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The Bottom Line On Options


More than one war has been fought over the fine points of religious dogma, and the narrowest differences in ideology have caused some of the bloodiest conflicts. These are the wars that sweep away everything in their path while the participants forget the reason they started fighting in the first place.

So it is -- minus the blood -- with the Great Options Battle. You will recall how it started, with Warren Buffett leading the charge on one side, Intel Corp.'s Andy Grove and Cisco Systems Inc.'s (CSCO) John Chambers waving their pennants on the other, all battling over accounting rules. Lifted on a tide of anger over ever-more-outsize executive pay packages, the corporate-governance party prevailed. Now the new rules that require U.S. companies to count stock options as an expense are in effect for nearly everyone. But it turns out CEOs might well lose little or nothing. If anyone is taking a hit, it is the professionals, engineers, and managers who hoped they too could cash in on the options boom.

Stock options became popular in the 1990s as a tool that was supposed to "align the interests" of shareholders and management -- in other words, reward CEOs for concentrating on raising their stock price. Silicon Valley, of course, seized on options as a way of attracting top engineering talent. Finally, at the height of the market boom, big companies that wanted to project an image of rapid growth and general with-it-ness started giving out options to thousands of their employees. Aetna, when it shed most of its old insurance businesses, instituted an option plan for all employees. So did Time Warner when it merged with America Online. The total number of U.S. employees who got stock options grew to roughly 10 million at the height of the options boom in 2002, according to a study by the National Center for Employee Ownership (NCEO), a think tank in Oakland, Calif.

Now the center's director, Corey Rosen, estimates the number is down to 7 million and shrinking. Before the new accounting rules kicked in, options were invisible on the corporate income statement. No matter how many a company handed out, they could tell investors that they cost nothing. Not anymore. Google, hugely generous with employee options through last year, when almost $420 million worth were handed out, this year has switched to giving out restricted stock, which vests over time. But Google's expansive stock program is the exception. Aetna, whose employees profited handsomely as its shares ran up in the five years or so that it gave options, last year replaced them for non-managers with $500 bonus checks.

"OUTLANDISH PAY"

For top execs who no longer get big option grants, the make-good money is far more handsome. Merrill Lynch & Co. (MER) last gave CEO E. Stanley O'Neal options in 2003. Over the past two years, it replaced his cash and options package with restricted stock grants of -- take a deep breath and feel free to whistle -- $51 million. A spokesman says O'Neal's compensation reflects the company's performance. Merrill Lynch is an extreme. But just as most big companies have cut options in some way, it's hard to find a CEO whose options weren't or won't be replaced by some other compensation.

Again, look at Aetna. It cut its broad-based option plan in 2004, anticipating the new rules, but continued giving options to top executives through last year. Starting this year, executives, including CEO John W. Rowe, will no longer get options -- but they will get substantial grants of restricted stock. And in a few cases the cutting back on options simply stops at the CEO's desk. FedEx's Fred Smith, for example, went from 250,000 options in 2004 to 325,000 options last year, even as the option pool for the whole company was cut by more than 30%. The impetus for the war on options, pay expert Rosen dryly notes, was "outlandish pay packages, but the pay packages are still outlandish."

It's not all gloom for the middle tier. Some in the tech industry predicted that the new expense regime would be the end of Silicon Valley's famous options culture. Not so. Network-hardware maker Cisco, in fact, continues to hand out options at roughly the rate it did before the new changes took effect. Pfizer, an old-line drugmaker whose options plan for managers turned out to be a less than terrific deal, with its stock languishing since the mid-'90s, has cut option grants by 42% companywide. But it replaced the options with shares of restricted stock.

The brand-new startups, meanwhile, have been affected a lot less by options expensing rules than by a host of other regulatory burdens. New companies, whose options are a big gamble, continue to hand them out to lure programmers. The problems created by the requirement to estimate the value of their shares, which are not yet public, are manageable. "If [complying with] Sarbanes-Oxley was 9 on a scale of 10," says Paul Matteucci, a partner at venture-capital firm USVP, the new option accounting rules are a "3." In fact, Matteucci says that new and little-noticed rules about valuing privately held stock are a much bigger headache for venture backed startups.

There's a pattern here. Tech companies that are asking top talent to take a big gamble and hope for outsize stock bonanzas are keeping their options, other companies aren't. For many employees of big companies, once the bright euphoria of the market bubble was gone, options turned out to be less terrific than the hype. Options are not as attractive at companies like Microsoft, Pfizer, and Time Warner, whose stock prices have not risen in years. There, options can be a painful reminder of the might-have-beens. Companies that have eliminated options now talk about the value of cash. And they might have a point. An Aetna spokesman argued that a $500 check is a comparable replacement for a typical $40,000 a year employee who would have gotten options under the old plan for about 45 shares of stock. A Time Warner spokeswoman points out that most employees would rather get cash than stock options that over the last few years have given them little.

Which points up an unfortunate truth about options: They are a great way to let employees share in the wealth at a company whose stock is rising dramatically, but in most other cases they don't make for a very good incentive at all. When they were easy to give out, options were billed as a magic potion that would make employees come to work every day hoping to increase the stock price. But motivating employees is just not that simple.

Nor, for that matter, is motivating CEOs. The history of the options boom is instructive here. The seminal moment for options was a 1990 paper by economists Michael C. Jensen and Kevin J. Murphy that argued that American companies didn't give CEOs enough incentive to worry about the stock price. Jensen and Murphy knew that giving top executives options would likely mean bigger pay packages, but they didn't anticipate how much bigger. (Murphy now says he feels like a doctor whose patient started swigging a bottle of wine a day when he prescribed a glass.)

And what did the bigger pay packages accomplish? It's not clear. Murphy, now at the University of Southern California, thinks that better-designed -- and, yes, bigger -- executive pay packages may have helped create the stock market boom of the late 1990s. But the link between pay (options) and performance (stock boom) is tenuous. Consider this: Murphy and Jensen ended their article with a list of 25 companies that gave their CEOs the most sensibly structured package of incentives. Among their selections: Enron, Pan Am (which declared bankruptcy just months after publication), UAL (UALQ), Toys `R' Us (TOY), and others just as dreary.

Now, with the new rules in place, the options game has come full circle. First they looked like a nice incentive for CEOs. Then, when it became clear to everybody that you could give any number out and still declare profits every year, they seemed like a good idea for all. Now that they are a lot harder to give out, they don't look so irreplaceable after all. Companies have found they can live with their top tier of executives getting fewer options and the corporate middle fewer still. So some of the options have disappeared. But the outsize pay packages that options mania brought about still remain.

By Mark Gimein, with Louis Lavelle in New York, Amy Barrett in Philadelphia, Dean Foust in Atlanta, and bureau reports


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