Options to Stock Options

By Pamela Babcock Apr 1, 2006
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HR Magazine, April 2006 With new accounting rules raising the cost of stock options, other equity-based incentives offer alternatives.

The Financial Accounting Standards Board’s (FASB) recent requirement that companies expense stock options on 2006 financial statements can be a challenge for HR professionals looking to offer equity-based incentives with minimum costs and maximum benefits.

While most companies aren’t expected to ditch options entirely, HR professionals have a number of alternatives for employees’ long-term incentives. The most popular include time-vested restricted stock, performance shares and long-term cash incentive plans.

“Over the past two years, we’ve seen a dramatic shift in the use of long-term incentives,” says Russell Miller, a principal with Mercer Human Resource Consulting in New York. “I’d say it’s the minority of companies that haven’t done anything.”

Donald Delves, president of The Delves Group, a Chicago-based compensation consulting firm, says HR professionals should look for three things when coming up with a long-term incentive plan. First, make sure you’re getting as much incentive value for the expense as you can.

Second, ensure you’re getting as much perceived value as possible. “That’s a problem that came up with options,” Delves says. “If you have a $5 million charge to earnings for the options and the people receiving them think they’re only worth $2 million, you’re losing money or wasting shareholder resources.”

And last, Delves says, make sure you’re paying for performance. With options, “you were just paying for stock performance, and now you can pay for real performance measures people can directly influence.”

There’s no one-size-fits-all approach, and your company’s long-term incentive portfolio should be developed with business strategy and compensation plan objectives in mind.

In general, more-mature companies are expected to move away from options, while growth companies, which have relied on options in the past to attract top talent, are more likely to continue using options and “focus on the assumptions of their valuation models,” says Brandon Cherry, a principal and consultant with Presidio Pay Advisors Inc. in San Francisco.

“There are ways that you can still deliver equity to your employees and create a culture of ownership without using stock options,” Cherry says. “These stock option alternatives use fewer company shares, reduce the expense recognized and still provide the same intrinsic value to your employees that was there before.”

Assessing the value

Under FASB’s new rule, FAS 123R, public companies are required to expense the fair value of employee stock options beginning in the first quarter of the fiscal year starting after June 15, 2005. The expense is recognized as a noncash charge to earnings in the income statement.

Assessing the value of your company’s stock and doing a detailed analysis of your equity incentive program should be the first step in determining what impact FAS 123R will have on your company and will indicate whether your company should overhaul its plan, Cherry says.

FASB requires the fair market value of stock options to factor in specific variables such as current stock price, expected volatility, expected dividends, expected term of the grant, the risk-free rate of return at the time of the grant and exercise price.

Conducting a comprehensive review of assumptions—such as the probability of share price changes and resulting shifts in employees’ exercise of grants—that are used to value options under various pricing models may reduce the recognized expense of option grants, Cherry says. He adds that any assumptions must be “supportable and indicative of your company.”

Time-Vested Restricted Stock Grants

Among the most popular alternatives at the executive level is to replace all or a portion of option grants with time-vested restricted shares, which are full-value shares that vest over time.

Unlike stock options, which are expensed over the vesting period based on their estimated fair value, restricted shares have an absolute value when granted that is more easily accounted for over the life of the vesting period. And restricted shares generally require 50 percent to 60 percent fewer shares than options to deliver the same net benefit, Cherry says, making them more attractive from an accounting and dilution perspective.

Restricted stock can serve as a retention tool because, in most cases, employees have to stick around until the end of the vesting period to get it. Unfortunately, restricted shares don’t provide any financial downside to the employee and so may not encourage a pay-for-performance attitude.

“We don’t believe moving toward restricted shares or restricted share units stock is a practice for every company and for all employees,” Cherry says. “If you are a large, multinational company, you may want to consider them, as they offer tax benefits to employees in some countries. But it’s a big cultural change and a potential administrative burden to implement a new type of equity incentive. And there’s an educational process that needs to occur with HR as well as across the company.”

Microsoft was one of the first companies to move away from options to restricted stock.

“What companies like Microsoft have said is we are a mature company and we don’t think we can deliver sufficient growth for the options to be effective from a cost-benefit standpoint, so it’s more efficient for us to grant restricted stock because you’re delivering a known value regardless of what the stock price does,” says Steven Van Putten, executive compensation practice leader for Watson Wyatt Worldwide in Wellesley, Mass.

Performance Shares

A variation on time-vested restricted stock is performance-based restricted stock, which employees vest in only if they stay with the company a certain period of time and the company meets certain goals for earnings or total shareholder return.

Performance shares that typically vest over three years, but sometimes longer, are quickly becoming the stock options of the new era, Van Putten says.

A performance share plan might require that you stay with the company for three years and that the company’s earnings per share (EPS) grow 10 percent a year over that three-year period for you to vest and be entitled to the full value of the shares. If EPS growth is only 8 percent, for example, a portion of the value of the original performance share may be issued, but not at full value.

So with a restricted stock grant, you might be given 10,000 shares and all you have to do is stay three years to get it. With performance shares, there may be a continuum of what you make at the end of that period—from zilch to, say, $20,000—depending on whether your company exceeds its performance goals. And the payout can be interpolated along the way.

“This really puts pressure on the human resource professional to optimize the return on what is now a valuable asset, and it means focusing stock awards on the employees who have high potential and are the high performers,” Van Putten says. “Companies are saying we won’t spread this like peanut butter, which we did with options—we’ll focus it on our top performers.”

From a cost and accounting perspective, performance shares differ from options because “if you don’t hit the goals and pay it out, you can reverse any accrued expense,” Van Putten says.

Cherry says another possibility is to align employees’ eligibility to participate in the stock plan with their annual performance review. By requiring a minimum rating, companies can reduce the number of eligible employees and provide an attractive incentive.

“It allows companies to be a little more conservative with their grants, weeds out some lower performers, and creates an incentive or drive to perform. And it really changes the ownership culture from one of entitlement to a truly pay-for-performance environment,” Cherry says. But he cautions that organizations need a well-defined and well-communicated performance review process for it to work.

Long-Term Cash Incentives

A variation on performance shares is performance unit grants, which allow employees to earn cash rather than shares when certain goals are attained.

Use of long-term cash incentives, also called performance unit plans or performance cash plans, is expected to grow, particularly since shareholders’ increased scrutiny of equity plans is making it more difficult for companies to get share plans approved.

A long-term cash incentive is a cash payment that is earned over a multi-year period—unlike a typical one-year bonus—based on the company achieving certain performance targets. The plans are not denominated in shares and look a lot like bonus plans. They can be designed in an infinite number of ways and are typically earned in addition to any annual bonus. Estimated payouts are accrued as an expense during the performance period, and are expensed in full when the final actual payout is known.

Such a plan “serves the purpose of balancing short-term decision-making with long-term decision-making,” Mercer’s Miller says. “There are times as a manager when you make a decision that will not benefit the company in the short term but will in the long term. Secondly, it acts as a long-term retention device because you don’t get it in one year; you have to stay around for three years.”

In the end, one thing is certain: There are plenty of options to options.

“If I’m an HR professional, it looks like a big pain in the butt because I have to learn all this new terminology and, unless I’m a CPA or a mathematician, the option valuation expensing thing is going to scare me a little bit,” says Delves.

But Delves says the new requirement to expense options will promote more variety in incentives and more-effective plans. “In the Fortune 500, we’re now going to have 500 different long-term incentive solutions, which we always should have had because it’s not one size fits all.”

Pamela Babcock is a freelance writer based in the New York area. She has worked as a reporter for The Washington Post and The News & Observer in Raleigh, N.C., as well as in corporate communications.

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