Stock Options: The Right Way to Go

Despite widespread CEO abuse, option grants can still be a powerful motivational tool for the entire workforce

The debate about stock options is about to flare up again. In February, the Financial Accounting Standards Board will begin hearing comments on a proposal that would require companies to expense options. The following month, London's International Accounting Standards Board will decide whether to require European companies to do the same. This is a prelude to pitched battles that are certain to erupt when the annual-meeting season kicks off in the spring. At more than 130 major companies, investors furious about widespread option abuse plan proxy fights, aiming to curb runaway executive option packages.

But there's nothing wrong with stock options per se, says a new book by Rutgers University professors Joseph R. Blasi and Douglas L. Kruse and

BusinessWeek

Senior Writer Aaron Bernstein. True, top execs have used options to grab extraordinary ownership stakes for themselves, as In the Company of Owners documents with new data. But the authors argue that if companies turned most or all workers into corporate partners with modest option grants, investors and employees alike would gain.

The model the authors point to, which they call "partnership capitalism," has its roots in Silicon Valley, where high-tech companies began granting options to employees in the 1950s. There, they say, reports of a wipeout have been exaggerated. Sure, many workers lost vast paper wealth as high-tech companies stumbled. But what is overlooked is that employees enjoyed huge--and to some degree undeserved--windfalls, and still get new options that motivate commitment and innovation. The authors show how employees today hold an astonishing 19% ownership stake in what they call the High Tech 100, the 100 largest public companies that derive more than half of their sales from the Internet. That's more than the stakes held by these companies' bosses--an unprecedented level of employee ownership.

What's more, the book argues, two decades of evidence demonstrates that widespread employee ownership lifts productivity, profits, and shareholder returns. Here's an excerpt from

In the Company of Owners: The Truth About Stock Options (And Why Every Employee Should Have Them).

PARTNERSHIP CAPITALISM. Since the mid-1980s, most of Corporate America has used stock options to extend ownership to the highest-level executives. At the same time, many companies have experimented with other ways to turn a broader range of employees into owners, including employee stock-ownership plans (ESOPs), 401(k)s, and stock-purchase plans. We found, however, that high-technology companies have granted an exceptional level of ownership to their employees.

To determine just how broadly the high-tech industry has embraced partnership capitalism, we drew up the High Tech 100, which consists of the 100 largest public companies that derive more than half of their sales from the Internet. We measured size by each company's market value as of October, 2000, the date we began the project--in that way including only the viable, post-2000-crash Internet companies.

Our High Tech 100 index allowed us to measure employee ownership, including the future shares to which employees had a claim through stock options, plus the small amount of stock they owned directly. There's no widely accepted term for the combination of stock and options, so we call it "employee equity."

We found that these tech companies had embraced partnership capitalism to an extraordinary degree. On average, employee equity in the High Tech 100--which includes companies such as Amazon.com (AMZN ), Cisco (CSCO ), and eBay (EBAY )--totaled 19% as of Dec. 31, 2000 (charts). This was greater than the 14% held collectively by the top five officers in each company. As far as we can determine, never before has an industry handed over so much potential ownership to a broad cross-section of employees. "Stock options send a message to all employees that they have an impact on the growth of the company," says Frank Marshall, vice-chairman of Covad Communications Group, a High Tech 100 company that provides high-speed Net access. "If you have this caste system where there are hourly workers who don't participate in the equity upside, then you have management that has private dining rooms and stuff like that. It sets up an attitude that some employees are not important."

Creating the index led us to other findings as well. One of the most startling was the inaccuracy of the perception that high-tech employees had been left with nothing when the NASDAQ collapsed. True, High Tech 100 workers--who numbered 177,000 in 2001--lost stupendous paper wealth. We calculated that at the peak of the market, their options would have been worth $175 billion, an average of $1 million per employee. As of July, 2002, they had lost more than $171 billion of that--at least on paper, since options don't require employees to shell out their own money. Yet even so, their remaining options were worth $25,000 per worker.

What's more, we found that High Tech 100 workers took home a total of some $78 billion in gains from all the options they have cashed in since their companies went public. Between 1994 and 1999, they collectively exercised options that gave them $53 billion, or $300,000 apiece. This was not paper wealth but actual cash profits. Many investors may be surprised, and perhaps angered, to hear that employees made billions more even as the market dropped. Because many started at their companies early on, they still held options granted at initial public offering and pre-IPO prices. Even in July, 2002, the stocks of 43 of these companies remained above the IPO levels. As a result, High Tech 100 employees collected $25 billion in 2000 and 2001--an average of some $125,000 each.

Employees deserved only part of all these gains. A significant amount of the $53 billion came because the stock market ballooned to unrealistic heights. Rank-and-file workers who cashed in options on the way up got a huge windfall on top of what they would have earned had high-tech stocks climbed at a more reasonable rate. This came at the expense of dot-conned investors.

For the most part, this option wealth enriched the high-tech workers over and above their regular salaries, which averaged a respectable $70,000 a year in 2000. Since the $78 billion in gains works out to a rough average of $425,000 per worker, partnership capitalism paid these workers an additional six times their annual pay on average.

The High Tech 100's large employee-equity stake is tangible evidence of the industry's commitment to partnership capitalism. Most of these companies were founded by entrepreneurs who dreamed up the business idea and bore the initial risk of putting it into practice. Some put in their own life savings. They got outsize rewards for doing so, which is the traditional way U.S. capitalism is supposed to work.

The break from tradition came when high-tech founders used options to promise their employees more of the company's future wealth than they reserved for themselves. These entrepreneurs embraced substantial dilution of their ownership because they believed in the incentive effect of stock option capitalism. "When you start a company, you own 100% of this pie, which consists of zero at that point," says Naveen Jain, the founder and CEO of InfoSpace Inc., a High Tech 100 software company. "If you can somehow have 10 other people who believe it is their pie, and they want to make their small section of it bigger, that means you are going to have an even bigger pie. So [granting options] is a very selfish thing to do. If my employees work hard for themselves, they are really working hard for me."

THE LUCKY FEW. The high-tech approach contrasts sharply with that taken by most of Corporate America. Employee motivation is a concern shared by most CEOs, but reality belies the rhetoric. Less than 2% involve more than half of their employees in joint decision-making and back it up with an inclusive approach to recruitment, training, and incentives. They do little better when it comes to sharing ownership with employees. Many companies have an ESOP, profit sharing, or incentive plan, but few involve meaningful financial rewards or are integrated into a culture of employee participation.

By contrast, executives lift their own pay to Olympian heights. Ironically, they call on the same justification the high-tech companies use: that ownership spurs them to better performance. Roughly 30% of all options issued by Corporate America are in the hands of the top five executives at each company. Most of the remaining 70% is spread narrowly among other executives and managers, who typically make up less than 5% of traditional companies. We estimate that of the country's 10,000 public companies, only 6% offer most of their workers options on a regular basis. Because many of the companies are small, only 2% of the U.S. workforce gets options every year. This top-heavy approach undermines Corporate America's stated goal of motivating their employees. Corporate leaders want the higher productivity gains an employee-ownership mentality can bring. But they want it on the cheap, without paying for it with the dilution that accompanies a true sharing of property and risk.

At the same time, many CEOs act as if they and a small cadre of executives and managers are the only ones who might be motivated by corporate ownership. Yet there's plenty of evidence that companies perform better when regular employees are owners. Employee ownership lifts a company's productivity by four percentage points and total shareholder returns by two percentage points, according to our analysis of more than 70 economic studies done on the subject in the past two decades. Conversely, there's little proof companies perform better as a result of the gargantuan ownership that executives have claimed for themselves.

To flesh out the stark difference between employee ownership in mainstream Corporate America and high tech, we created an index of traditional companies comparable to the High Tech 100. We call it the Corporate America 100, which we constructed as a representative group of large corporations listed on the New York Stock Exchange. We found that the average large company has granted 8% of its potential ownership to its top five executives (although the share is often smaller in the largest companies). Average employees own a mere 2%, a far cry from the 19% held by High Tech 100 workers. In addition, much of this 2% represents not options, which cost workers nothing, but stock that employees purchase themselves through 401(k)s, ESOPs, and share purchase plans. Corporate America doesn't grant options worth even 1% of its shares to regular workers.

This is employee ownership for the top. Almost everyone else, including most middle managers and professionals, is left out. You can see how much top executives have taken by looking at how their options paid off over the past decade. We calculated that the top five executives at the largest 1,700 U.S. companies collected total gains of $2.4 billion from options they cashed in during 1992. By 2000, they were making $18 billion, an increase of 750%.

These compensation figures are matched by the paper wealth executives have accumulated from the stockpile of options they own but haven't yet cashed in. If all these options had been exercised at once, they would have brought the top five officers a total net gain of $93 billion at the end of 1999, after they had paid the market value for each share. This is a more than tenfold increase from 1992, when the top five held options with a paper value of $7 billion. Contrast that with the same companies' total market value, which climbed by only 350% over this period. Of course, the market crash that followed has made the discrepancies even more glaring.

[The authors updated the wealth data after their book went to press and found that the top five's options were still worth $60 billion as of Dec. 31, 2001--more than an eightfold increase since 1992, despite the market slump.]

It turns out that investors surrendered tremendous ownership to executives with no clear evidence that all of these stock options were judiciously handed out. They've also lost out on the gains they could have reaped if their companies had shared the wealth with average employees and changed their corporate cultures accordingly.

Traditional companies have taken all the lessons about employee participation and ownership that they learned in the past two decades and applied them only to this top layer. There is a better way--to share options more broadly.

Adapted from In the Company of Owners: The Truth About Stock Options (And Why Every Employee Should Have Them) by Joseph Blasi, Douglas Kruse, and Aaron Bernstein. Copyright 2003. Reprinted by arrangement with Basic Books, a member of the Perseus Books Group. All rights reserved.

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