Out of options? Stock options may be out of favor, but the benefits of employee ownership never go out of style explore these alternatives - Compensation

HR Magazine, August, 2003 by Chris Taylor

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: It's 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 point--for 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 potting 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.