Companies & Industries

Stock Options Aren't the Only Option


Want to start a fight in Silicon Valley? Just say stock options should be counted as an expense on the income statement. Technology executives will shriek that such a move -- suggested by the Financial Accounting Standards Board last month -- will slash profits and force them to cut options grants to most of the 90% of employees who now get them. That will numb their motivation, execs say, and ultimately hurt innovation.

This argument, however, is beside the point. Even before expensing is required, probably next year, it's clear there are much better ways than options to keep innovation humming.

Especially attractive are restricted stock, which converts into common stock over time, and performance shares -- grants based on meeting certain goals. Their appeal: They don't hide costs or dilute shares as much as options, and they're more flexible and effective at motivating people to act like owners. Says McKinsey & Co. partner Neil W.C. Harper: "This is an opportunity to fundamentally rethink incentive compensation."

"LOTTERY TICKET." The appeal of options is clear. Besides their miraculous invisibility on the bottom line, they provide both tax deductions and cash infusions as they're exercised. But they don't motivate when they're nearly worthless -- as many are now because their exercise price is far higher than the stock price.

"They're a lottery ticket, to be honest," says Tim Halladay, vice-president for investor relations at Amazon.com Inc. (AMZN), which recently began issuing restricted stock units instead of options. Even in good times, options are dubious incentives, because accounting rules prohibit tying unexpensed options to meeting goals such as profit or sales growth. Says Matt Ward, chief executive of San Francisco consultant WestWard Pay Strategies Inc.: "Options are probably the worst incentive." (For more from Ward, see this Q&A.)

That's why tech companies must consider the alternatives now. One promising tool is restricted stock, which converts to full shares over a three- to five-year period. As with options, employees gain if the stock rises. But even if it declines, the shares are worth at least something, so they remain an incentive in bear markets.

DON'T GIVE IT UP. Restricted stock also doesn't lower earnings or dilute common shares as much as options: Because employees deem restricted shares to be more of a sure thing, Amazon, for one, needs to give out less than half as many restricted shares as options.

Even better would be shares granted only when performance goals are met. Ideally, say experts, they would combine achieving stock gains against a peer group of companies with meeting internal goals such as a certain level of revenue or profit growth. That ensures that employees benefit only when a company truly outperforms the norm.

No single form of incentive pay is perfect. But whatever they do, companies must not follow through on their threat to drop any equity compensation for most employees. That will backfire when the upturn comes and talent is again in short supply. Instead of continuing to trot out the same tired arguments against expensing, tech firms should devise more innovative solutions. Isn't that what they're supposed to do best? Hof is BusinessWeek Silicon Valley bureau chief


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