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Motherhood, Apple Pie Stock Options

Although stock options are widely used to attract quality employees, they can have negative effects on your company if employees misunderstand them of if they're issued irresponsibly.
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Stock options have become part of the American dream and the managerial weapon of choice for the savviest companies. Trouble is, that weapon may threaten the very companies that employ it

Siebel Systems Inc. is on a roll. The developer of customer-support software, based in San Mateo, Calif., generated sales of $77 million in the first nine months of 1997, up from just $8 million for all of 1995. In 1996 the company's head count tripled, and it doubled again to 330 in the first nine months of 1997. Ask Siebel employees what they owe their success to and many will tell you it has much to do with a companywide stock-option program that has made them substantial shareholders in Siebel--and millionaires in the process. A quarter of Siebel Systems' employees own options to buy stock at less than $5 a share, not bad given that the stock was trading at $37 a share at press time. "Even people buying the stock at this price think this is a great opportunity," says Heather Beach, Siebel's director of sales operations, who started out as the company's office manager and loaded up on options largely in lieu of salary in the company's early days.

By granting so many options, growth companies like Siebel Systems are making what amounts to a simple yet significant bet: they're wagering that in the ensuing years their employees' efforts will have increased the value of the company's shares enough to offset the considerable payout promised by the options they hold. They're betting that the workers can bail out the boat faster than the water can rush in.

In the rampaging, skills-hungry global economy of the 1990s, employee stock options have become the new manna--a widely accepted means of attracting and retaining key workers. In a recent survey of 1,000 public companies by ShareData, a Silicon Valley-based supplier of employee-stock-plan software and services, 74% of the companies with less than $50 million in sales, and 68% of those with fewer than 100 employees, offered stock-option plans to all employees. Scott Spector, a Silicon Valley compensation expert with law firm Fenwick & West, says the typical small technology company he advises may well grant options equal to 24% or more of total shares outstanding, up from 15% just three years ago. Meanwhile, in those companies, the median value of options granted equals roughly 37% of an engineer's--and 265% of a CEO's--base salary, according to Mark Edwards, president of iQuantic, a compensation consulting firm based in San Francisco.

The option mantra reads as follows: As workers become equity holders in a business their interests become "aligned" with those of managers and shareholders. All will profit as all join in the common cause of moving the company forward. That's the upside. The downside is denser--and darker.

Growth companies love options because they defer payments to the piper--forever, if all goes well. Granting options enables managers to pay employees with an IOU rather than cash--with the prospect that the stock market, not the company, will one day pay up. And yet options can be a time bomb, inflicting damage in future years not only on a company's financial underpinnings but also on the fragile sense of trust between leaders and the led. Options have gained credibility for the wrong reasons. They have been made possible because current rules allow them to be accounted for in lax and dubious fashion. Moreover, their soaring popularity is inextricably linked with an external event, an unusually long bull market.

Meanwhile, what's most remarkable about options is how widely embraced--and poorly understood--they are as a management tool. While they're lauded as an effective incentive to keep employees motivated to achieve the long-term goals of a company, in fact they often bring about the opposite result. Options--which can well turn out to be worthless--place undue risk on many unsuspecting employees. The least-sophisticated employees tend to cash out their options quickly, obliterating any long-term incentive. Conversely, among a minority of more savvy workers, primarily in the precincts of Silicon Valley, options create a lottery mentality that perversely drives employees from company to company in restless search of the next big payoff, snubbing any expectations of loyalty to a particular company.

At present, the voices critical of employee stock options tend to be muted amidst the clamor for options. One such voice belongs to Charles Munger, vice-chairman of Berkshire Hathaway, the holding company run by legendary investor Warren Buffett. Munger says options resemble "a chain letter." Dennis Beresford, the former chairman of the Financial Accounting Standards Board (FASB) and now a professor of accounting at the University of Georgia, likens them to "a Ponzi scheme," adding, "people are oversold on the idea that options are a cure-all for other forms of compensation and other things that management should be doing."

For those employees best able to calculate the odds, the place to be in the options sweepstakes is at a company in its "pre-initial-public-offering phase." That's when options are being doled out at rock-bottom prices, often under a dollar a share. If all goes well, and the company later goes public at a significant multiple of the option price, the average employee can reap a huge payoff. Some employees time their comings and goings with a cool eye toward their company's performance. Few know how to play the game as adroitly as Frank Lee, who has deftly turbocharged his career with options.

In October 1991, Lee signed on with Synoptics, a networking company, which was then struggling. Synoptics' stock was at $12 a share, down from $50. Lee recalls: "I saw it as an opportunity for me. The stock could go up." Sure enough, the management turned the company around, and within two years Lee's hunch had paid off big, as the stock soared to $120 a share. He recalls how the atmosphere at the company shifted during that heady period. "The stock was going up $2 and $3 a day. People were stopping each other in the halls, asking, 'How much are we up today?" The parking lot was again suddenly 80% full after hours, and Synoptics employees were back to calibrating car and house prices using their shares as the unit of currency. In mid-1994 Lee doubted the good times could last, as Synoptics announced a merger with Wellfleet Communications. "The merger created uncertainty. I asked myself, 'Why should I stay here?"

Lee's next stop was 3-Com. He had received a near-identical offer from Cisco Systems, but then he sat down with the financial histories of the two companies side by side. One thing stood out: Cisco's stock had split numerous times; 3-Com's had never done so. It was overdue. Lee believed that having more shares would give him a psychological boost and could offer a bigger payout down the road. He arrived for his first day of work at 3-Com and opened up his very first E-mail message--which announced a stock split.

Lee had learned at Synoptics how volatile technology stocks could be. He resolved to diversify. "I decided to exercise my options every year and invest in other people's companies." Now Lee--with a fistful of options--has joined GRIC Communications, a start-up that's developing a global communications technology using the Internet. He thinks it's a good time for a change, because the stock market has been so hot of late and he believes it's due for a breather. Also, he can afford the change to a start-up. "I made enough money in the last two companies that I'm willing to take more of a risk," he says. He adds that as the head of a business unit at GRIC Communications, he must recruit new hires. "I have people asking about stock options before salary now. It's the number one thing they want," he says.

Frank Lee as the option-savvy employee may be a portent of things to come, but for now, what's more typical is the unsophisticated worker who knows little about options.

"They didn't have a clue." That's how Doug Mellinger, the CEO of PRT Group Inc., describes his employees' understanding of options in the then-private company. (See " The Antihero's Guide to the New Economy," January.) Their cluelessness hit Mellinger when he and an employee of the New York City-based financial-services software developer were traveling by plane. During their conversation, the employee told Mellinger that options in the company "weren't worth very much" because their purchase ("strike") price was so high, $56 a share. The employee could find countless stocks at lower prices and hence could buy many more shares in those companies. Mellinger was stunned. He tried to explain the difference between price and value and that PRT had only 1.2 million shares outstanding. "I realized this was a very pervasive problem," Mellinger recalls. PRT was a company with paper millionaires who hadn't even bothered to read the documents outlining the option program. "We found that we had very senior executives who had no idea how the program worked," he says. Before taking the company public last year, Mellinger instituted an education program to explain to employees how the stock was valued and how options work.

Mellinger's experience corroborates the work of Mark Lang and Steven Huddart, professors of accounting at the University of North Carolina and Duke University, respectively. They have studied option-related transactions in a number of companies to gauge how employees perceive options. Lang and Huddart found that most workers exercise their options quickly and then sell their shares prematurely, which on its face contradicts the notion of granting options as long-term incentives. "They are willing to give up a lot of the option's theoretical value in exchange for getting rid of the risk," says Lang. "Market volatility spooks most people. A lot of them are reading the Wall Street Journal daily. They see a two-point drop in their stock, which translates into a $40,000 loss of wealth. It doesn't take much of that before they get out."

Lang and Huddart often speak to executive groups about options and find their members have only a vague understanding. "Very little is known about how options really work," says Lang. "Managers are surprised when they see an employee bail out after 5 years on a 10-year option. They don't know that this is common." Lang says that options can represent a substantial future liability to a company, "yet they are not highly valued by the employees." Maybe with good reason. After all, small companies are volatile; they're adept at destroying shareholder value.

That happened at Molten Metal Technology Inc., a Waltham, Mass., developer of technology to treat toxic waste, which declared bankruptcy in December 1997. Two years earlier the stock had traded as high as $40 a share. Liz Brodbine Ghoneim, formerly Molten Metal's director of contractors compliance and business administration, came to the company in November 1993, nine months after it had gone public. "I know a lot of people who started with the company before it was public and were able to cash out their options," she says. Her options had been granted at $24.75, but before they vested, the stock had sunk below that level, making her options worthless.

Then in October 1996, Molten's stock collapsed, losing nearly half its value in one day. "A lot of people were shocked; every single employee had options," Brodbine Ghoneim says. In fact, as she recalls, the management was already backpedaling. "When I first started, the option packages were very generous...but [in early 1996] they dramatically cut back."

Still, she adds, the management's message to the employees was clear: "They told us that our options definitely had value. They said, 'This is additional compensation because it's going to pay off someday." After the stock tanked, Brodbine Ghoneim recalls, "then they [management] came around and said, 'You should never count on the stock market."

Brodbine Ghoneim, who left the company in mid-1997, had envisioned using the payoff from her options to take a year off for travel. She even lost $15,000 investing in Molten Metal stock and allows that after the shares collapsed, "it was a real struggle working for a start-up."

Stock options were once bit players in the drama of capitalism, first intended back in the 1940s and 1950s as bonuses for key executives who could truly influence a company's fortunes. There has been a sea change since then. Amid the restructuring of the 1980s, many top executives took options in lieu of salary, reaping huge windfalls--and negative publicity--as American industry resurged. Small wonder, then, that others would want to hop onto the gravy train.

Robb Kundtz is a Silicon Valley headhunter who specializes in placing mid- and upper-level employees. He says that despite near-zero unemployment in the valley, his business is strong because the fortunes of local companies can shift so quickly. There are always good people bailing out of bad companies. He likens stock-option roulette, Silicon Valley-style, to "teenage sex. You're in and out in no time. You join a start-up, get your options, ride them through the IPO, and sell your shares as soon as you can at Schwab because there are no insider-trading prohibitions. Then you're ready to start looking at the want ads again."

As Kundtz's terminology suggests, options have not-so-subtly altered the rules of the company-building game. In the entrepreneurial world of the '80s, people got rich through logical means: starting companies, working hard, and hoping their efforts would build value. People like Steve Jobs, Bill Gates, and Michael Dell did so, becoming cultural heroes and creating value along the way.

Now it seems that the mind-set has shifted. Join the right company, hitch your wagon to the star of the next Jobs, Gates, or Dell, and the payoff is yours. Getting rich used to first require the creation of wealth. Now it seems possible--via options--that getting rich can be disconnected from that process, not unlike waking up one morning to find yourself holding the right lottery ticket.

Options owe much of their current vogue to an event that exists apart from the fortunes of any one particular company--a powerful and long-lived bull market. The surging prosperity it has conferred has created an expectation that share prices will continue to rise and thus options will keep paying off. And the urge--the need, even--to use them, notably among small and fast-growing companies, is greater than ever since new technologies now mature so quickly. "The time frame from start-up to IPO recently has been collapsed from five years to a year and a half," says compensation expert Scott Spector. That gives more people the opportunity to join a start-up, cash out--and try again. At the same time, says Spector, "companies are out there looking for the same few good people. They have to increase the price they're willing to pay." How that's done is simple: offer more options than the competition does.

The aggressive use of options in the start-up arena is a key concern of people like Mark Edwards of iQuantic, which structures compensation packages for high-tech companies. "These things are like candy," he says. Edwards adds that while the typical Fortune 500 company grants options equal to about 1.25% of its outstanding shares each year, the number for the typical high-technology company is 3.5%--almost three times greater. Edwards labels that number the "burn rate." It signals how much of the company is being transferred from investors to employees each year. Software and Internet companies, desperate to get to market even faster than other high-tech companies, have median burn rates of 5% and 8%, respectively. Says Edwards, "A lot of these companies don't have the discipline to think about options the way they would think about real money."

Now a commodity, options have long since become diverted from their original purpose of rewarding a cadre of managers for a job well done. While they can reward hardworking employees, options also smack of financial and accounting gimmickry that could someday collapse a company's equity like a house of cards.

Companies use options as a portion of employees' compensation, so one would assume those options are of demonstrable value. But virtually all companies deem them worthless on their books: current accounting rules do not require that companies show options as an expense. Companies granting large numbers of options thus show a fatter bottom line than they would if those options had been listed as an expense. For now, in valuing stocks, the investment community has tended to ignore the drag on earnings that a more realistic valuing of options would produce. If sentiment were ever to shift and require a more conservative accounting treatment of options, corporate earnings would suddenly fall, likely taking share prices with them.

That is implicitly acknowledged by even the staunchest proponents of options. David Hofrichter, compensation consultant in the Hay Group's Chicago office, ardently defends options, arguing that it's the stock market that pays whatever bonus the employee merits, through the enhanced market value of the stock. And yet he cautions that it might be risky to account for options in a more conservative fashion. "If I show less income, people will stop investing in my stock, which brings the whole thing down."

The current nonaccounting for options is a practice that sickens some investors, especially those with a nose for value. Charles Munger of Berkshire Hathaway says, "One thing we hate with a passion is this phony accounting. We regard it as a detestable compromise of ethics and good sense."

Even those who work closely with the high-tech growth companies that use options liberally concede the point. "A large reason companies like options is because of the attractive accounting treatment, no question about it," says Scott Spector. Asked about the claim often made by management that options need not be listed as an expense because they are worthless, Spector replies, "That's a lot of gibberish. Those things can be valued."

When growth companies grow too reliant on options, another quandary for managers--and a concern for investors--arises. It is now quite common, should a stock collapse, for companies to lower the purchase price on options already granted to employees, in order to stem a mass exodus of talent. That practice is called "repricing."

"I can't think of anything more irritating from an ethical standpoint than when companies reprice options," says Dennis Beresford. As he notes, while investors who have risked their funds in a company "lose real dollars" when a stock declines, option holders lose nothing and even get a second chance to buy the stock at a better price. Repricing undermines the primary reason for granting options: to reward superior performance.

Repricing, in fact, rewards mediocre and even poor performance. Still, it's common in Silicon Valley because it's about the only tool that managers of a wounded company have left to keep employees from joining a competitor. Beresford recalls meeting some years ago with two dozen contentious chief financial officers of Silicon Valley companies who opposed a proposal by FASB that would force the expensing of options. After a number of them spoke about how vital options were to the fortunes of their companies, Beresford recalls how one participant objected. "He said, 'Let's be honest. Half of us in this room are worth a lot because we have a lot of options and our stock is up. With the other half of us, the stock is under water and our employees are worrying that their options are worthless. They're not thinking about how to make the company perform better."

While repricing may be a hot-button issue for investors in growth companies, the real time bomb is dilution. Pat McGurn, a vice-president at Institutional Shareholder Services, which reviews proxy questions for institutional clients, cautions that the issue could trigger "the battle of battles" between shareholders and management. Dilution becomes an issue as a company's management continues to issue new rounds of options in order to attract and keep talent. Says McGurn, "In Silicon Valley the attitude right now is, 'If I [the CEO] go for a little more dilution each year, my investors won't figure it out."

Dilution becomes a threat when a company's stock rises and employees begin cashing in their profitable options. That increases the shares outstanding and dilutes the stake of existing shareholders, since shares issued by the company through the exercise of options are not sold in exchange for cash at fair market value but are exercised at a discount.

Dick Wagner is the president of Strategic Compensation Research Associates, in New York City, a consulting firm that helps companies design stock-plan proposals. He says that options represent nothing less than "a commission paid to employees by investors out of the future growth of the firm." But what is unknown is whether a company's growth will be robust enough to pay off those future obligations to employees without weakening the financial performance of the company. Options, says Wagner, are long-term and "irrevocable" contracts between company and employee. What happens if a company's earnings slow down and the stock price remains high? One likely scenario: to forestall dilution, the company would have to venture into the market and buy back large blocks of stock as wave after wave of options granted in earlier, more profitable times get exercised.

Which brings us back to Siebel Systems, which, as employee Heather Beach attests, would appear to be a surefire advertisement for the wisdom of stock options. And yet, buried in a footnote in Siebel's latest 10-K filing is the fact that the company has granted options to employees to buy 9.8 million shares at an average purchase price of $6.46. If those options were exercised and the stock was then sold at, say, $40, it would amount to a bonus of almost $330 million--the market price less the strike price, times the number of options granted--paid out to Siebel employees over the next nine years. That's a lot of cash, given that Siebel earned just $12.5 million over the first nine months of 1997. Are investors prepared to think that Siebel's employees are worth it and to pay that bonus by continuing to buy Siebel stock without fear of dilution? Or might they have second thoughts, knowing that Siebel's board has granted the company's management the authority to increase the number of options granted to 20 million?

Insight into how Siebel might fare can be gained by looking at a legendary growth company. Microsoft's stock is now among the most widely held by American investors. But the company has also granted 290 million options--against 1.2 billion shares outstanding. Last year Microsoft spent 91% of its $3.4 billion in net earnings repurchasing 37 million shares to avoid diluting existing shareholders' stock. A closer look at those transactions, according to Dick Wagner, reveals that Microsoft ended up buying back shares on the open market at $84 each, while it had previously sold them to employees via option grants for $13--not exactly a great deal for shareholders.

Meanwhile, as Microsoft was all but vaporizing its hard-earned profits to buy back those 37 million shares last year, it was busy issuing another 45 million shares that employees had exercised through the option plan.

Another curiosity of the accounting system: when companies issue shares to employees exercising their options, the company can take a tax deduction as compensation expense. It's a neat trick--having what starts out as a nonexpensable item, stock options, turn into deductible "compensation," which is, in fact, appreciation in the stock's market price. In its latest fiscal year, Microsoft garnered a $792-million tax deduction for its issuance of shares.

It is axiomatic in the world of finance and investment that if an idea sounds too good to be true, then it probably is. Employee stock options fit that description because they make, in effect, a set of imposing presumptions. Those presumptions include the idea that corporate earnings and share prices will rise steadily, well into the future, and thus it will be an appreciating stock market--not cash from company coffers--that will compensate workers who have taken options and their attendant risks as a substitute for salary.

Meanwhile, since 1985 the total value of options outstanding in U.S. public companies rose 10-fold, from an estimated $60 billion to $600 billion, which leads to a second truism about finance: Those who partake first in a given investment idea reap the largest returns. After that, the rewards diminish until finally the risks exceed them. That process is likely under way now with options, as top executives, who scored big with them earlier in the decade, have begun doling them out to workers. How can something once so closely held retain its value when it's now so broadly cast?

With employee stock options, the period of undue rewards has ended, and the period of intolerable risk is about to begin.

Edward O. Welles is a senior writer at Inc.


Biz 101: How Options Work

  • Employee stock-option programs are typically authorized by a company's board of directors (and have historically been approved by the shareholders) and give the company discretion to award options to employees equal to a certain percentage of the company's shares outstanding.
  • Options give employees the right to buy a certain number of their company's shares at a fixed price for a certain period of time, usually 10 years.
  • That price, usually the market price of the stock on the date the options are granted, is called the "strike price."
  • Options usually begin vesting after one year and vest fully after four years. If an employee leaves the company before his or her options vest, they are canceled.
  • Once an option is vested, the employee can then "exercise" it--that is, purchase from the company the allotted number of shares at the strike price--and then either hold the stock or sell it on the open market.
  • The difference between the strike price and the market price of the shares at the time the option is exercised is the employee's gain in the value of the shares.
  • When the option's strike price exceeds the market price of the stock, the option is technically worthless, or "under water."
  • When the market price of the stock exceeds the strike price of the vested option, the option has value, or is "in the money."
  • When an employee exercises an option, the company must issue a new share of stock that can be publicly traded. While the employee pays the company the strike price for that share, the company's market capitalization grows by the market price of that share.
  • Having more shares outstanding dilutes (or reduces) earnings per share--and thus the value of shares held by investors who already own the stock.
  • To forestall dilution, one of two things must happen: earnings must increase commensurate with the increase in outstanding shares, or the company must repurchase shares on the open market to reduce the number of outstanding shares.

FOCUS ON STOCK OPTIONS




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