Beyond Options

However you slice it, the new mix will cost companies more

Every few months, compensation consultant Paula Todd meets with a group of clients from large corporations in the Stamford (Conn.) offices of Towers Perrin. Generally they cover a variety of topics, but on Tuesday, July 15, a week after Microsoft (MSFT ) Corp. announced it would halt issuing stock options in favor of more traditional restricted shares, they were still fixated on the move. "Microsoft is a powerful company with a lot of influence," says Todd. "There is a powerful knee-jerk reaction to follow them."

To follow Microsoft or not. To rein in the use of stock options or not. That's a decision companies across the economic landscape, small and large, high tech and nontech, are heatedly debating. Over 50% of all corporate stock options are currently underwater -- i.e., their strike prices are higher than the price the underlying shares are trading for. That has decimated their usefulness as a tool to retain and motivate employees. At the same time, in reaction to the freewheeling 1990s, there is a growing push to account for options as an expense. And shareholders, still stung by the options-fueled stock packages that made multimillionaires of managers at scandal-rocked companies such as Tyco International, Global Crossing (GBLXQ ), and Enron, are also up in arms.

Put it all together, and there's plenty of impetus for reconsidering the dominant pay incentive of the 1990s. "Options were a very long fad. They had a very long run," says Ford Motor Co. Vice-Chairman Allan Gilmour. "This is the time to rethink how this works going forward." Even many tech companies recognize that options need to be limited. "If you look at high-technology companies, the use of stock options -- it got to be like the nuclear arms race," says Dell Computer (DELL ) Corp. founder and CEO Michael S. Dell. "And it just didn't make sense."

It's a very different picture from the go-go bull market days, when options were handed out like candy. Behind that craze was the conviction at many companies that options were essentially free. Although they dilute shareholders' equity when they're exercised, taking the cost of stock options as an expense against earnings has not been required. That helped keep earnings plump. If options had been expensed in 2002, for example, 23% of the S&P 500's earnings would have been erased. "It was a free resource, and because of that, it was used freely," says Bank One (ONE ) Corp. CEO James Dimon, who has voluntarily begun expensing options. "But now, when you have to expense it, you start to think: 'Is it an effective cost? Is there a better way?"'

If options seemed for a time to be a magic bullet that enriched CEOs, employees, and investors alike, what's coming next will likely be less volatile, possibly less remunerative, and more complex. Pay will increasingly consist of a mix of options, restricted shares, and cash bonuses. And whatever form new compensation perks take, they're likely to be more closely tied to achieving specific operating goals. If options are expensed, companies face "a lot of hard choices," says Blair Jones, an executive-compensation expert at Sibson Consulting.

Moreover, it's not just employees who are looking for a new route to riches after several years of poor stock performance. Investors, no longer able to count on capital gains, are also demanding more secure returns. That, in combination with the reduction in dividend taxes, is forcing more companies to consider upping their dividends. On July 14, Citigroup hiked its meager dividend 75%, by $3 billion annually -- a move many companies are expected to imitate.

The combination means increased financial pressure on companies. Not only will they have to come up with more cash to reward shareholders, but those dividend paying companies that switch to restricted stock will also owe them to employees from the date of the grant. That adds up to more demands on corporate cash -- and less kept in-house to invest in future growth.

Still, going the Microsoft route is neither possible nor preferable for every company. Since the software giant has already decided to expense options, it's likely to save north of $500 million a year in compensation by replacing stock options with more modest amounts of restricted shares. But not every company is armed with a cash hoard of $50 billion and plenty of shares to give away in restricted grants. Given its strong earnings history, Microsoft is also in a better position than many others to move toward a form of stock compensation that will take a chunk out of the bottom line.

Yet there's little question that Microsoft's thunderbolt means executives and boards of directors throughout Corporate America will have to engage in an increasingly public debate over what to do. In response to a story in the Financial Times about board disagreement over expensing options, Sun Microsystems (SUNW ) Inc. issued a statement asserting its commitment to them. At chip-equipment maker Applied Materials (AMAT ) Inc., CEO Michael R. Splinter spoke up for options after his CFO publically called Microsoft's decision to issue restricted stock a bold move that could provide a blueprint for other companies.

Elsewhere, the impact is being debated down the line. Earlier this year, for instance, Dell CFO James M. Schneider sat down with managers of each of the computer maker's business units. He forced them to factor their planned options awards into their individual profit-and-loss projections as if the company were already expensing them. The dramatic effect: This year, Dell will dole out roughly 40 million options -- less than half the 84 million it gave out last year and about a quarter the number it granted in 2000. There is no plan to make up the difference for the rank and file, though Dell added a long-term cash-bonus plan for a handful of top executives.

The danger, of course, is that the pendulum could swing too far the other way. Options may have been overused in the boom, but evidence suggests that smart use of options and other compensation do boost performance. Companies that spread ownership throughout a large portion of their workforce, through any form -- options, Employee Stock Ownership Plans, or other means -- deliver total shareholder returns that are two percentage points higher than at similar companies, according to a review of three decades of academic studies in The Truth About Stock Options, a book on the topic by Joseph Blasi and Douglas Kruse, professors at Rutgers University, and BusinessWeek Senior Writer Aaron Bernstein.

Better stock performance isn't the only benefit. Companies with significant employee ownership do better on a wide range of performance metrics, including productivity, profit margins, and return on equity, according to the studies. By giving restricted stock broadly, Microsoft showed it's still a believer in equity culture. "What Microsoft didn't do when they switched from options to stock is to cut back on who gets equity," says Corey Rosen, executive director of the National Center for Employee Ownership in Oakland, Calif. "They just changed its form."

For companies looking to emulate the huge success of Microsoft over the past 20 years, that's a point well worth taking to heart.

Corrections and Clarifications In the table "Late to the party," which accompanies "Beyond options" (News: Analysis & Commentary, July 28), the percentage change in shares listed for ConocoPhillips, Sysco, Southwest Airlines, Safeco, and Campbell Soup was incorrectly labeled. The change represents the 2002 grant vs. the three-year average grant from 1999 to 2001, not 2002 vs. 2001. The difference at Campbell Soup Co. reflects an unusual spike in 2002 caused by a transition that the company was undergoing in 2001 and 2002, not a shift in its options plan or philosophy. For the past five years, the company has averaged approximately 6 million shares granted per year.

By Nanette Byrnes in New York, with Andrew Park in Dallas, Joseph Weber in Chicago, David Welch in Detroit, and bureau reports

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