Consider Your Options: Alternatives to Traditional Incentive Models

January 1, 2004

In the wake of Enron, Anderson, World Com, and other recent corporate scandals, the Financial Accounting Standards Board ("FASB) has reiterated its intention of introducing new rules requiring companies to book stock options as expenses. As the mandatory expensing of stock options looms near, companies should begin exploring alternatives to traditional incentive compensation models. At its September 10, 2003 board meeting, the FASB stated that a draft of the new rules will be completed by March, 2004. The final rule is expected September, 2004.

Presently, Employee stock options are the only form of stock-based compensation not required to be expensed under the Generally Accepted Accounting Principles, or GAAP-- Hence their popularity. Companies have come to exploit the dual benefits of options. In a good market, options exercised under a qualified plan add cash to the company, while providing tax deductions to the employee-- all without a reduction in corporate earnings.

Understandably, many companies, especially those that have relied heavily on options to attract and retain qualified workers, oppose the FASB's proposal. Hewlett-Packard, for example, has publicly stated that its third-quarter profits would have been slashed 64% had it treated stock options paid to employees and executives as a compensation expense. Last year, Microsoft announced that the reporting of options as expenses over its history would have eliminated "billions of dollars" from its profits.

Recent surveys suggest that the adverse impact to earnings will reach far beyond the tech industry. Merrill Lynch, for example, has estimated that the expensing of options would have lowered earnings for the broad-based S&P 500 by 21% lower in 2001.

Given the relative certainty surrounding the FASB's proposal, companies should evaluate alternate compensation vehicles as soon as possible. Viable solutions may include: restricted stock, performance shares and equity-based cash awards such as phantom shares and stock appreciation rights.

When awarding actual stock (via a restricted stock plan), as opposed to options, fewer shares are needed to provide a target level of value to the employee since the employee does not have to pay a strike price in order to receive the shares. Consequently, restricted stock weighs less on a company's earnings than expensed options and will dilute the common shares to a lesser extent. Further, and perhaps most important given recent market conditions, restricted stock will not go "underwater."

Restricted stock awards, like option awards, are subject to a vesting schedule. For example, an employee may receive 100 shares of common stock pursuant to a restricted stock grant. If the stock vests over a five year period, then the employee would receive all 100 shares up-front, but only be permitted to sell 20 shares of the award each year.

Performance shares function similarly, with the added benefit of incentivizing employees. Under a performance share plan, stock is awarded upon the satisfaction of predetermined benchmarks. Such benchmarks may represent personal, departmental or enterprise-wide goals.

While cash awards in the form of phantom shares or stock appreciation rights carry some of the same downsides attributable to expensed options, such awards also bear the unique benefit of rewarding employees for the company's success, without sacrificing equity. In other words, employees get the financial boost associated with stock ownership, while shareholders benefit from uncompromised equity positions�a scenario that is often appealing to smaller, closely held companies.

Businesses are encouraged to assess the impact of option expensing now. While a well thought-out and comfortably- paced transition plan won't necessary cure all of the concerns attendant to option expensing, such a plan should go a long way in minimizing some of the inevitable stresses relating to shareholder expectations and employee morale.