When Stocks Suffer, So Should Options

Companies with sagging shares are creatively repricing options -- which rewards mediocre performance while further burning investors

By Louis Lavelle, with Jay Greene

For months, corporate governance experts have been warning of a wave of stock option repricings, once company execs realize their share prices won't be bouncing back anytime soon. So far, out-and-out repricings have been sparse. But that doesn't mean companies have stopped the practice. Far from it -- they've just come up with new ways to bail out execs. Problem is, these new practices are just as bad for outside shareholders as the simple repricing schemes they replace. In some cases, they're even worse.

Companies know investors despise it when they reprice options. By lowering the exercise price on options, repricings bail out employee shareholders, but leave nonemployee investors twisting in the wind.


  What to do? In recent weeks, companies such as Commerce One (CMRC ), a Pleasanton (Calif.) software company, and i2 Technologies (ITWO ), an e-business company in Dallas, have announced that they'll be offering their employees so-called options exchanges, which allow them to trade in underwater options for new, lower-priced ones six months down the line.

In addition, a recent survey by iQuantic, a San Francisco consulting firm, says many tech companies are actively considering several other alternatives for dealing with underwater options, including granting new options and immediate exchanges as well as traditional repricings. "I think we're already seeing a wave," says Patrick McGurn, director of corporate programs at Institutional Shareholder Services. "It's already on the beach."

The problem is that such gimmicks don't get around many of the problems investors have with repricings. Providing employees with the chance to make a huge equity gain through new, lower-priced options at a time when shareholders have suffered significant losses from stock drops simply isn't fair play.

Such deals raise the same fundamental issue as repricing: Why should employees -- in some cases top executives -- be rewarded for poor performance, at investors' expense? What's more, companies that reprice or immediately exchange old options for new will take a significant charge to earnings. And companies that simply issue new options without canceling old ones will dilute earnings, assuming the stock ever recovers enough for options holders to cash them in. Whichever method is used -- repricings, exchanges, or supplemental option grants -- investors aren't happy.


  Investors have plenty of other reasons to despise options exchanges in particular. Just like straightforward attempts to reprice underwater options, exchanges bail out execs out in a big way, severing the link between pay and performance. That, corporate governance experts say, removes some of the performance incentive options were intended to instill.

Moreover, when an options exchange is set for six months in the future -- a way for companies to circumvent accounting rules requiring them to take a charge to earnings -- employees and executives actually have a disincentive to boost the shares. The more a stock falls over the six-month period of the swap, the cheaper the exercise price and the more valuable the option.

Carol Bowie, director of corporate governance at the Investor Responsibility Research Center, a Washington (D.C.) governance think tank, says investors are becoming increasingly intolerant of such efforts. In fact, according to the IRRC, the number of "no" votes cast for management plans to set aside shares for option plans at Standard & Poor's Super 1,500 companies increased from 3.5% in 1988 to 21.8% in 2000, when 10 such plans failed. "Companies, in many people's eyes, have overused options," says Bowie. "Employees are practically addicted to them. And investors are realizing that's not a beneficial situation."


  Many companies continue to insist that repricings are essential to keep top talent in their ranks. That's why Nx Networks (NXWX ) recently did a traditional repricing, while Amazon.com (AMZN ) chose an option exchange, and RealNetworks (RNWK ) exchanged options over a six-month period. But in today's market, when a performance incentive paid in options can sink underwater in a flash, such offerings have little power to attract or retain employees.

In fact, companies that have tried repricings and exchanges concede that they have had little or no impact on attrition. Gordon B. Hoffstein, CEO of Be Free (BFRE ), a Net marketing company that exchanged options for stock on Jan. 1, says the company had a "slow trickle" of employees leaving before the exchange. And now? "The slow trickle is still there," he says.

There's a better way: When the market is going down, talent can be rewarded with good old-fashioned salaries and bonuses. In a topsy-turvy economy, nothing is quite so attractive as a sure thing. And paying cash is not only fair to employees, it's not dilutive to shareholders.

In a rising stock market, using options to attract and keep employees made sense. But years of double-digit gains have led to a too-easy assumption that employees deserve to rake in big market gains regardless of the impact on outside shareholders. It's time for a reminder that options were intended to reward superior performance, not simply showing up.

Lavelle covers executive compensation for BusinessWeek. Greene is a correspondent in BW's Seattle bureau

Edited by Douglas Harbrecht