Options: "Probably the Worst Incentive"

Compensation pro Matt Ward on why this popular benefit is so bad -- and what would work much better

Big changes are afoot in incentive compensation. Last month the Financial Accounting Standards Board voted to draft new rules requiring stock options, the incentive tool of choice especially for technology companies, to be counted as an expense on the income statement. That's likely to spur a number of new incentive pay methods, according to Matt Ward, chief executive of WestWard Pay Strategies, a compensation consulting firm in San Francisco.

Ward, who works with many tech outfits, says companies are still hoping to avoid having to expense options. But he says they need to look at alternatives now, and he has strong views about what works best. In a recent conversation with BusinessWeek's Silicon Valley Bureau Chief Robert D. Hof, Ward talked about the best pay options beyond options if expensing is required sometime next year, as many people expect. Here are edited excerpts from that interview:

Q: Is this a big issue for companies yet?


I met recently with a huge tech company. When I said they probably wouldn't want to use nearly as many options anymore, I had to use electroshock therapy to revive the founder. But we certainly should not be thinking it's the end of the world. It'll be a different world.

Q: What's the problem with stock options?


The problem with the stock option is that it's prevalent because of its favorable financial characteristics. A lot of money comes into the company [from employees exercising options and buying the stock from the company], and there's no reduction of earnings.

Once the option has an expense, you have to look at it, and say: "What have you done lately for me as an incentive?" Clearly, in our toolbox, options are probably the worst incentive. It's entirely tied to the vagaries of the market. An individual or a company could be doing a great job, and the options are worthless on any given day.

And vice-versa, people weren't necessarily doing that great a job, and yet these things were extremely valuable. That's just perverse. The ideal incentive is when you achieve good results, you get compensated well for it.

Q: You come out strongly for performance shares, which is stock granted only if certain performance goals are met. Why do you like them?


You use a lot less shares than with options. So you'd cut way back on dilution, so shareholders aren't angry with you. Performance shares don't go underwater [lose value when they fall below the current stock price]. Employees in Silicon Valley would like that very much.

And you've got folks tied to the performance of the company stock as part of their compensation. This is a way to address all of the negatives of options. Over the long term, it could deliver as much or more opportunity as options for people who perform well, because you're just not going to see the market returns we had.

But most of all, you can actually have fun doing compensation, much more so than with options, because you can start putting some performance contingencies in front of people that make real sense for what they do -- like for a software company, meeting milestones on development.

Q: Other compensation experts favor restricted stock, which converts to common shares over several years but isn't tied to performance goals besides the stock price. How do you view them?


They vest based only on continued employment. What that equals is bad compensation. I call it the "lay low" incentive. Don't rock the boat, and in three years, you'll get it. We don't want people like that. We want people motivated to do something. Especially for senior executives, it's ridiculous.

Q: (AMZN ) last year replaced its options program with restricted stock, figuring it would better make employees feel like owners (see BW Online, 4/3/03, "Stock Options Aren't the Only Option").


Yeah, well, great. Amazon has tried everything. They'll try something else in two months. It doesn't cost you any more to put a performance measure on it. Why in the world wouldn't you do that? If I was a shareholder, I'd be outraged by [a restricted stock plan].

Q: Any downside to performance shares?


The biggest downside to performance shares is the company's ability to look out and set goals. I could see maybe transitioning...maybe starting out with restricted stock for most employees, and use performance shares at the top to get some experience in goal-setting. Then, as you get better at goal-setting, roll the performance goals down to the employees. Particularly in the tech sector, a lot of companies don't have much experience in goal-setting.

Q: What goals do you recommend?


Usually some sort of balanced approach -- growing revenue or market share, and doing so profitably. How you measure profit is a function of your own culture: If it's not a household word, don't tie performance measurement to it. So if you're a company that does, say, earnings before interest, taxes, depreciation, and amortization, go with that. The purest form of measuring performance is revenue growth against operating margin, particularly for tech firms. And at the end of the day, there's the stock price.

Q: Are options going to be used at all if they must be expensed?


If you keep some options as part of the total package, in the event that you're one of the lucky companies that hits the cover off the ball, there's some major upside for people.

Q: One big upside of stock options is that they gave at least some rank-and-file employees literal ownership in the company. Isn't that a good thing?


Some people at companies think that employees having an ownership interest in their companies is a bad thing. I'm starting to hear, "Oh, this is a mistake. Let's go back to the time when everybody worked 9 to 5." I don't think that's what we want out here [in Silicon Valley].

Q: So there's a danger that incentive pay won't be used broadly anymore?


The culture of broad-based stock is very much at risk. A lot of people at the top are saying, "People don't appreciate them anyway, let's just get rid of them."

I'm fearful many might do that. I'm hearing them worry more about protecting their executives at the expense of the egalitarian culture that built Silicon Valley. No one is speaking up for that. If the companies do that, they'll never return to egalitarianism. That will kill something really special.

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