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
