The golden age of stock options is over.
Microsoft Corp., the
quintessential high-tech success story whose stock options turned thousands
of employees into millionaires, sounded the knell Tuesday when it announced
it would stop issuing options and instead begin giving its 50,000 employees
restricted stock. Those shares typically can be sold only in future years
and only if the employee is still at the company.
Microsoft also offered employees the opportunity to sell the nearly
worthless options they already hold, in an unusual arrangement with J.P. Morgan Chase & Co. But in
most cases they'll make far less than what they had once hoped to reap by
exercising them.
The company's decision comes amid mounting pressures on stock options,
long a pay perk for senior executives. More recently companies began doling
them out to rank-and-file employees, making them an iconic trapping of
wealth during the boom of the 1990s. Because options carry the right to buy
stock at a fixed price during a specified period, they have the potential
to create enormous windfalls if the stock goes up.
Today they face a multifront assault. Employees are unhappy because
after three years of stock-market declines many of their options are close
to worthless. A growing chorus of critics argue that they tend to warp
managers' views by emphasizing short-term performance and giving them an
incentive to play accounting games to inflate the stock price.
Federal Reserve Chairman Alan Greenspan last year blamed "poorly
structured" options as a major contributor to the "infectious greed" that
gripped business in the 1990s. "The incentives they created overcame the
good judgment of too many corporate managers," he testified before the
Senate Banking Committee. Investors howled when leaders of companies
including Enron Corp. and Qwest Communications International Inc. reaped
huge gains from exercising options and selling shares just before bad
corporate news broke.
Some investors and regulators are pushing to change the favorable
accounting treatment for options, under which companies aren't required to
show option-based compensation as an expense on their income
statements.
For Microsoft, the move to abolish options signals that the
once-fast-growing tech business is becoming a mature industry. Microsoft
Chief Executive Steve Ballmer said in an interview that grants of
restricted stock will prove more valuable to employees than options at a
time when Microsoft shares are unlikely to rise as rapidly as they did in
the 1990s.
After its initial public offering in 1986, Microsoft stock price soared
as the company turned its control of the standard for personal-computer
software into one of the most lucrative franchises in business history. Its
co-founder Bill Gates became the world's richest man. But following the
slowdown in the PC market, Microsoft's share price dropped from its high of
$59.56, adjusted for stock splits. Microsoft
says that most of the options held by its employees are now "underwater,"
meaning that exercising them wouldn't yield any money.
"It is very important to me that we absolutely have an environment where
we are attracting [talented employees] and our compensation has to be part
of our attraction," said Mr. Ballmer. He said Microsoft employees have been
expressing "angst" about compensation that he thinks "reflects nothing more
than the drop in stock price."
Increasingly Microsoft has come to grips with the possibility that its
soaring share price, and the rich rewards of options, are a thing of the
past. "If you think what happened in the nineties is going to happen again
-- it's not," said Microsoft Chief Financial Officer John Connors. In a
recent interview he described the PC market boom as a "phenomenon" that
"nobody will ever likely repeat."
Compensation experts said Microsoft's move is the latest, and most
significant, in a migration away from stock options. About 216 companies --
including a handful of tech firms -- have announced plans in the last year
to count options as an expense. Dozens of others are switching to
restricted stock.
"It is a watershed moment because of [Microsoft's] size and the size of
their options program," said Brian Foley, managing director of Brian Foley
& Co., a pay-consulting firm in White Plains, N.Y. "When a player of
this size takes an action likes this, it forces other people to rethink
what they should be doing." Mr. Foley thinks that other companies "will do
the same thing because they want a more predictable accounting
expense."
To be sure, options will remain a valuable tool for many companies,
particularly fast growing start-ups that don't have a lot of money to pay
employees.
Microsoft's switch is an outgrowth of a dinner Mr. Ballmer had last year
with executives of J.P. Morgan. Mr. Ballmer's intention was to sell the
bank more software. Instead, he got pitched on the outlines of a new
employee-compensation package. Since then, Mr. Ballmer said, Microsoft has
engaged in months of internal polling and focus groups with employees.
Under the plan, which will start in September, Microsoft says it will
end its employee stock-option program and make all employees eligible to
receive awards of restricted shares, which vest -- and thus can be sold --
over a five-year period.
Microsoft also hopes to help employees realize some value on their
nearly worthless options, by selling them to J.P. Morgan. Employees would
receive cash reflecting the approximate value of the options. Even when an
option is underwater, it still has a value because of the chance the stock
will rise above the exercise price before it expires.
For example, if Microsoft's shares were trading at $25, options with a
specified purchase price (known as the strike price) from $33 to $34 are
expected to be sold for about $1.80 to $2.10 each, according to an e-mail
Mr. Ballmer sent employees Tuesday.
J.P. Morgan declined to elaborate on the structure of the purchase plan,
citing a pending review by the Securities and Exchange Commission and the
Microsoft board. But the bank's private banking division has bought options
held by individual senior executive clients. The deal lets J.P. Morgan do
pioneering business on a large scale with one of America's most coveted
corporate clients.
Microsoft's restricted-stock plan is also unusual; most companies that
issue restricted shares give them to executives, but Microsoft intends to
give them to all rank-and-file workers.
The move could significantly change Microsoft's financial statements.
The company said that in the future it will record an expense for the
restricted stock. It did not immediately offer an estimate of the financial
effect. But in an SEC filing in May, Microsoft said that counting stock
options as an expense would have reduced its net income in the nine months
ended March 31, by a fourth to $6.05 billion from $8.07 billion.
Microsoft's shift away from stock options reflects an astonishingly
quick reversal in public sentiment. Just a few years ago, consultants,
professors, investors and politicians championed options as the ideal
incentive for executives and rank-and-file employees. The idea was that
they aligned staffers' fortunes with those of shareholders. Government tax
and accounting policies helped, by giving companies tax breaks when
employees exercised options and allowing them not to count options as
expenses.
But options have fallen out of favor amid a wave of corporate scandals
and the end of the '90s bull market. The Financial Accounting Standards
Board has been moving toward requiring that options be treated as expenses
in financial statements.
All that has helped fuel the move toward restricted stock. Progressive
Corp., a Mayfield Village, Ohio, auto insurer, this spring began giving 615
top managers restricted shares instead of options. A portion of the
restricted shares received by the 30 top executives are linked to
Progressive's future growth and profitability. The switch "was no big deal"
to investors, who have raised no questions, said Treasurer Tom King.
Some investors complain that restricted stock does less to motivate
workers than a stock option, because the stock is almost always worth
something while an option can easily expire worthless. "Is that pay for
performance?" asks Ann Yerger, deputy director of the Council of
Institutional Investors, which represents more than 130 pension funds, with
more than $3 trillion in assets. She says restricted stock "is a
freebie."
The AFL-CIO has backed shareholder resolutions at six companies that
favored giving executives restricted stock in lieu of options. The labor
unions want the stock linked to performance of the company's shares.
Without the link, one federation official has said, restricted shares are
"pay for pulse."
Seattle Internet retailer Amazon.com Inc. made the switch late last
year. Amazon gives employees fewer restricted shares than it used to
give options, which the company says reduces dilution for other
shareholders.
Others have begun treating stock options as an expense. Online DVD
rental company Netflix Inc. will begin expensing stock options when it
reports its second quarter later this month. Barry McCarthy, chief
financial officer of Netflix, said the company made the change because
regulators and accounting groups were encouraging it and "early adoption
seemed like the best practice."
Mr. McCarthy said Netflix considered moving to restricted stock, but
chose not to because tax rules would require employees to pay taxes on the
shares when they vest, discouraging employees from holding the shares as
long-term investors.
There are still many holdouts, most notably chip giant Intel Corp. and
networking titan Cisco Systems Inc. An Intel spokesman said Microsoft's
plan "in no way affects our resolve, or affects our argument" that treating
stock options as an expense is a bad idea. In the past, Intel Chairman Andy
Grove has defended options as a way to link employees and shareholders.
Mr. Grove and Cisco Chief Executive John Chambers have argued that it
doesn't make sense to treat options as an expense, because companies don't
expend any cash. They argue that financial statements already recognize the
impact of options reduce the ownership stake of existing shareholders and
per-share earnings. Moreover, these executives say, there's no way to
accurately estimate the value of options, so counting them as expenses will
make financial statements less reliable.
The Microsoft move "is not going to have any impact on our coalition
because they remain committed to broad-based stock option plans," said Jeff
Peck, a lobbyist for the International Employee Stock Options Coalition.
Members include more than two dozen companies, such as Intel, Cisco and
AOL/Time Warner Inc.
Stock options have been around since at least the Roaring '20s. After
1950, when Congress liberalized capital-gains-tax treatment on selling
acquired shares, many companies started offering options to executives as
compensation, although they were granted sparingly. They became virtually
irrelevant during the bear market of the late 1960s and early 1970s.
Between 1975 and 1985, however, corporate superstars emerged demanding
superstar pay, which triggered a wave of similar demands by other chiefs.
During the following decade's bull market, the payoff from stock options
surged. To protect themselves against hostile takeovers, many corporate
chiefs sought big stock option grants that matched the equity stakes given
participants in risky buyouts.
In 1986, when Microsoft went public, Chairman Bill Gates offered options
to all full-time employees. During the 1990s, Microsoft shares soared and
thousands of option-rich employees became millionaires. But after Microsoft
shares peaked in December 1999, Mr. Ballmer, who succeeded Mr. Gates as CEO
in 2000, had a morale problem.
Mr. Ballmer arrived at J.P. Morgan Chase's executive dining room at its
Park Avenue headquarters last year expecting to make a sales pitch to three
bank executives, David Coulter, the head of investment banking; Thomas B.
Ketchum, the executive in charge of technology at the bank; and Peter
Engel, who handles the bank's Microsoft account.
The dinner morphed into a brain-storming session about how the two
companies might work more closely together. Stock options came up and Mr.
Ballmer quickly concluded the two companies should talk more.
Over the next few months, Mr. Ballmer said Microsoft considered several
compensation plans, including combinations of options and restricted stock.
The biggest concern, according to a person involved in the discussions, was
how big a change employees could accept.
Employees who hold options will have the choice to keep them or to sell
them to J.P. Morgan for their approximate market value. Microsoft
executives predict that most employees will sell their options.
If that's the case, employees will tacitly be saying that they don't
expect Microsoft's shares to rise the way they did in the 1990s. Still,
executives said, the new plan would offer powerful incentives to recruit
and retain talent. "If you're planning on being here 10 or 15 years this is
a hell of a deal," Mr. Connors said. "You can build a very solid financial
future."
