Options: Swimming Under Water

Market woes may further dampen the appeal of stock options as a tool for retaining executives.

http://www.cfo.com/article.cfm/12281585?f=alerts

David McCann
- CFO.com | US

September 19, 2008

The extreme volatility in the stock market likely will nudge some
companies toward further reducing the weight of stock options in their
compensation portfolios for senior executives.

Once virtually the sole compensation tool for motivating
performance, options already had declined in importance over the past
few years, as new accounting rules, regulatory requirements, and
shareholder unrest pushed many companies to add restricted stock,
performance shares, and even cash to the mix. And the visceral
experience of watching the Dow Jones Industrial Average lose 500 and
450 points on Monday and Wednesday, respectively, will do nothing to
bring options back into favor.

With the market having its second straight big upswing today, some
options that had appeared impossibly under water just a couple days ago
were suddenly looking better. But that will do little to ease the
increasing distrust executives are feeling about options as a reliable
component of their compensation.

"The perceived value of these awards has taken a huge hit," Derrick
Neuhauser, a senior manager in BDO Seidman's compensation and benefits
practice, told CFO.com. "Definitely, employees will view stock options
as a less attractive compensation tool [because of the market
volatility]. And companies will have to work a lot harder at convincing
them of the value of holding onto their awards and sharing in their
upside."

There is still no better way to tie an executive's pay to his or her
long-term performance than granting options, according to Richard V.
Smith, senior vice president and principal at Sibson Consulting. Still,
he conceded, "It's not going to be real attractive for awhile."

Peter Oppermann, principal and lead executive remuneration
consultant for Mercer, also acknowledged that the recent market losses
may have a dampening effect on companies' inclination to grant options
— but only temporarily, in his opinion.

"I think, based on past experience, everyone is going to realize
again that options are for the long term," said Oppermann. He pointed
to October 1987, when the Dow lost more than 22 percent of its value,
only to gain all of it back in less than a year. Referring to the
common 10-year option length for awards to executives, he added, "If
you got an option at $40 six months ago and now it's at $20, it doesn't
look too good — but you've got nine-and-a-half years left."

For Smith's part, even the financial services sector can be expected
to come back eventually. While most options at those firms are way
under water, he said he would not consider them worthless, except those
that were granted to Bear Stearns and Lehman Brothers employees.

Of course, it all depends on how much of a time window remains in
an executive's option term and just how far under water the options
are. If those factors are not positive, the options have no value to
the company as a retention tool. "When can you reasonably foresee a
stock going from $1 all the way back up to a $10 strike price?" said
Neuhauser. "It might take six or eight years of growth. That's a real
issue."

In such cases, companies, especially healthy ones whose stock is
depressed just because of the current widespread "sell" mentality among
investors, may issue new grants at the lower price. However, Oppermann
said there has been a strong trend toward companies trying to prevent
employees from "timing the market" by awarding grants at the same time
each year or, for new employees, at the same time each month.

Smith, though, said companies can accomplish the same goal and still
boost the value of newly awarded options by granting them at regular
intervals but moving to a shorter cycle — say, from once a year to two
or three times.

Another possible strategy is trading in underwater options for
something of value, such as restricted stock, but Smith said few
companies will do that.

One thing companies are even more unlikely to do is reprice existing
options. "If you did that you would have to reveal it in your proxy,
and that would be the worst possible optic a public company could have
with regard to compensating executives," said Smith. Some companies
tried that strategy a few years back and met with harsh shareholder
reaction, he said.