Shareholders know that many of the companies they invest in pass out stock options like candy on Halloween. They know management loves to use stock options as an incentive-based remuneration program that gives executives, staffers and board members a stake in the company’s financial future.
They also know that handing out too many stock options can easily dilute a company’s stock. They know all that and yet they still don’t seem to mind. Or at least they didn’t seem to mind until the bottom fell out of the 20-year bull market and the finger-pointing began.
‘There’s a big problem with stock overhang right now,’ according to Marc Poerio, an analyst at Paul Hastings LLP, a Los Angeles-based international law firm that specializes in employee compensation issues. ‘Some companies may already be maxed out at a time when cash is critical.’
That sentiment is echoed across the investment industry. New York City-based employee benefits and human resources consulting firm Watson Wyatt Worldwide recently released a study called Stock option overhang: A study of potential dilution from employee stock options and its relationship to total returns to stockholders. It concludes that companies with high stock option overhang show increased levels of stock price volatility.
‘By contrast,’ the 2001 study reports, ‘companies whose executives and employees directly own more shares experience lower stock price volatility and achieve better financial results.’ During 1997-1999, volatility at low ownership firms grew at an annual rate of over 13 percent compared to 4.5 percent for high ownership firms.
According to the Watson Wyatt study, there may be a point at which the dilutive effect of stock option overhang on share value can outweigh the motivational effect. Some define stock option overhang as the potential dilution from previously granted options (combined with options available for future grants) expressed as a percentage of total shares outstanding.
‘Stock options can be a case of too much of a good thing,’ says Ira Kay, global practice director at Watson Wyatt. ‘The challenge is to find a company’s sweet spot or the level of overhang that maximizes returns to shareholders.’ Kay adds that overhang has grown because of much larger executive option grants and increased option eligibility.
‘Over the past decade, stock option overhang has grown dramatically, to an average of 13 percent at a typical firm,’ says Kay. ‘The increased use of stock options has generally been healthy for both companies and the equity markets, but higher overhang levels also appear to be having a significant effect on stock price volatility.’
But dark clouds are beginning to gather, especially because of the way stock options impact corporate management strategies. ‘Executives with increasingly large stock option holdings have an added incentive to undertake riskier business strategies, including higher debt and lower dividends, which can contribute to higher volatility,’ Kay says. ‘A board of directors that is concerned with stock price volatility should encourage executives to own shares, as executives who have more of their stock-based compensation in ownership may take action to reduce the volatility of those shares.’
Healthy options
In general, Kay sees stock options as a healthy development, getting employees to think more like owners and thereby enhancing performance. Nevertheless, stock options are not without their controversy and challenges. ‘From an investor perspective you worry about stock options, which we call the dilution effect. From a management perspective you love them, which we call the incentive effect.’
With the incentive effect, stock options motivate employees to create superior financial performance, placing upward pressure on stock prices. With the dilution – or volatility – effect, stock options represent a potential future issuance of shares, creating dilution and putting downward pressure on stock prices. ‘If physics is any guide, one effect will eventually dominate,’ says Kay, who adds that finding the stock option sweet spot is the key to knowing which incentive is in play. ‘Our research shows that up until the sweet spot, the incentive effect dominated. After the sweet spot, dilution dominates.’
The trick, some say, is to locate the point at which dilution meets incentive. ‘If it is true that stock options boost company performance, then stock options are a good thing,’ explains Rick Wood, an attorney and employee compensation specialist at the Pennsylvania-based law firm of Kirkpatrick & Lockhart. ‘Of course, there can be too much of a good thing. Presumably, at some level, the dilutive effects of options overbalance the positive impact on the company. I don’t know at what level option plans begin, in effect, to be counterproductive. I don’t think anyone else knows either, although some act as if they do.’
Wherever the sweet spot is, finding it is critical. According to the Watson Wyatt report, companies that are more judicious in their use of stock options on average deliver higher total returns to shareholders than companies with stock option overhang levels that are significantly above or below average.
Rise & fall
Research data from Watson Wyatt indicates that as the financial markets skyrocketed in the early and mid-1990s, so too did management’s enthusiasm for distributing stock options. Only at the latter end of the decade did option mania begin to subside – and then only for a short spell.
‘Between 1990 and 1995, stock option overhang grew at an annual rate of 11 percent,’ says the Watson Wyatt report. ‘From 1995 to 1997, overhang grew by more than 13 percent per year. Since then, overhang has grown by less than 5 percent per year. It is assumed that this slowdown is occurring because institutional investors and other shareholders are losing their taste for additional dilution and are pushing back at requests to increase stock options.’
According to Watson Wyatt, the firms with highest overhang are in the technology and healthcare industries, while the lowest levels are reported in communications and energy. The company cites ‘valid economic reasons’ for these industry differences, including differences in human capital, R&D and capital intensity.
While these numbers have opened a lot of eyes in corporate management circles, they’ve also opened a can of worms over the merits of having a stock options program in the first place. Some say it’s good and some say it’s bad. Naturally, there are also those who say it’s both.
‘Are stock options a good or bad thing for companies? This is the $64,000 question,’ notes Wood. ‘The real issue is: Do stock options increase the productivity of employees and enhance the performance of companies? If they do not, then you can argue that stock options are a bad thing because all they do is dilute the investments of shareholders. If stock options do improve company performance, then, at some level, they are a good thing and may not be dilutive at all in an economic sense.’
Obviously, in stronger economic times options are a boon to management, to employees and even to shareholders. ‘If option grants are accompanied by strong company performance and growth in company value, the options may actually make shareholders better off financially,’ adds Wood. ‘Then shareholders own a smaller piece of the pie, but the pie gets larger.’
Work reaps rewards
For evidence that stock option plans have a positive influence on company performance, Wood points to the web site of the National Center for Employee Ownership (NCEO), found at nceo.com, which contains summaries of most of the academic literature on stock option distribution trends. ‘While more work needs to be done on this, the studies to date have shown a positive relationship between broad-based stock option programs and company performance,’ he says. ‘If these studies are correct, this does not mean that every company will do better by putting an option plan in place. The studies show only that there is a positive relationship between options and performance. This must mean that option plans help companies attract and retain excellent employees and/or provide motivation to employees to work harder and better.’
Of course, employees can work as hard as they want but it may not amount to much in a languishing stock market. In fact, some go as far as to say that the recent stock option overhang levels had a lot to do with early 2001’s market woes. ‘One of the reasons the Nasdaq corrected 60 percent was so many companies had a high level of overhang,’ claims Watson Wyatt’s Kay. ‘On the other hand, one of the reasons that the S&P and Dow corrected only 10 percent is because US companies, even below-average ones, seem to be managed reasonably well on a global standard. And one reason for this is that executives have a big stake in stock options.’ Kay’s conclusion? Stock options are good up to a point, but all companies’ option programs need to be balanced with real stock ownership in order to create optimal incentives.
Distribution confusion
But balanced they are not. According to Wood, most stock option programs are heavily weighted toward upper management and away from workers, although the gap is narrowing. ‘When I first started working with option plans about 18 years ago, most option grants were reserved for top executives,’ he says. ‘As Silicon Valley rose in prominence, the practice there of having option grants go deeper into the organization began to catch on throughout the country.’
But a recent survey of 500 companies by the NCEO found that almost half had option plans that were broad-based, with the average company in that group granting options to 92 percent of all employees. ‘Even those companies that use the broad-based grant approach tend to skew the grants in favor of higher-paid employees,’ says Wood. ‘The NCEO study found that the average CEO received almost six times more options than the average employee in middle management.’
The data supports that sentiment. In a 2000 study done by the American Compensation Association in Scottsdale, Arizona, of the 2,900 respondents to its salary survey, 94 percent say they offer stock options for officers and senior executives; 65 percent offer stock options for salary-exempt employees; 24 percent offer stock options for salaried, non-exempt employees; and 20 percent offer stock options for hourly (non-union) employees.
No matter who’s grabbing the lion’s share of company stock options, a bear market is not the time for stock option holders or shareholders to be panicking. ‘It has always been the case that option programs are more attractive to employees, and thus more effective compensation tools for companies, when markets are rising,’ says Wood. ‘This is not necessarily as it should be. Employees should look at options as long-term opportunities. Viewed as such, it might actually be preferable to receive option grants when markets are low in order to lock in lower exercise prices (which typically reflect market prices at the time of grant). Perhaps greater emphasis should be placed on educating employees to appreciate the long-term benefits of options.’
For his part, Hastings’ Poerio says that there’s really no corporate formula for handing out stock options – nor do top managers seem to be interested in finding one. ‘The process of distributing stock options is helter-skelter,’ he claims. ‘Most go to executives who management view as key to the company.’ After that, things get dicey. ‘Then you have to ask how far you have to go. Middle management? Factory workers? At some point stock options become more trouble then they are worth, especially in a down market.’
That, unfortunately, is no surprise to companies that suffer from stock option overhang in mid-2001. ‘You just can’t reprice and grant more of them,’ sums up Poerio. ‘Those days are over.’
Overhang defined
To most Wall Street observers, stock option overhang is defined as the number of stock options granted plus those remaining to be granted as a percentage of a company’s total shares outstanding. An overhang percentage is calculated by dividing the number of options available (granted and available to grant) by the sum of the total number of shares outstanding and the number of options available. The market standard stock option overhang is roughly 10 or 15 percent for companies with a small market capitalization.
