Stock option backlash

Stock option backlash – Industry Trend or Event

Vincent Ryan

To re-price or not to re-price? Granting stock options is a valuable compensation tool for recruiting and retaining employees – or at least that’s the idea many telecom executives have embraced lately.

Stock options let employees purchase shares at a given price for a specified period of time. In the go-go stage of Internet startups, they were all the rage, and the stories of administrative assistants becoming millionaires from option windfalls stoked employees’ lust for equity participation.

Now many telecom companies, desperate to retain employees, are waking up to the idea of issuing stock options to a broader base of workers:

– In early September, Qwest Communications announced a program under which all nonunion workers – about 30,000 people – would receive 200 stock options, and all employees would have the opportunity to purchase company stock at a discounted price. “We wanted to make them feel more like owners of the company,” said a Qwest spokesman.

– Fresh from the Bell Atlantic/GTE merger, Verizon Communications announced a onetime “founders grant” that gives the entire roster of 210,000 employees between 100 and 700 stock options each. The options are priced at about $43 apiece and vest after three years.

– To boost morale and stanch employee defections as its stock plummets, Lucent Technologies announced an “aggressive effort” to grant more stock options to middle managers and clerical workers and changed its cash bonus plan from yearly to quarterly.

However, the volatility of the stock markets poses a problem to many companies whose stocks have tanked, leaving employees with options that are worthless – “out of the money” or “underwater” in market parlance. So telecom companies face substantial risk in issuing stock options, especially when they do so to a broad employee base.

“Everyone wants them because they think they are a quick road to wealth,” said Anna Tapling, vice president in the executive compensation practice for The Hay Group. “But not all stocks move in that manner.”

As a solution to the problem of under-water options, early on many Internet companies “re-priced” their options – lowered the strike price (the price per share placed on the options) to below the stock’s current trading price – so employees would remain motivated and not flee to a competitor. But a 1998 ruling by the Financial Accounting Standards Board, or FASB, designed to discourage the practice, requires companies to take an expense hit if they do so. The rule removes favorable accounting of options if a company re-issues options within six months of the time options of comparable value are canceled.

Re-pricing also risks alienating shareholders, who also may have a “paper loss” in the stock, because it doesn’t hold option holders accountable for the company’s performance.

“It gives the option holder a benefit shareholders don’t get,” said Karin Estes, director of special projects for Institutional Shareholder Services.

In October, Sprint devised a repricing plan that raised some eyebrows because it could be construed as an attempt to circumvent the FASB rules. The carrier said that all executives and employees, except CEO William Esrey and Chief Operating Officer Ronald LeMay, could choose to cancel the options they received in 2000 in exchange for replacement options.

Option holders must cancel by Nov. 10, and the strike price of the new options would be the market price of Sprint stock on May 11, 2001, six months and a day after the old options are cancelled. The move affects 28,000 employees and covers options for 17.8 million shares of Sprint stock at an average exercise price of $59.15. Sprint stock recently traded in the low $20 range, less than one-third its 52-week high of $75.94.

The move does not constitute a repricing, and the original options were awarded at a time when the stock was at a “huge premium” based on the proposed WorldCom merger, which subsequently was blocked by the federal government, said a Sprint spokesman.

“Unemployment is so low, and the demand for jobs in software engineering, hardware and communications is so great that we can’t fill all the positions,” he said. “The last thing you want to do is lose people because someone else offers them options.”

The problem with the Sprint maneuver, according to analysts, is that employees who cancel their options will be better off if Sprint’s stock price remains depressed until May 11, removing the employee incentive element.”It would be a much greater incentive if they had a higher option price to shoot for before they would be able to benefit,” Estes said.

Sprint’s contention is that the move complies fully with FASB regulations. More important, many of Sprint’s employees have multiple year options and would lose their jobs if they performed poorly to deflate the company’s stock price, according to the Sprint spokesman.

There are better ways for companies to rescue underwater options without having to re-price, said Ted Jarvis, a consultant at Towers Perrin. They include buying out the underwater options with cash or exchanging them for a lesser number of restricted shares with an equivalent value. A company also could extend the term of outstanding options, accelerate the timing of the next round of grants or increase future grant levels.

Lucent, for example, does not plan on repricing any options. Instead, the vendor is increasing the size of the “pool” from which options are distributed, moving up the distribution date to November and changing to gradual vesting, in which a percentage of the options vest each year for four years, a Lucent spokeswoman said. Although not cost-free, these fixes are a way to deal with de-motivated employees.

Companies considering any form of action on options need to think long and hard beforehand, Jarvis said.”The options had better be very deeply underwater, where a few days’ trading couldn’t completely wipe out the deficit,” he said. In addition, the top senior executives should not be included. “Don’t hold harmless people who ought to be responsible for keeping the stock price up,” he said.

Some analysts say employees below the executive ranks, who are not directly responsible for increasing shareholder value, shouldn’t receive options anyway. “Options aren’t like jellybeans at the receptionist’s desk – you don’t hand them out indiscriminately,” Jarvis said. “A lot of companies grant options because other companies grant options. But ideally, stock options should be given to people who have a line of sight directly to shareholder value.”

An overabundance of stock options dilutes the value of a stock and creates “overhang,” a situation in which the market could be flooded at any moment with optionholders seeking to cash out, The Hay Group’s Tapling said. And because many employees immediately cash out when their option vesting period is up, stock options often amount to no more than another form of cash compensation, Tapling said, and do little to increase retention.

“Options are either not above water and therefore easy for competitors to buy or they vest while they are above water, and the employee can go cash them out,” Tapling said. “They’re a compensation lure, not a great retention vehicle.”

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