests and therefore before any cash is paid to the recipient.

Under the FASB rules likely to be adopted in 2005, the expensing of TSO costs is also likely to be similar to that of ESOs. But TSOs, for which valuation is based on the prices paid by investment banks, are rather simpler to value. With ESOs, there are no clear ways to estimate two key valuation parameters: expected life and expected volatility.

Further, TSOs solve three of the main problems with traditional stock options: the challenges of option fragility, value-cost inefficiency, and transparency and understandability. ESOs’ fragility — the ease with which they fall underwater — defeats their purpose as a retention tool. TSOs continue to have value — albeit reduced value — when the stock price falls, maintaining their ability to provide “golden handcuffs.”

ESOs also lose much of their value-cost efficiency as the stock price falls. As the stock price goes down, so does the value of options to the employee relative to the “opportunity cost” of that equity to the company (what the company loses by selling the equity to employees instead of a third party). On the other hand, TSOs “share much of the value-cost efficiency advantage enjoyed by restricted stock,” providing relatively high value per dollar of company cost to employees.

TSOs, finally, are much easier to value than options. While options are generally valued by Black-Scholes, an abstract formula, TSOs can actually be sold to the investment bank, making their value more transparent to both employees and shareholders.

Transferable Stock Options and the Coming Revolution in Equity-based Pay

from the Winter 2004 issue of Journal of Applied Corporate Finance

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Outlook 2005: Integrating Cost Control and Revenue Growth

from the December 2004 issue of Business Finance

With global economic growth slackening into 2005, one of chief financial officers’ main concerns in the coming year will have to be a better balance between cost-control techniques and top-line growth strategies, writes Fay Hansen. Though those are the “twin paths to profitability,” companies tend to focus on one or the other, depending on the direction of the economy, the author maintains.

But such an ad hoc approach is unsustainable — particularly because many businesses have reached their cost-cutting limit even as the economy continues to slow. One way to integrate cost control and revenue growth is to make the most of globalization — “the primary corporate imperative for 2005.”

Offshore outsourcing, foreign direct investment, and global materials sourcing are essential to cost control. At the same time, “the search for top-line growth means that companies must continuously explore new markets.” Hansen describes how several companies, including BorgWarner and EDS, are using globalization to grow and save.

The Three Capitals of China

from December 2004 issue of Chief Executive

Hong Kong, Beijing, or Shanghai: Author Rebecca Fannin investigates which Chinese city is best for basing Asian operations. That largely depends on the industry, since all three are vibrant cosmopolitan centers with English commonly spoken and similar real-estate prices.

Beijing offers unique access to key government decision-makers in the Communist country — an important feature for companies in highly regulated industries such as insurance. With two major universities, it’s also a good source of talent for technology firms. Shanghai is a draw for semiconductor companies. As for Hong Kong, several of its benefits are unique among Chinese capitals, not least of which is a reliable legal system, “which Hong Kong has and the mainland simply does not.”

Near-Sighted Justice

from the December 2004 issue of the Journal of Finance

With the bankruptcies of the likes of Enron and WorldCom fading into the past, is it possible for a bankruptcy court to be too fair?

Perhaps, say authors Dan Bernhardt of the University of Illinois and Ed Nosal of the Federal Reserve Bank of Cleveland. According to their research, a court that consistently liquidates “bad” (unviable or unethical) firms and allows “good” (or potentially viable) firms to continue as a restructured business may actually be too predictable. That can lead a bad company, aware of the probability of bankruptcy, to take actions that temporarily inflate revenues — such as holding a fire sale — in order to appear financially healthier and avoid court-ordered liquidation.

Good firms, meanwhile, knowing that liquidation by an error-free court is unlikely, may make decisions that potentially decrease the firm’s value — such as indulge in overly generous perks for managers. Rather than error-free, or blind, justice, the authors suggest that an “optimal design of a bankruptcy court is “one in which the court occasionally makes errors, sometimes liquidating good firms and failing to liquidate bad ones.”

An error-prone court, they argue, keeps bad firms on guard for liquidation and encourages them to make decisions that could increase the probability of bankruptcy — such as desisting from fire sales. Meanwhile, good firms are rewarded in the long run because they are discouraged from value-subtracting management actions.

The Path to Corporate Responsibility

from the December 2004 issue of Harvard Business Review

Companies arrive at corporate responsibility through five stages, says author Simon Zadek, CEO of AccountAbility, a U.K.-based nonprofit. He uses Nike Inc., the former poster child for sweatshop conditions at overseas suppliers, to illustrate this path.

The five stages include “defensive,” in which companies deny responsibility; “compliance,” when companies behave responsibly only to meet regulatory obligations; and “managerial,” the stage in which firms start to inject social responsibility into core business practices.

At the “strategic” stage, companies realize corporate responsibility offers a leg up on the competition. Finally, at the “civil” stage, companies promote broad industry participation to address society’s concerns, as when alcohol companies promote responsible drinking. It’s not easy to reinvent a company as socially responsible, grants Zadek, which is why “making business logic out of a deeper sense of corporate responsibility requires courageous leadership.”