Date: August 8, 2003 SPECIAL ISSUE OF PERFORMANCE BYTES The Ten Myths of the Microsoft Restricted Stock Plan Microsoft's recent announcement of changes in its stock-based compensation program for employees and associated accounting treatment was really four announcements in one: 1 - Microsoft will cease using stock options as a cornerstone of its compensation strategy and instead make stock award to employees and performance shares to a group of approximately 600 "senior leaders." 2 - Microsoft will offer employees the opportunity to sell ("monetize") their underwater options to a third-party. 3 - Microsoft will adopt fair value accounting for its stock-based compensation programs. 4 - Microsoft will elect to restate its previous financial statements to reflect the fair value accounting method (under FAS123). The prominence of the company and magnitude of change represented by the announcements created a media frenzy. As often happens in such cases, a highly inaccurate reporting of facts accompanied by "expert" speculation has generated a series of myths we need to dispel before companies begin their plan evaluation and design efforts in response to the development. Let's ignore the accounting technicalities and focus on compensation issues: Myth #1: Microsoft is giving grants of restricted stock to employees. False. Actually, Microsoft is awarding "restricted stock units" which are in essence a multi-year promise to give unrestricted shares once the employee satisfies the vesting schedule. Contrary to many "expert" statements in the press, employees cannot make an 83(b) election to realize tax advantages as they could if actual restricted shares were granted, and they will not be receiving dividends on Microsoft shares during the vesting period. Myth #2: Restricted stock has less upside than options. Incorrect, for two reasons. First, a share of restricted stock obviously has the identical "upside" - appreciation potential - as an option. Plus, because the employee pays zero for the share, versus the strike price of the option, it truly has more total potential value than an option. This myth originated in the premise that employers will give fewer restricted shares than they would have options, which is generally the case. Second, companies like Microsoft who move to restricted stock will do so because of the lack of upside projected in their shares. That is, if a company projects a flat stock price for several years, the option will have zero upside and the restricted share will have value. So, in a low growth company even a smaller number of restricted shares might have more total value to the employee than a larger number of options. (Note: For more information on this concept, contact us for information on our Option/Share Crossover Model.) Myth #3: Microsoft's restricted share plan better aligns employee interests with shareholders. Arguable. Unlike shareholders, who pay for their shares, have a long-term perspective, and receive dividends, employees will receive free shares, will typically sell some (through withholding) at vesting to pay tax, and do not receive dividends. And to the extent that employees receive fewer shares than they would have options, they have more guaranteed value and less upside potential. In fact, depending on the conversion ratio of options to shares, the restricted stock units may be more valuable than the options and have less risk. Myth #4: Restricted shares will prevent employees from the "take the money and run" approach from the cashless exercise of stock options. Not necessarily. Employees can just as easily sell a share awarded at the vesting date - and may have to sell some to pay taxes - as they can a share realized from an option exercise. While there is some research in the field of behavioral economics indicating that people are less likely to sell property held than to buy property offered, it will be years before we see if employees are more inclined to be shareholders. Myth #5: Microsoft can afford to grant restricted stock and treat options as an expense because they are so profitable. Hmmm. There is no concept of what a company can or cannot "afford" with respect to non-cash expenses. The election to expense options may be designed to soften the blow to investors of choosing a compensation strategy now that is much more "expensive" than options in terms of accounting expense under APB25. Myth #6: Employees will be able to earn dividends on the restricted shares now that Microsoft pays a dividend. Nope, see Myth #1. Because there are no shares granted until vesting, no dividends will be paid to employees. Microsoft could choose, however, to provide "dividend equivalents" to employees but this would be for accounting and tax purposes nothing more than cash bonuses in the amount of the dividend. Myth #7: Microsoft management will still be tied to shareholder value because their shares have performance restrictions, not just time-based vesting. What? It is true that the 600 or so top managers at Microsoft will have performance conditions attached to their shares. But the two oversights here are (1) the awards still have a guaranteed minimum value regardless of performance (performance merely "modifies" the awards) and (2) the performance measures are based on customer satisfaction and growth in number of customers, which may have absolutely no relationship to shareholder value (Do customers need to be satisfied when you're a monopoly? Do more customers increase company profitability?). In fact, the same result could be obtained with stock options if option programs were properly designed. It is not the use of stock options, per se, that misaligns executives and shareholders - it is plan design features like monthly vesting schedules, cashless exercise provisions and a lack of holding periods, which eliminate the possibility for options to align employee-optionees' interests with shareholders. Myth #8: Microsoft still believes that its stock is a good investment even though it is repurchasing options from employees and granted restricted stock units. Double Hmmm. Microsoft believes that its stock price appreciation will be so limited that even options at strike prices of $33 will have a repurchase offer of only about $2 while the Black-Scholes model indicates they have a value of more than twice that. Microsoft does not believe that stock options will deliver in the future adequate compensation required for attracting and retaining employees, which can be inferred to result from limited stock price growth. Investors might hope for a substantial dividend. Myth #9: Microsoft's move makes sense because stock options no longer have any value. Really? Ask the employees at the thousands of companies whose stock price is at or near a 52-week high, and the hundreds of companies whose stock price is at an all-time high, about their options. They would beg to differ. Vibrant growth companies with an entrepreneurial culture, high level of individual accountability and - most importantly - willingness to help employees understand the link between their day to day work and the stock price will continue to find options an ideal compensation tool. On the other hand, a no-growth, entitlement-oriented, sluggish culture will find restricted stock and restricted stock units an ideal way to continue to dilute shareholders, conserve cash, and avoid the need for goal-setting and performance-based compensation. Myth #10: Many companies will follow Microsoft's lead on this. Microsoft's complex proposed program is by no means a done deal. The option repurchase program has not been approved, no tender offer documents have been filed disclosing the offering, and many other loose ends appear to exist. For example, will Microsoft include RSUs in overtime calculations for nonexempt employees? Will making employee options transferable with a readily ascertainable market value render them taxable at the actual purchase price, or the Black-Scholes value (which is far greater than the purchase price) even though they are underwater? And most importantly: will this work? Believe what you will about option expensing, options vs. restricted stock, and Microsoft's recently announced program. But do base your beliefs on factual information, not the naive musings of business journalists. Index: msft Back Issues of "Performance Bytes"... August 22, 1997 "Management Pay -- Unintended Consequences" The Economist, August 22, 1997 [strategy.002] March 7, 1997 "Performance Stock Options" Congressional Record, January 21, 1997 [alleeso.004] February 24, 1997 "Most EDS Employees To Get Stock Options..." Wall Street Journal, February 24, 1997 [alleeso.003] January 29, 1997 "American Air Pilots Asked to Agree to Arbitration" Wall Street Journal, January 29, 1997 [union.001] January 24, 1997 "A Tale of Two Compensation Strategies: (Eastman Kodak & AlliedSignal)" Fortune, January 13, 1997 [strategy.001] January 8, 1997 "Small Concerns Are More Likely to Pay Directors in Stock Than Large Firms" Wall Street Journal, January 8, 1997 [bdcomp.001] December 31, 1996 California Qualified Stock Options (CQSOs) State of California, Secretary of State (AB 3194) [alleeso.002] December 27, 1996 "All about EVA" CFO Magazine, November, 1996 [perfmeas.001] December 18, 1996 "Stock Options to Be Given to 69,000 Staff Members" (Chase Manhattan Corp.) Wall Street Journal, December 18, 1996 [alleeso.001]