> [From 1994-1998,] a staggering 4 billion shares [in stock options] were
> granted [to employees of Nasdaq 100 companies], worth $220 billion at
> recent prices. That amounts to roughly 9 percent of the market value
> of the entire NASDAQ 100 index. "This is an avalanche-in-waiting."
> ...
> Giving options in lieu of cash keeps employee costs down and helps
> financially strapped start-ups. But when stock prices no longer rise,
> companies will be forced to pay more in cash to workers, driving up
> costs.
This follows on the heals of an Economist cover story from August 7, 1999:
> Microsoft, the world's most valuable company, declared a
> profit of $4.5 billion in 1998; when the cost of options awarded that
> year, plus the change in the value of outstanding options, is deducted,
> the firm made a loss of $18 billion, according to Smithers.
This is a problem just waiting to happen at everywhere from Microsoft
and Cisco to every Internet startup in existence, isn't it?
A sampling of "high flying" companies sorted by market cap:
Microsoft (MSFT) -- price: 84 11/16 -- market cap: $432b -- trailing PE: 60
Gen Electric (GE) -- price: 107 3/4 -- market cap: $353b -- PE: 36
Intel (INTC) -- price: 79 3/4 -- market cap: $264b -- PE: 38
IBM (IBM) -- price: 123 3/8 -- market cap: $224b -- PE: 31
Cisco (CSCO) -- price: 63 9/16 -- market cap: $206b -- PE: 103
Lucent (LU) -- price: 65 7/8 -- market cap: $200b -- PE: 92
Hewlett Packard (HWP) -- price: 106 -- market cap: $107b -- PE: 35
AOL (AOL) -- price: 96 7/8 -- market cap: $105b -- PE: 161
Dell (DELL) -- price: 41 7/16 -- market cap: $105b -- PE: 71
Nokia (NOK) -- price: 85 3/4 -- market cap: $98.3b -- PE: 41
Ericsson (ERICY) -- price: 31 3/8 -- market cap: $61.2b -- PE: 46
Motorola (MOT) -- price: 93 -- market cap: $56.4b -- PE: 101
Yahoo (YHOO) -- price: 132 13/16 -- market cap: $33.8b -- PE: 886
Qualcomm (QCOM) -- price: 160 -- market cap: $25.6b -- PE: 235
Amazon (AMZN) -- price: 97 7/16 -- market cap: $15.7b -- PE: not applicable
Athome (ATHM) -- price: 37 -- market cap: $13.5b -- PE: N/A
eBay (EBAY) -- price: 98 -- market cap: $12.2b -- PE: 9800
Broadcom (BRCM) -- price: 120 1/16 -- market cap: $11.1b -- PE: 267
Juniper (JNPR) -- price: 213 3/4 -- market cap: $10.6b -- PE: N/A
Priceline (PCLN) -- price: 66 1/2 -- market cap: $9.4b -- PE: N/A
Apple Computer (AAPL) -- price: 60 1/16 -- market cap: $8.2b -- PE: 16
CMGi (CMGI) -- price: 81 1/2 -- market cap: $7.8b -- PE: 240
JDS Uniphase (JDSU) -- price: 97 1/16 -- market cap: $7.8b -- PE: N/A
Connexant (CNXT) -- price: 66 11/16 -- market cap: $6.4b -- PE: N/A
VISX (VISX) -- price: 95 1/2 -- market cap: $6b -- PE: 87
Red Hat Software (RHAT) -- price: 85 1/4 -- market cap: $5.7b -- PE: 2131
Redback (RBAK) -- price: 220 -- market cap: $4.6b -- PE: N/A
Brocade (BRCD) -- price: 152 1/4 -- market cap: $3.9b -- PE: N/A
QLogic (QLGC) -- price: 76 1/16 -- market cap: $2.7b -- PE: 88
Emulex (EMLX) -- price: 105 3/4 -- market cap: $863m -- PE: 141
and for Pokemon fans...
4Kids (KIDE) -- price: 50 1/4 -- market cap: $269m -- PE: 81
Anyway, here are the options articles...
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NEW YORK -- Even though the NASDAQ composite index rallied late last
week, it is down 8 percent from its July 16 high, close to the 10
percent drop that Wall Street considers a correction.
These stocks deserve a rest. At its peak, the NASDAQ was up 31 percent
this year, compared with the 22 percent rise in the Dow at its high and
the 15.4 percent increase in the Standard & Poor's 500-stock index.
But the NASDAQ has dropped further than the other indexes, raising a
troubling issue that was hidden as the market rose: Hanging over the
market are an immense number of shares in big NASDAQ stocks, including
top technology companies, in the form of option grants awarded to
executives and employees.
Companies of all kinds have issued oceans of options in recent years. As
long as stocks were rising, option holders hesitated to exercise them,
waiting for even further gains. Now, with many stocks -- especially
NASDAQ stocks -- well off their highs, transforming paper profits into
real gains is mighty tempting.
How big is the overhang? Bob Gabele, director of insider research at
First Call/Thomson Financial, calculated all the option grants made by
companies in the NASDAQ 100 stock index from 1994 to 1998. A staggering
4 billion shares were granted, worth $220 billion at recent prices. That
amounts to roughly 9 percent of the market value of the entire NASDAQ
100 index.
"This is an avalanche-in-waiting," said Baruch Lev, professor of
accounting and finance at New York University's Stern School of
Business. "And this avalanche may fall at the worst time of all."
If the market slows or a recession hits, expectations for these shares
will fall, Lev said. Employees who can exercise their options and sell
shares will do so, thereby depressing an already declining market.
An option grant is exercisable only if its so-called strike price is
lower than the prevailing market price. But given the hefty gains
registered by NASDAQ every year since 1994 -- the index is up almost
sixfold -- most option grants are exercisable now.
Cisco Systems said in its 1998 annual report that the average strike
price of its option grants -- 1.562 billion shares -- was $25.23. Cisco
stock closed Friday at $63.5625.
Companies report their option grants in the footnotes to their financial
statements. To calculate the overhang, take the number of shares
provided for in those grants and divide it into the total shares the
company has outstanding.
It doesn't take much of a fall in stock prices to make option holders
itchy, said Steven E. Hall, managing director at Pearl Meyer & Partners,
a compensation consulting firm. When stocks plunged last fall, Hall
said, "everybody got stomachaches looking at their stocks. All of a
sudden people started saying, 'Maybe I don't want as much of my pay in
stock."'
Studying the effect of declining stock prices on option grants at 60
companies, Hall found that a 15 percent drop in stock price translated
to a 25 percent decrease in the value of options held by chief
executives.
Corporate America's love affair with options worked well as stocks rose.
Giving options in lieu of cash keeps employee costs down and helps
financially strapped start-ups. But when stock prices no longer rise,
companies will be forced to pay more in cash to workers, driving up
costs.
Lev points to another concern about an options avalanche. "Firms in the
last four to five years increased debt significantly, mainly to
repurchase stock so they can provide it to managers and employees," he
said. "So debt is very high, the market slows down, people are dumping
their shares. There is a significant risk here."
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ONCE upon an Arabian night, sultans were paid their weight in gold.
Today, such an approach to pay would leave the typical boss of a large
American company sorely disappointed. Bosses now prefer to be paid in
share options, which are far more valuable than mere metal. Tipping the
scales -- let's be kind, and ignore those boardroom lunches -- at around
200 pounds, and with gold now at about $258 a troy ounce, the average
chief executive of one of America's top 200 firms would take home just
over $750,000 in gold. In fact, in 1998 he made a pre-tax profit of
$8.3m by exercising executive share options, which give the right to buy
a fixed number of his company's shares at a fixed price in what is now a
rising market. At the end of last year, he also had total unrealised
profits on stock options of nearly $50m.
Inevitably, such gigantic sums have provoked envy. AFL-CIO, the main
American trades-union federation, points out that, thanks largely to
share options, the average American chief executive now takes home 419
times the wage of the average factory worker. In 1980, he made 42 times
as much.
But put to one side questions of justice and inequality. Force down the
thought that the chief executive's enormous share options may demoralise
the deputy chief executive and make the company harder to manage. Ignore
the bleating bondholder, who sees his risk rise as companies borrow to
buy back shares to give to executives. The fundamental question is
whether share-option schemes are doing what they were designed to do:
aligning the interests of managers with those of owners, motivating
bosses to do their level best by shareholders.
Are share options working? Are other shareholders seeing gains from
handing over so much equity to their managers? Or are bosses receiving
the largest peacetime transfer of wealth in history simply for being in
the right job at the right time -- namely, during America's strongest
equity bull market ever? Indeed, could share options be encouraging
bosses to behave in ways that are contributing to a bubble in share
prices which, should it pop, will leave everyone worse off?
Options, options everywhere
Share-option awards to company bosses have grown at a breathtaking pace
in America. (They have increased in other countries too, but even in
Britain and France they are tiny next to America's.)
The 200 largest American companies granted shares and share options to
employees amounting to 2% of their outstanding equity during the year to
June 1998, according to Pearl Meyer & Partners, an executive-
compensation consultancy. When these awards are added to those made in
previous years, the total of shares and share options still "live" in
incentive schemes at the end of 1998 amounted to 13.2% of corporate
equity, or around $1.1 trillion (see ). As recently as 1989, annual
awards totalled about 1% of company shares, and all accumulated awards
were 6.9%. Now, almost every big firm uses equity as a management
incentive, up from around half ten years ago.
For some companies, the picture is even more dramatic. Last year, Apple
Computer granted shares and options equal to nearly 18% of its total
shares, Pacificare Health Systems made grants of 13% and Lehman Brothers
awarded almost 12%. Lehman's total outstanding equity allocations to
executives and other employees amount to over half its shares. Only
Merrill Lynch, another Wall Street giant, has committed a higher
proportion of its shares to equity incentives: nearly 53%. Fifteen of
America's largest 200 companies have set aside more than a quarter of
the shares they usually have outstanding.
While share options for lower-ranking employees have also grown quickly,
most of the value goes to a handful of top managers. Chief executives
have extended their lead, thanks to the birth of the "mega-option".
These are options which, if used, would be worth at least $10m. In 1998,
92 of America's 200 leading chief executives (up from 34 in 1996) were
given mega-options, with an average minimum value if exercised of $31m.
Using the formula to value options that was developed by Fischer Black
and Myron Scholes, share-option grants accounted for a record 53.3% of
the compensation given by America's top 100 companies in 1998 to their
chief executives. This compares with 26% in 1994, and a mere 2% in the
mid-1980s.
To some, these statistics are grounds for celebration. Starting in the
1960s, there was growing concern that the split between those who owned
big firms and those who ran them might be hurting the economy.
Shareholders in public companies mostly had small stakes in each, and
thus little ability to restrain managers from furthering their own
interests, the argument ran. A thirst for power might lead bosses to
pursue takeovers that expanded their empires but reduced the value of
shareholdes' stakes; a hunger for status might encourage them to build
grandiose headquarters or fleets of executive jets.
Some economists argued that the solution was to make owners and managers
as much alike as possible by paying a large part of the managers'
remuneration in shares. Unlike most of economists' bright ideas, this
one spread, though only gradually during the 1980s before taking off in
the 1990s. Those urging better corporate governance supported it, and
the bull market in shares convinced bosses of the potential benefits of
this incentive to better performance.
At first glance, it has paid off handsomely. As executive share options
and other share schemes have soared in America during the 1990s, so too
have corporate profits and share prices. In 1998, the profits of
companies in the S&P 500 share index were double what they had been in
1990. The index is now nearly four times higher than it was at the start
of the decade. Surely, such spectacular gains justify paying bosses a
fortune?
Alas, the relationship among these three trends is not the simple
cause-and-effect that some economists and executive-pay consultants
suggest. And the trends themselves are not all they are cracked up to
be.
Only perform
First, it is hard to tell whether profits have, in fact, risen all that
much, for the cost of most executive share-option schemes is not fully
reflected in company profit-and-loss accounts. Attempts by the Financial
Accounting Standards Board ( FASB ) to require firms to set the cost of
options against profits were killed by corporate lobbyists in 1995. They
argued that if the cost of option schemes were treated in that way,
fewer of them would be awarded, fewer people would have reason to
maximise shareholder value and the economy would suffer.
FASB did, however, manage to make firms include a footnote in their
accounts detailing the share options awarded during the year. Smithers &
Co., a research firm in London, calculated the cost of these footnoted
options and concluded that the American companies granting them
overstated their profits by as much as half in the financial year ending
in 1998. In some cases, particularly that of high-tech firms (which tend
to be generous with options), the disparity is even greater. For
instance, Microsoft, the world's most valuable company, declared a
profit of $4.5 billion in 1998; when the cost of options awarded that
year, plus the change in the value of outstanding options, is deducted,
the firm made a loss of $18 billion, according to Smithers.
Some maintain that these numbers exaggerate the problem: there is
genuine dispute over how best to calculate and account for the cost of
executive options. But this is quibbling. Warren Buffett, a well-known
American investor, put the case succinctly for tightening the rules on
share-option schemes in the recent annual report of his investment
company, Berkshire Hathaway, "Accounting principles offer management a
choice: pay employees in one form and count the cost, or pay them in
another form and ignore the cost. Small wonder then that the use of
options has mushroomed," he observes. "If options aren't a form of
compensation, what are they? If compensation isn't an expense, what is
it? And, if expenses shouldn't go into the calculation of earnings,
where in the world should they go?"
Bubble trouble
So much for profits. What of share prices? The price of an equity, in
theory, reflects the profits that are expected in future. If reported
profits have been overstated, investors may have overestimated future
profits when valuing shares, and paid too much for them.
Most economists reckon that investors are not impressed by accounting
twists and turns. Numerous studies have shown that the market usually
responds only to "real" events. For instance, share prices were not
affected when FASB recently required firms to account for health-care
benefits for workers after retirement, a change that looked huge but
made no difference to their real liabilities. Options are a real
economic cost, and investors take that cost into account each time
options are granted.
Now, they have no excuse not to do so; but was this always the case? In
the mid-1990s, when the use of share options soared, the accounting
problem received little attention. In 1996, for example, headlines in
the financial press were full of rising corporate profits in America;
yet, says Andrew Smithers of the eponymous research firm, if the cost of
share-option schemes had been properly accounted for, it would have been
clear that corporate profits had fallen from the previous year. This, he
suggests, was the point at which a stockmarket bubble began to expand
that has yet to pop.
There are other ways, too, in which share-option schemes may have helped
to nudge share prices upwards. Companies are buying back their shares in
the market in order for employees to exercise their options. In 1998,
firms announced repurchases of $220 billion-worth of shares, compared
with only $20 billion-worth in 1991. At the same time, they are
borrowing more. Indeed, although net new issues have picked up a bit of
late, many companies are still borrowing to buy back their own shares.
This seems strange at a time when shares are more expensive than ever
before, and interest rates, though low in nominal terms, are high in
real terms. Surely, it would make more sense to raise money by selling
shares at current high prices -- which is what bright investment bankers
at Goldman Sachs have done in floating their firm and some other
companies appear to be doing as well.
A recent study of share repurchases by George Fenn and Nellie Liang, of
the Federal Reserve, found that much of the recent surge in buy-backs
reflects an attempt to return cash to shareholders in a way that raises
the value of executive stock options more directly than a simple
increase in the dividend would do. Others see the buy-backs in a more
sinister light. They say that companies often buy their own shares
aggressively at times when the market looks about to tumble, thus
helping to reverse its direction.
Perhaps this is all as it should be: managers spotting the chance to
bolster their firm's share price and return cash to shareholders. On the
other hand, managers with share options may be using their firm's
resources to increase the short-term value of their own holdings. And
that sounds suspiciously like the sort of abuse that many reckon went on
before share options supposedly aligned bosses' interests with those of
owners.
Though corporate profits may be duller than billed, and share prices a
touch hyped, what of the claim that managers, thanks to the incentive of
shares and share options, are working harder for shareholders?
All shall have prizes
It is hard to argue convincingly that most firms' improving fortunes in
recent years are down to the efforts of managers as individuals or as a
group. The American economy recovered from recession, interest rates
were low, inflationary pressures were dormant, spending was strong
because consumer confidence was high (due partly, it must be admitted,
to high share prices). All these things were beyond the control of
corporate bosses.
Nor does the link between executive performance and pay look rock-solid.
Many top managers have got rich simply because their company's share
prices rose in line with the market. A recent study by Kevin Murphy, one
of the first economists to argue for paying bosses with shares,
concludes that "there is surprisingly little direct evidence that higher
pay-performance sensitivities lead to higher stock performance."
It is possible, of course, that share options encouraged most companies
to become more profitable, and so some of the rise in the market as a
whole reflected the additional efforts of the market as a whole. But
American firms have mostly run a mile from share options designed to
reward market-beating or above-average performance. One powerful reason
for this is accounting rules. The cost of granting an option with a
performance benchmark (one that specifies, for example, that a company's
share price must outperform the average in that industry before its
bosses collect) must be set against profits, unlike the cost of pure
options.
One of the few firms to use rigorous performance-related options is
Level 3 Communications. Its bosses cannot cash in their options unless
its share price rises by more than the S&P 500 ; they then receive a
rapidly sweetening deal as the gap widens.
Graef Crystal, an economist who specialises in executive pay, has
calculated the impact a similar scheme would have had on all the S&P 500
companies between 1995 and 1998. Under a conventional option plan, 86%
of chief executives would have received an average of $8m apiece over
the period. With a scheme similar to that at Level 3, only 32% of them
would have received a dime.
An indication of how little executives like having to perform for their
money is the frequency with which share options are repriced when the
firm's share price tumbles below the strike price originally agreed.
When share prices plunged in the late summer of 1998, many firms
repriced their options just in time to enjoy massive gains when the
market rebounded. James Record, an analyst with SNL Securities, a
research firm, found that 17 financial-services firms lowered their
strike prices last autumn, by one-third on average; since then, their
share prices have, on average, trebled.
Many Internet companies, their shares now fallen by half from their
recent highs, are considering repricing their share options. They may be
less lucky than their predecessors: FASB has changed the rules and, from
later this year, the cost of repriced options must be written off
against profits in the company accounts. Even properly accounted for,
however, the fact that firms reprice manager's options reduces to
nonsense the comparison of bosses with owners, who cannot write off
downside risk so blithely.
The aim of share options is to increase the executive's exposure to the
undiversified risk of his firm's shares, so that he faces personal
financial hardship if its share price falls. Do these schemes really
bind managers to their firms' fortunes?
Managers cannot sell their shares too quickly, for fear of panicking the
market. But the number of executives selling is higher than before,
according to Craig Columbus of Primark, a firm that tracks such
share-trading. It is becoming the norm for bosses to sell a parcel of
shares every quarter. And some figures suggest that top executives may
be getting quietly out of the market while ordinary employees are keener
than ever on entering it: though grants of shares and share options rose
to a record level in 1998, the overall stock of shares in company
incentive schemes did not, for the first year in over a decade. Since
share options for lower-level employees have grown rapidly, it seems
that their bosses may be reducing their stakes.
There are other ways, too, for managers to weaken the link between
personal and corporate financial health. They may diversify their risk
by holding a portfolio of different assets -- if they have enough cash.
Derivatives offer another route. In the early 1970s, when executive
share options promised so much, financial derivatives were in their
infancy. Now, according to a study from Arizona State University,
executives are making increasing use of them to escape restrictions on
exercising or selling their share options, especially when they know
that bad news about their firm is pending. The rules governing the
disclosure of such trades are ambiguous. Certainly, they are a
fast-growing business for Wall Street investment banks.
Other options
It is possible that the problem of share options will sort itself out.
If there is a share-price bubble, it will one day burst. If there is
not, share prices are unlikely to keep rising so quickly in any event.
Bosses' pay should fall to less audacious levels either way.
Even so, there needs to be much harder thinking about what to reward,
and how much. Nell Minnow of LENS, an investment fund, now wishes that
in the early 1990s, "when we asked for pay for performance, we'd been a
lot more specific." A few more customised options with specific targets
have recently appeared, though most of them, admittedly, accompany
bigger-than-ever mega-options.
That leaves the question of how large the share component of a salary
package needs to be in order to motivate its recipient. Would current
pay-outs be less inspirational if they were half as big? Experience has
shown that it is impossible fully to align the interests of managers
with those of shareholders anyway. So why go so far down that road?
Ultimately, reforming executive pay in ways that encourage genuinely
superior performance depends on two groups: institutional investors and
auditing bodies. Big pension funds and insurers have the clout to make
compensation committees be tough. So far they have barely used it. And
accountants must create a level playing-field for all executive
compensation. It is absurd that different kinds of share-option schemes
have different accounting rules, and worse than absurd that most schemes
are not written off against profits like ordinary pay. Investors and
auditors may both be more willing to lay down the law in an earthbound
stockmarket than in a perpetually rising one. It would certainly be the
right option.
----
adam@cs.caltech.edu
Real human wealth, in the form of security, freedom, productivity, and
knowledge, is scarcely captured by unexercised stock options. There are
no line items that gauge the real engines of prosperity: vision,
passion, and commitment. The plain truth is you cannot suck reality
from the hypnotic glow of a vacuum tube.
-- Jerry Kaplan, _Startup_