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."

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