By Louis Lavelle
They were the crack cocaine of incentives, and for many years U.S. businesses were hooked. The combination of a stock market in overdrive and favorable accounting treatment made stock options a powerful form of compensation that cost companies next to nothing, and they were granted with abandon. But as new rules take effect in June, 2005, requiring companies to treat stock options as an expense, U.S. companies are getting more serious about kicking this habit.
For the third consecutive year, the number of new grants at America's 200 largest companies declined in 2003, with nearly two out of three cutting back. Compensation consultants say the trend continued through 2004 and will accelerate in 2005. "Once you begin expensing options," notes H. Keith Poston, a spokesman for Progress Energy (PGN ), which abandoned options entirely on Jan. 1, "the attractiveness significantly drops."
By reining in options, many companies may be taking the first tentative steps toward curbing both out-of-control executive pay and the era of corporate corruption that it spawned. In the 1990s, executives with huge option stockpiles had an almost irresistible incentive to do whatever it took to goose the stock price and cash in their options. And many did.
Now, with options in decline, the big paydays that marked that decade may slowly be replaced by less excessive remuneration packages. Executives will continue to receive options, but stock outright will be a bigger part of the pay picture.
To curb option grants, companies are using a variety of strategies. Many, like Progress, are replacing some or all of their options with fewer shares of restricted stock. Others are simply reducing option grants, without offering a replacement.
That's the case at Dell (DELL ), which awarded employees 51 million options in 2004, down from 126 million two years earlier. Dell spokesman David Frink says even though most employees are still receiving grants, better-performing and higher-level employees are receiving more. In fiscal 2004, CEO Michael S. Dell received options worth nearly $3 million more than those he was awarded in 2003. Dell is hardly alone in reducing grants overall. Says New York City pay consultant Pearl Meyer: "Without a doubt, the option grants at lower- and middle-management levels are being reduced or discontinued."
Some companies are making sure executives bear at least part of the pain. The biggest targets are two of the most egregious executive pay practices now on the books: so-called mega-grants of options worth more than $10 million and evergreen provisions that replace options as executives exercise them. According to Pearl Meyer & Co., 92 of the 200 largest companies reported awarding mega-grants in 2004, down from 130 in 2002, while five companies reported eliminating evergreen provisions in 2004, leaving only 22 companies still using them.
Fears that expensing would cut deeply into the bottom line have proven somewhat overblown. For companies in the Standard & Poor's 500-stock index, Bear Stearns (BSC ) says option expensing would have reduced net income from continuing operations by 3% in 2004, from an 8% drop in 2003, in part reflecting an improved earnings picture last year. With many companies taking aggressive steps to reduce option grants or the accounting expense associated with them, the impact of options on the bottom line is expected to keep shrinking in 2005.
In the tech world, however, where broad-based option programs are the rule, a more severe bottom-line impact is expected. In 2003, expensing would have reduced operating income by 44% among the Nasdaq 100 companies.
By far the most popular method for reducing option grants is replacing a portion of the grant with restricted stock. The advantages are clear. Unlike options, stock can never become completely worthless. And under mandatory expensing, companies will incur no cost for stock grants that never vest because an employee quits or a company fails to hit performance targets.
What's more, since stock is worth more than options when it's granted, companies can award fewer shares, allowing them to reduce sky-high dilution rates, which have concerned institutional investors for years.
The simple substitution can work wonders for a company's option program. General Electric (GE ), for example, has trimmed its equity grants from 47 million shares in 2002 to 38 million in 2003 by replacing 60% of its option grants with restricted stock.
Cendant (CD ), which started expensing voluntarily in 2003, has gone even further. An employee who used to receive an option grant worth $1,000 now receives about $550 worth of stock -- but only if the company hits financial targets. That, and CEO Henry Silverman's decision to forgo options starting in 2002, has helped Cendant cut its equity grants from 59 million options in 2001 to just 1 million options and 12 million shares of restricted stock in 2003.
Rank-and-file workers aren't the only ones feeling the options pinch. So are CEOs, if one considers slightly less massive option grants a hardship. At Sun Microsystems (SUNW ), which has posted losses of $4.4 billion over the last three years, CEO Scott G. McNealy received 3.5 million options in 2002, followed by a relatively paltry 1 million in 2003 and 1.5 million in 2004 -- even though the entire 2002 mega-grant is worthless.
The growth of option stockpiles -- and future option payouts -- is slowing somewhat at AT&T (T ), BellSouth (BLS ), ChevronTexaco (CVX ), and Xerox (XRX ). Those companies have eliminated evergreen provisions.
When the new expensing rules take effect -- barring any last-minute congressional intervention -- option-reduction strategies like these will become more widespread as companies search for ways to reward talent without breaking the bank. The good news for companies: They have plenty of alternatives to choose from, and it's not quite as difficult as it looks. And the positive impact on corporate behavior, while hard to measure, should benefit investors in years to come.
Lavelle is Management editor for BusinessWeek in New York
Edited by Beth Belton