This May Be the End of the Options Era


A year ago, Microsoft Chief Executive Steven A. Ballmer was asked why the company didn't take a leadership role in reforming tech-industry accounting. Why, an analyst asked, didn't the tech giant deduct the cost of stock options from its earnings? Ballmer's response: Others in the tech world say the fallout would be "very, very gloomy." As a leader, Microsoft stood by its industry.

No more. On July 8, Microsoft (MSFT) did the unthinkable: It scrapped stock options, eliminating a form of pay that made thousands of Microsoft employees millionaires and helped define the culture of the tech industry. Instead, starting in September, the company will pay its 54,000 employees with restricted stock, a move that will let employees make money even if the company's share price declines. Like stock options, the restricted stock will vest gradually over a five-year period from the issue date. Under accounting rules, grants of restricted stock are counted as expenses and charged against earnings.

"A SMARTER WAY"? Microsoft's explanation for the switch was the "angst" it faced from employees whose stock options were worthless. "We asked: Is there a smarter way to compensate our people, a way that would make them feel even more excited about their financial deal at Microsoft and at the same time be something that was at least as good for the shareholders as today's compensation package?" says Ballmer.

More than just altering one company's pay program, the move promises to change forever a perk that is as closely linked with technology as the assembly line is with the auto business. "This marks the beginning of the end of the options compensation era," says Robert B. Austrian, an analyst with Banc of America Securities.

Stock options paved techdom with gold, making millionaires out of top execs and rank-and-file software programmers alike. But critics argue that they distorted company earnings, camouflaging an expense that never showed up on the bottom line. In response, the Financial Accounting Standards Board is preparing a rule that would require expensing of stock options. Here's how Microsoft's move will affect employees, investors, and the tech industry.

What does this move say about Microsoft?

No company has been more of an icon of the tech boom over the past quarter-century than this software giant. But as the company nears its third decade, its financial performance has become staid. Sales, which climbed an average 36% a year through the 1990s, haven't cracked 16% growth this decade. In the 1990s, Microsoft shares grew nearly 100-fold, from a split-adjusted 60 cents to $59.19. Share prices have been halved since the 1999 peak.

The new pay plan is a tacit admission that Microsoft isn't the growth stock it used to be. Microsoft shares haven't kept pace with others in the industry. Its stock is up 6.3% this year, compared with a 43.6% rise in the Merrill Lynch 100 Tech index.

What does the change mean for Microsoft employees?

The biggest shift is that employees can get some value from their stock even if the price doesn't climb. That may not seem like much of a motivational force. But with shares well off their 1999 high, virtually all the options granted since then are worthless. That means the 20,000 employees who joined Microsoft in the past three years have seen little or no benefit from their stock compensation.

Now, employees will still have a strong incentive to improve the performance of the company and its stock price. But they don't have to wait for the gargantuan price jumps of the past decade -- jumps that aren't likely to come from a mature company, anyway.

Their existing stock options won't be worthless, either. Under the new plan, which needs regulatory approval, employees can elect to sell their options to J.P. Morgan. In an e-mail to employees, Ballmer wrote that at a Microsoft stock price of $25, the company expects that options with a grant price ranging from $33 to $34 could be sold for approximately $1.80 to $2.10 each. Not much, but it's better than nothing.

What's the effect on earnings and accounting?

Microsoft will announce on July 17 the impact on its earnings. With its report for its first fiscal-year quarter ending in September, the company will begin to account for the expense of new stock awards and for stock options that are vesting. The hit from the fresh expense could be as much as 23% of earnings, according to analysts at Goldman, Sachs & Co., who looked at the cost of past Microsoft stock-option payments.

But the company probably won't have to hand out as many dollars' worth of stock as it did of stock options in order to satisfy employees. If it can cut its costs for stock-based compensation by one-fourth, its newly reported expenses would be about 17% of earnings. Microsoft is choosing to account conservatively for the ongoing vesting of options it has granted in the past. That means the potential advantage of switching to stock awards will phase in gradually.

What's in it for Microsoft shareholders?

Investors aren't too rattled. The day after the announcement, Microsoft shares fell 23 cents, or 0.8%, to $27.47 in a trading session in which the Dow Jones industrial average dropped 0.7%. Over the longer term, its stock price could go up, notes analyst David Bianco of brokerage UBS. Investors could be encouraged if Microsoft gets more output from employees because its stock compensation provides stronger incentives without extra cost. Plus, since Microsoft plans to hand out fewer restricted shares than it did stock options, it may not need to buy back as many shares, which could conserve cash and minimize dilution.

What does Microsoft's move mean for other tech titans?

Intel (INTC), Cisco Systems (CSCO), and others have vowed to keep issuing options. They argue that there is no accurate way to account for options and it would be a disaster, they say, if tech companies had to expense them. Unlike Microsoft, most tech outfits face fierce competitors in the U.S. and overseas. They believe stock options are a good way to keep competition from poaching key employees.

These are legitimate concerns, but Microsoft's move and the expected ruling from FASB mean it's probably only a matter of time before the day of reckoning comes for the rest of the industry. There's already momentum in that direction in all types of corporations. According to Mercer Human Resources Consulting, a compensation consultancy, 220 companies have announced plans to expense options this year. And on July 9, DaimlerChrysler (DCX) revealed that it is considering scrapping stock options.

Won't expensing of options crimp innovative startups?

Indeed it may. The FASB ruling will apply to private companies as well as public ones. Startups typically offer recruits generous grants of stock options because they can't afford the salaries that more established companies offer. They also say they need a come-on to convince talented people to give up secure positions and risk their careers on unproven companies. If these businesses have to expense stock options, it may take longer for them to achieve profitability, delaying an initial public offering and requiring them to raise additional venture-capital funds.

With mandatory expensing, "it will be very hard to have a successful startup company in Silicon Valley or in the U.S.," warns Marc Benioff, CEO of Salesforce.com, a software company that is expected to go public next year. He may be overstating the case, but in a world that is increasingly hostile to startups, any additional burden makes it even more difficult for these innovators to thrive.

What does this mean for executive compensation?

With Microsoft as their trailblazer, expect many other companies to reexamine their compensation programs. Under the Microsoft plan, its top 600 executives and managers will receive most of their compensation in the form of restricted stock. The amounts will depend on growth in the company's customer base and improved customer satisfaction.

Many other businesses will likely be persuaded by the Microsoft example to replace some option grants with restricted stock. But no one expects options to disappear entirely, whatever the cost. Compensation consultants say that options -- with their promise of a big payoff -- will remain an important, albeit smaller, part of the executive compensation landscape. By Jay Greene in Seattle, with Cliff Edwards in San Mateo, Calif., and Steve Hamm, David Henry, and Louis Lavelle in New York


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