Stock options may be out of favor, but the benefits of employee ownership never go out of style. Explore these alternatives.
It may not be a death knell for stock options, but it’s enough to place a frantic call for a medic.
Microsoft -- software giant, workplace of the world’s richest man, the ultimate symbol of the bull market -- recently announced it was sending its longtime use of stock options to the trash heap. In its place, starting next month, will be a more sober program of restricted stock.
So what led to this major shift in compensation strategy? In the market heyday of the 1990s, stock options, for many companies, were the magic words for luring and hiring top talent. Start-ups needed executives to work insane hours, and those executives dreamed of a huge payoff when the company went public and those options vested. Large, established firms got on the bandwagon, too. It was a mutually beneficial marriage for companies looking to reward players in a cost-effective way and for employees who had an almost guaranteed payoff.
Fast-forward to 2003, and that marriage appears to be fading into a trial separation, if not an outright divorce. Many stock options are worthless as the market price sinks below the option price, and more companies are moving toward booking options as expenses as regulatory bodies consider mandating this action.
Now comes the decision to cease option granting from Microsoft, which had been held up as a model of how well stock options can work to reward employees. But it’s a different day, and as a result, stock options aren’t the all-purpose solution they once were.
“Stock options really took the scene by storm in the 1990s, and they were a great fit for the conditions at the time,” says Martin Staubus, director of consulting services at San Diego-based Beyster Institute, which advises companies on employee ownership. “But now, every one of those conditions has changed.” The market is volatile, the job market is tenuous and many employees aren’t willing to stay with a company simply for the “promise” of a possible return on their hard work.
However, Staubus adds: “Nothing has changed about the advantages of giving employees a stake in the success of a company. If anything, that's more important than ever.”
Weighing Your Options
Although stock options may no longer be the king of the hill when it comes to compensation, the good news is there are a number of perfectly viable employee-ownership alternatives to consider; the bad news is there is no foolproof formula for deciding which ones to use.
“There’s no magic bullet out there,” warns Dan Janich, an attorney in Chicago with the Janich Law Group, which specializes in employee benefits and executive compensation law. “Each [vehicle] has its advantages and disadvantages. Many companies are using multiple ideas to suit their own needs.”
Think of it like balancing a portfolio. Just as you might spread your assets among stocks, bonds and cash to minimize your risk, so might your company try a combination of different options instead of rolling the dice on any one of them.
Of course, before you can select from those options, you have to understand them. To get acquainted with what’s available, here’s a quick breakdown of equity vehicles to consider, along with some pros and cons for each one:
- Stock grants. These are outright gifts of stock to employees.
Pro: Stock will never go “underwater” where the market price is lower than the option price; stock grants will always have some value, unless the company goes into bankruptcy.
Con: Its a taxable benefit, so your employees may have to sell off some stock to pay the tax bill. If employees face major tax headaches as a result, it defeats the purpose of the incentive.
- Restricted stock. An increasingly popular vehicle, these are stock grants that often are based on length of service, such as three to five years, or on performance criteria.
Pro: Encourages long-term involvement and interest in the company.
Con: If issued too widely, it could dilute company stock and anger shareholders.
- Delayed issuance awards. These stock grants are delayed until a certain pointfor instance, until after an executive has left the company.
Pro: By not issuing stock up front, these awards ensure that objectives will be achieved. Also, the stock is not in danger of dilution since stock grants are less likely to be issued en masse.
Con: These awards are a tad riskier for employees than typical restricted stock, since they are “phantom” compensation until they are actually granted. They also may not encourage better employee performance if they are based solely on time served.
- Performance shares. These are a variation of restricted stock in which shares are granted according to performance, not on length of service.
Pro: Employees are encouraged to perform, not just stick around for a length-of-service vesting requirement.
Con: Executives might be encouraged to take high-risk ventures for the potential payoff of boosting the stock price.
- Nonqualified deferred compensation. Executives can use this tax-deferred income to invest in company stock.
Pro: Employees gain a tax advantage by putting off compensation; the employer can use such a plan to lure high-value executives and add retention clauses like “golden handcuff” provisions.
Con: For regulatory reasons, these plans are available only to the highest levels of management.
- (For more information on nonqualified deferred compensation plans, see "Smaller Firms Consider a New Retirement Option" the July 2003 issue of HR Magazine.)
- Employee stock ownership plans (ESOP). These are broad-based plans in which the company contributes stock into employee retirement accounts.
Pro: Employees get free stock, and the company gets a nifty tax deduction.
Con: Employees cant access the stock whenever they want; as with a 401(k), they have to wait until retirement or face early withdrawal penalties. Employerseven small onescan incur significant costs to create and maintain ESOPs.
- Employee stock purchase plans (ESPP). These plans allow employees to buy company stock through payroll deductions.
Pro: Stock is usually offered to employees at a 15 percent discount, the maximum allowable by law; employers get wide equity participation at a low cost.
Con: There are no guarantees that the stock will retain its value over time. And when an employee sells the shares, the original discount is treated as income. Employers may not be getting long-term commitment if employees flip their shares relatively quickly. If the program proves extremely popular, share dilution could become an issue.
- Stock purchase arrangements. These plans work like an ESPP, except employees buy stock upfront with a lump sum.
Pro: Hefty employee discounts usually apply here, too, and the overall cost to the employer is relatively modest.
Con: Employees must have ready cash on hand to buy in, so employers may not be able to encourage much equity participation at all, especially from lower-income segments of the workforce.
- 401(k) plans. This is the pre-eminent retirement savings plan, which often offers company stock as an investment option.
Pro: Contributions are pre-tax, and matches in company stock are basically free money for employees; the company gets nice tax deductions for contributed stock.
Con: With no federally mandated limits on company-stock percentages, employees could potentially get “Enron-ized” if they’re locked in and can’t dump the stock as it freefalls. Meanwhile, the company gets terrible PR about its employees losing their nest eggs.
- Share appreciation rights. These are similar to stock options, except no actual shares are involved; employees get the cash equivalent of rises in the stock price.
Pro: Prevents dilution of a firms shares, and workers develop a keen interest in positive companywide performance.
Con: Major potential cash drain on company finances if stock price skyrockets.
Selecting Your Options
Sorting through the plethora of employee ownership options might give anyone a headache. And while the benefits of encouraging employee ownership are clear, the road leading there can be somewhat foggy. (See “The Benefits of Striking the Right Balance.”) Still, there are some general tips that can help guide your decision making.
The first course of action is to decide whether your organization wants to encourage wide company ownership through a broad-based plan, or ownership limited to higher-level executives.
“Ask yourselves, 'What are we trying to accomplish?'" advises David Wray, president of the Profit Sharing/401(k) Council of America in Washington, D.C. “Some smaller companies might want to make everyone an owner, to make them full partners in the enterprise. Others might want to give employees a small stake, but not hand over control. Still others might want to give senior management a big stake in the outcome to help ensure that the company appreciates in value.” (Such a decision might also depend in part on the employee ownership options you already have in place. For more information, see “Three’s Company.”)
ESOPs, ESPPs, stock purchase arrangements, 401(k) plans and share appreciation rights are the usual vehicles for broader initiatives. Restricted stock, delayed issuance awards, performance shares and nonqualified deferred compensation are often—though not always—reserved for the executive suites.
Restricted stock and performance shares, in particular, are generating a lot of buzz these days, thanks to two main trends: Companies want to give an award that will always be of some value, and they also want to recognize top performers.
“There’s a great deal of talk in those areas,” says Janich. If your primary goal is to boost company earnings—a key driver in tough times—performance shares may be the best way to go, he suggests.
Telecommunications company Verizon, for instance, has tried restricted stock, which vests based on performance relative to the Standard & Poor’s Index and other telecom stocks. It’s a simple equation: “If the company doesn’t perform well, compensation is held back,” says Blair Jones, a senior vice president at Sibson Consulting in New York.
On the other hand, if your goal is a broader initiative—getting everyone, at all levels of the company, to think like an owner—“there’s a movement toward ESPPs,” says Janich. These plans are comprehensible and popular, and they are administered through simple payroll deductions.
Offering company stock in the 401(k) plan is another easy way to achieve the same goal of broad employee ownership.
If you have a bolder goal of giving some corporate control to your employees through voting privileges, an ESOP is “clearly the way to go,” says Wray. Smaller companies, especially, might be attracted to this option, he says, because employees can actively participate in the direction of the company, and the workforce size hasn't yet made that prospect unwieldy. Also, the tax benefits are too juicy to pass up since firms get a full tax deduction for the stock offered, increasing their cash flow.
Public vs. Private
One of the biggest considerations in deciding which vehicle or combination of vehicles to use is whether your company is public or private. The whole idea of stock valuation, for instance, becomes trickier when it isn’t being traded on the open market.
However, that doesn’t mean “stocks” aren’t a feasible option for private companies: Privately owned Spring Valley, Calif.-based catalog firm Chinaberry, for instance, has an appraiser come in once a year to determine its value, and the board then sets the discounted price at which employees can buy actual shares.
Once the valuation process is settled, employee holdings at private firms can be more stable than at public ones, where the markets are influenced not just by company performance but by a host of external factors such as the war in Iraq and investor psychology. If the markets are hammering a public company’s stock despite solid performance, employee ownership could actually become a “de-motivator,” says Wray. Private companies aren’t quite as vulnerable to market tempests.
More public vs. private considerations: ESOPs are generally more popular among private firms—as are share appreciation rights and other “phantom” stock plans—because private owners are less likely to hand out actual equity, says Janich.
For public companies, ESPPs are an option that’s “hard to beat,” notes Staubus. Absent a plummeting stock, employees stand a good chance of making a profit. The only cost to the company: the 15 percent discount given to employees on the stock price.
Whatever vehicles you choose, introducing holding requirements is one way to help ensure retention, suggests Jones. When beneficiaries are required to hold stock for a year or more, they have to “ride with the shareholders,” Jones says, which is in everyone’s interest. Among the companies that recently bolstered holding requirements are Coca-Cola, GE, Pepsico and Citibank.
Another thing to keep in mind: Get professional advice sooner rather than later. If you launch into a particular program without expert guidance, you could run into “legal or accounting or tax problems, which could be potentially disastrous,” says Janich. Each vehicle has its own peculiar regulatory restrictions and tax considerations.
Or, if the vehicles you select aren’t well suited to the goals you want to achieve, you might have to scrap programs after they’re up and running, which would be more expensive—and demoralizing to employees—than seeking out advice in the first place.
Don’t get too cute or complicated, either. “I’m a big fan of keeping things simple,” Staubus says. He says that when programs get too numerous, complex and overwhelming, employees will tune out and not participate, which defeats the whole purpose. Also, voluminous programs that require constant tinkering can become an administrative nightmare.
“At a certain point, it not only becomes counter-productive, it also becomes a hell of a lot more work,” Staubus says.
Instead, consult the experts and create targeted programs—then revisit those programs perhaps once a year. You can tweak the programs that aren’t working from a participation level or organizational goal standpoint and boost the ones that are.
Most important, inform employees that because they’re now owners, their own bottom line is at stake.
“Sometimes employees just treat stock like lottery tickets and feel powerless about the stock price,” says Staubus. “So there needs to be an educational process there: Employees own stock; the value of the stock is determined by how much profit the company generates, and that’s determined by what the employees are doing every day to drive up revenues and hold down costs. If they don’t understand that, there’s a lot of wasted potential.”
Chris Taylor writes on employment issues for
Smart Money magazine in New York.