The economy and the stock markets may be perking up, but not nearly enough to push many stock options back above water. That’s especially true in the technology sector. At 90 of the 100 largest publicly held tech companies, at least some options granted in the past 10 years remained sunk as of July 31, says executive-compensation consulting firm Steven Hall & Partners.

At 21 of the companies, there were no outstanding options with any current value to their holders, including both senior executives and other employees. For the group as a whole, 57% of options held by companies’ five top executives were under water, at an average of 42% below exercise price, Steven Hall research shows.

While that’s bad for the executives, it’s just as bad for the companies. The 100 public tech firms with the highest revenue in their most recent fiscal years were carrying an average expense of $48 million on their income statements for options held by their five top officers. But those options’ intrinsic value — the difference between their strike prices and the current share prices — averaged only half that amount, the consulting firm notes. (Under FAS 123(R), a company must expense over the option period the full value of options at their grant dates as determined by the Black-Scholes valuation formula, regardless of movements in the company’s stock price.)

That means a huge expense has created very little of its intended value, which was supposed to be retaining and motivating high performers. Executives who hold worthless or nearly worthless options “are more susceptible to poaching by other companies, taking the call from the executive-search firm, or deciding on their own that they want to go somewhere else that may offer a better upside,” says Lawrence Robinson, managing director of Steven Hall.

Indeed, the deal is likely to be better somewhere else. Almost all new options granted today have lower exercise prices than those granted a few years ago. But most companies grant new options only to new employees because, in most cases, shareholders must approve exchange programs. In such programs, executives can trade old, underwater options for a smaller number of new ones with lower strike prices. That could be a good compromise — enabling the company to retain key talent at a relatively low cost — but shareholders usually won’t approve. “We’ve only seen a few companies do this,” says Robinson.

But while granting low-priced options to newly hired executives may be a good recruiting tool, it can be a discouragement to veteran executives holding underwater options. “An internal imbalance between new hires and older ones is one of the problems caused by these underwater options,” says Derrick Neuhauser, senior manager with BDO Seidman’s executive compensation and employee benefits group and technology practice. “The new hires may even be in the money now, with the stock market’s current run-up.”

And IT executives, Neuhauser notes, are notoriously difficult to retain. “They’re more willing to take their skill set and go across the street,” he says, attributing that mind-set to the entrepreneurial spirit that typifies the technology sector and the prevalence of start-up companies with possibly breakthrough technologies.

On top of the accounting burden and the retention challenge, a third problem with the devaluation of stock options is that “it’s paralyzed companies in their thought process on how to design comp programs,” adds Neuhauser. “They’ve waited on the sidelines hoping the market would recover.”

With the goals of making executives think like owners and aligning their interests with those of shareholders not having been met, Neuhauser says, companies now are thinking: Do we need to reexamine that strategy? Should we take on the cost of a new option program in the short term for the long-term benefit of shareholders and employees? If so, should we do that now, or wait some more?

Some companies, Robinson notes, are opting for a selective strategy of locking in a limited number of top contributors and “hoping for the best with everyone else.” Such companies, he says, may put a priority on reviewing corporate succession plans to identify up-and-coming talent and redesigning those employees’ compensation programs to include new incentives.

 

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