Microsoft's Bold New Pay Plan

Turning years of compensation policy upside down, Microsoft Corp. announced on July 8 that it would start issuing restricted stock to its employees instead of doling out stock options. This is a big deal. As Microsoft stock soared during the boom years of the 1990s, such stock options turned thousands of employees into so-called Microsoft millionaires. Restricted stock has much less upside potential. To help with the transition, the company has set up a program to let J.P. Morgan buy back the stock options Microsoft's employees already have been granted. And it will change its accounting procedures to expense the stock options it already issued.

Because of Microsoft's prominence, its actions will have a tremendous impact on the compensation debate nationwide. Many companies already were discussing whether or not stock options were a cost-effective way to motivate employees and top executives. Now, it may be a lot easier for companies to take the plunge and get rid of options. The pressure to cut back on options will intensify after the Financial Accounting Standards Board issues new rules, probably in spring 2004, requiring all companies to count stock options as an expense on their earnings statements, as Microsoft is planning to do.

It's certainly worthwhile for other companies to take a look at Microsoft's example. Restricted stock has the advantage of offering employees more certainty, even if there is less potential for a big win. It also means shareholders don't have to worry about massive dilution after employees exercise big stock gains, as happened in the 1990s. Another plus: Grants of restricted stock are much easier to value than options, since restricted stock is equivalent to a stock transfer at the market price. That improves the transparency of corporate accounting.

Remember, though, that one size doesn't fit all in this case. Just because Microsoft has shifted to using restricted stock doesn't mean that everyone else should follow. Companies have many choices when they set up compensation plans -- bonuses tied to personal or corporate performance, stock options, restricted stock -- and they should use a mix of all of these methods as needed.

For example, it may still be appropriate for many startups to use stock options when they are an essential spur for innovation, especially in Silicon Valley. A big carrot is necessary to persuade the best people to leave good positions at big companies and come to work at risky new businesses. Stock options offer the possibility of getting rich should a new outfit prove to be successful. That's highly motivating.

True or not, stock options are often blamed for some of the 1990s excesses. Many companies used them indiscriminately, jumping on the options bandwagon just because everyone else was doing so. But as Microsoft's announcement points out, management needs to think about the best way to compensate employees, not just follow the crowd.

    Before it's here, it's on the Bloomberg Terminal.