workspan, April 2003, Volume 46, Number=20 4

Viewpoint

Expensing = Options: I=20 Still Don=92t See Any Elephants

By Fred E. Whittlesey, CEP=20

Like many of us, I keep an = elephant=20 repellant device right on top of my desk. Not only does this give me = comfort=20 that I=92ve done everything possible to avoid an elephant entering my = office, but=20 I can point to my good business judgment in selecting and employing this = device=20 and argue for its universal effectiveness -- I haven=92t seen any = elephants yet.=20 It=92s an old model, but obviously successful, and based on this = success, I must=20 assume that removing it would result in an eventual elephant incursion. = Who can=20 argue with that?

But my topic is not elephants; = it=92s the=20 highly charged issue of expensing employee stock options. Debated since = the=20 early 1980s, this issue currently occupies center ring in the total = rewards=20 arena.

As of this writing, it is all but = certain=20 that companies will be required to report employee stock option grants = as an=20 expense on their income statements, which will reduce profitability in = most=20 companies. The focus of the debate has turned from whether options = should be=20 expensed to the highly technical discussion of the mechanics of the = proposed=20 accounting standard. While the International Accounting Standards Board = (IASB)=20 and the Financial Accounting Standards Board (FASB) fire policy = suggestions of=20 proposals, statements and drafts to define a new standard, most of the = high-tech=20 community continues to steadfastly oppose the practice in any=20 form.

Accompanying the argument against = option=20 expensing is the highly emotional socio-political claim that such a move = will=20 result in companies drastically reducing the magnitude and levels of=20 participation of option grants. Anti-expensing pundits are quick to = highlight=20 that it is the little guy who will suffer, as executives will not see = reductions=20 in their lucrative pay packages. Some companies go further in predicting = disaster by pointing out that they will be forced to either reduce total = compensation or replace options with cash = compensation.

It=92s interesting how = professionals -- both=20 in our total rewards arena and in the business community at large -- = accept the=20 media buzz that expensing stock options will result in the end of = all-employee=20 option programs. This is confirmed by companies that say if required to = expense=20 options, they will reduce employee option grants. (Generally, this is = from the=20 same companies that are opposed to option expensing because of the = significant=20 impact it will have on their reported profitability.) Proponents of this = view=20 are pleased to cite one study from the Employment Policy Foundation that = indicates a cost to the economy of $2.3 trillion over the next 10 years. = The=20 conclusion reached from this speculation is that the requirement to = expense=20 options will lead to reduced option participation, lower employee pay = and=20 ultimate damage to the U.S. economy and its global = competitiveness.

All of this because of expensing=20 options.

I think one research study also = indicated=20 that expensing options might lead to a reduction in companies=92 ability = to repel=20 elephants from their corporate offices, but I=92m not sure. While I = share their=20 concern about elephants, and would be happy to share my experience with = my=20 elephant device, I simply must say, =93hogwash,=94 on the issue of stock = option=20 expensing.

Yes, options will be an expense = for=20 financial accounting purposes. More than 150 companies have voluntarily = elected=20 to use FAS 123 reporting and more will follow. And, beyond the = Euro-based IASB=20 crowd, nations around the globe (including Canada, Australia and Korea) have=20 indicated strong support for the practice. The United = States=20 likely will not be able to ignore an accounting practice that the rest = of the=20 world endorses. Son-of-FAS 123 is inevitable by = 2004.

Yes, companies are likely to grant = fewer=20 stock options in the future. But just like the anti-elephant device on = my desk=20 that has successfully repelled elephants for decades, causality must be = explored=20 before conclusions are drawn. I think we all learned that in freshman = year,=20 Logic 101.

Leading the = Charge
There are, = in fact, six=20 factors -- not one -- that will lead companies to change their = option-granting=20 practices, but not necessarily end the use of stock-based compensation = and, by=20 no means, will they result in lower compensation for=20 employees.

First, due to market boom and = bust,=20 option-based compensation has caused turmoil for employers and = skepticism among=20 employees. New millionaires have left the work force, while others who = were not=20 in the right place at the right time commiserate over worthless stock = options.=20 Three years of efforts to rescue underwater stock options through repricing, 6-plus-1 and other replacement plans, = and layers=20 of new grants have been thwarted by the continuing market decline. = Dilution and=20 overhang have increased, but commensurate compensation has not been = delivered.=20 This thing just ain=92t working like it was = supposed=20 to.

Second, forecasts indicate there = is no great=20 wealth opportunity in stock-based compensation in the foreseeable = future. With=20 projected real gains of 3 percent to 5 percent, the prior decade=92s = upside will=20 not be repeated during what would be the next typical vesting period for = current=20 grants. So, any cost associated with option grants may not produce an = amount of=20 compensation that provides a reasonable return on investment (ROI). The = golden=20 days of options may be over for now.

Third, investors are livid over = the dilution=20 they have experienced from previous option grants and the future = dilution=20 represented by current overhang levels. They are putting extreme = pressure on=20 companies to reduce run rates. This is the crux of the movement to = reduce option=20 grants -- not accounting expense.

Fourth, the accusations of the = perverse=20 incentive of stock options has tainted the vehicle and drawn demands for = a=20 return to other forms of pay. Even restricted stock, which fell into = disrepute=20 in the 1990s as a length-of-service incentive, has emerged as a = potential=20 savior.

Fifth, many employers have = realized that the=20 distribution of small option grants to all employees does not create a = feeling=20 of ownership or substantively change employee behavior, but does result = in huge=20 advisory and administrative costs. Many flavor-of-the-month plans rolled = out in=20 the 1990s failed to meet their objectives, and this is a convenient time = to end=20 the practice -- sorry folks, no more options, new accounting=20 rule.

And, sixth, yes, expensing options = will be a=20 factor. Some companies will insist that investors really care about = earnings per=20 share (EPS), not cash flow, and will conclude that reducing a=20 non-cash expense, thus boosting reported profit, will help create = value=20 for shareholders.

Plus, let=92s not forget a = potential seventh=20 factor: President George W. Bush=92s proposal for the elimination of = taxation on=20 dividends. This wild card may open up radical new design possibilities, = such as=20 high-dividend performance-based stock grant plans.

Nothing Against=20 Equity
I once worked = for a CEO=20 who divided the corporate world into =93smart companies=94 and =93dumb = companies.=94=20 When we discussed competitive benchmarks, he wanted to know what the = smart=20 companies were doing and didn=92t care what the dumb companies did. = Today, smart=20 companies know that expensing options is inevitable and have shifted = their time=20 and energy from political lobbying and public relations campaigns = against=20 accounting standards to a thoughtful reconsideration of how to use stock = in a=20 meaningful total rewards strategy coupled with investor relations = efforts to=20 create support for the new strategy.

For example, one CEO who = apparently thinks=20 he heads a smart company replaced option grants with restricted stock = units on=20 the basis that investors care about cash flow and dilution, not earnings = per=20 generally accepted accounting principles (GAAP). A major investor in = this=20 company stated publicly that there should be no stock option grants in = any=20 company given their flawed nature. But he never said, =93No equity,=94 = just =93No=20 stock options.=94

By no means is this the end of = all-employee=20 equity plans. It is the end of mindless, all-employee option grants and = the=20 beginning of effective, all-employee stock-based compensation that = really aligns=20 workers and owners. It also is the beginning of an increased need for=20 professionals who can develop rigorous, strategy-based and = financially-sound=20 equity compensation practices. And, one hopes it is an end to = stock-based=20 compensation programs that produce more value for those designing and=20 administering the plans than those participating in the=20 plans.

I=92m just glad that everyone is = focused on=20 stock options and no one is proposing changes to elephant repellants, = even=20 though global forces may require that users carefully evaluate the = effectiveness=20 of these and their alternatives. Regardless, I certainly would not want = to=20 conclude that changes will result in an inevitable elephant invasion = before=20 conducting an evaluation. That just wouldn=92t be = logical.

For now, I=92ll leave that old = elephant device=20 on my desk, just in case. But I would also caution that there are many = ways to=20 repel elephants, and not to overlook any of them without careful = analysis.=20