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ExecutiveCompensationRevisitingStockOptionsintheCurrentEnvironmentInthe1990s,stockoptionsshiftedfrombeingalong-termnetworthbuildertoashort-termcashgenerator.Therehasbeenmuchspeculationregardinghowstockoptionshavegrownoutofcontrolandwhattodoaboutit.Thebottomline:StockoptionsasLTIsshouldbedesignedtodrivelong-termbehaviorandthussustainedperformance.VIEWPOINTHAYExecutiveCompensationCopyright©2002HayGroup,Inc.Allrightsreserved.TheDebate1HowWeGottoThisPoint3IsanOptionExpenseontheHorizon?5So,WhatDoWeDo?6AboutHayGroup9RevisitingStockOptionsintheCurrentEnvironmentVIEWPOINTHAY1Stockoptionsareaccusedofreinforcing“executivegreed.”TheDebateMuchhasbeensaidandwrittenaboutstockoptionsinrecentmonths.Yeteachpositionhasacounterpoint.Thesideyoutakemaydependonyourmotivesorwhoyourepresent.Themostcommonthemes—andtheircounterpoints—canbesummarizedasfollows:POINT:Stockoptionsaresaidtocauseexecutivestofocusondrivingupthevalueoftheircompany’sstockpriceintheshortterm.Theargumentthengoesontosaythatthisleadsexecutivestomakequestionabledecisionstoinflaterevenuesandunderstateexpensessothattheycancash-inontheoptiongain.Insum,stockoptionsareaccusedofreinforcing“executivegreed.”COUNTERPOINT:Institutionalinvestorsandmoneymanagersdemandnear-termprofitperformance;otherwise,theymayimmediatelypunishthestockbyselling.Theyarefreetodoso,butmostexecutiveoptionshavevestingrestrictionsandtopmanagershaveadditionalconstraintsimposedbytheircompaniesandsecuritieslaws.Inaddition,inthe1990s,anyshort-termmarketweaknesscouldthrowacompanyintoplay.Exactlywhohasthelonger-termfocus?POINT:Stockoptionsarenotaccountedforasanexpensetothebusiness.Oneviewisthatthisomissioninflatesreportedprofitsandtherebymis-leadsinvestors.COUNTERPOINT:DilutionofshareholdervaluebystockoptionsisalreadyaccountedforinFAS128—theso-calledtreasurystockmethod.Thataccountsforoptionsbydilutingthecompany’sreportedearningsperdilutedshare.Also,thepro-formaexpenseimpactofoptionsisalreadydisclosedinthefootnotesofthecompany’sForm10-K.Granted,mostpub-licdataavailablethroughthemediaandanalystsignorethefullydilutedEPS(earningspershare)data.However,sophisticatedinvestorsandmar-ketmakershavealreadydiscountedtheeffectintothetradedshareprices.Inaddition,webelievethatitisfaster,easier,andsafertohavepunditsspeakto“dilutedEPS”thanchangeanentireaccountingstructureandriskeconomicdislocations.VIEWPOINTHAY2Muchofthedilutionfromoptionshascomefrombroaden-ingeligibility,notincreasingtopexecutivegrants.POINT:Asecondaryclaimisthatthe“nocosteffect”ofoptionsallowsboardstomakeexcessivegrantsthatexacerbatethe“greedfactor.”COUNTERPOINT:The“nocosteffect”isafacilitatingfactorforincreas-inggrants,butthemoregermanequestioniswhethertheboardshavemadeexcessivegrantsand,ifso,why.Partofthereasonhadtodowithblindlyusingcompensationsurveys,whichhadaratcheting-upeffect.Also,useofthecommoncompensationphilosophiesof“mediancash”and“75thpercentiletotalcompensation”leadstoveryhighoptiongrants.Thisismoreaproceduralissuethanitisbasedongreed.Inaddition,muchofthedilutionfromoptionshascomefrombroadeningeligibility,notincreasingtopexecutivegrants.POINT:Somepointoutthatgainsfromnonqualifiedstockoptionsresultinataxdeductionforthecompany,althoughthereisnoexpense.Thisissaidtobeunfairtothetaxpayersandwillfurtherencourageexecutivestograntthemselvesmoreoptions.COUNTERPOINT:Thecompanyreceivesthattaxdeductioninthefutureandonlytotheextentthattheexecutivereceivestaxablepersonalincomefromtheoptionexercisetransaction.Sinceexecutivetaxratesaregenerallyhigherthancorporatetaxrates,thetaxpayersgaininthenettransactions.Also,notaxdeductionisavailablewithrespecttoanincen-tivestockoption.Ingeneral,themedia,politicians,and“buyandhold”investorsarecallingfortheendofstockoptions,atleastaswenowknowthem.Thecatalystispopularoutrageattheexecutivesatsomefailedcompaniesandaccountingfrauds.However,itisfairtoask:“IftheDowhadnotplummeted,howmanypeoplewouldcareaboutexecutiveoptions?”Nottoolongagooptionswerecitedasthereasonforthestockmarketboom.Venturecapitalistsandinvestmentbankersrequiredstrongoptionprogramsasaprerequisitefortheiragreeingtoinvestinstart-upsorunderwriteofferings.All-employeeoptionplansallowedstart-uptechnologycompaniestocontrolcashoutlaysandattracttalentthatwouldbeotherwiseunavailable.Whilethedebateisinteresting,itshouldnotbethefoundationofanyreviewofhowacorporationmanagestheuseofstockoptionsinthefuture.StockVIEWPOINTHAY3Stockoptionshavebeenaveryeffectivetoolforlinkingmanagementintereststothoseofshareholders.optionshavebeen,andcancontinuetobe,averyeffectivetoolforlinkingman-agementintereststothoseofshareholders(i.e.,thesuccessandgrowthofthevalueoftheircompany).Anychangetothedesignofstockoptionsandtheiraccounting/regulationshouldbebuiltonanassessmentofhowtomakethemmoreeffectiveatachievingthisgoal.HowWeGottoThisPointTherehasbeenmuchwrittenabouthowstockoptionshavegrownoutofcontrolduetolackofoversightbyboardsandexecutivegreed.Therealityofthecurrentstateofstockoptionsismuchmorecomplex.Stockoptionshavebeenaroundforalongtimeandhavehistoricallynotbeencontroversial.Compa