Stock Options Have Their Ups & Downs

Like many chief executives, Howard Schultz was thrilled when his company,Starbucks Corp., went public in June 1992. On the first day of trading, thestock closed at $21.50 — up from an opening price of $17. Not only did the CEO’snet worth zoom, the coffee retailer had finally reached the big leagues. Butinstead of hoarding his beans, Schultz decided that he would give some of themback to employees in the form of stock options. At a time when other firmsoffered options only to key senior executives, Schultz made them available toeveryone working 20 hours a week or more, including those standing behind thecounter at a local Starbucks store.

Today, Seattle-based Starbucks has a market capitalization somewhere in theneighborhood of $4.2 billion and about 2,100 stores in Asia, Canada, the UnitedKingdom and United States. But Schultz hasn’t veered away from his originalphilosophy of giving employees a stake in the company. More than 10,000 of thefirm’s 26,000 workers participate in the plan, which Starbucks refers to asits “Bean Stock” program. They’ve made down payments on houses,purchased cars and paid for their college education. Meanwhile, the company hasmanaged to cut turnover to approximately one-third the industry norm.

Stock options. These days, the words are everywhere. And it’s not difficultto understand why. Pick up a newspaper or click on the television and you’relikely to hear about some young entrepreneur who’s worth tens of millions –sometimes even billions of dollars — through options. There’s Jeff Bezos ofAmazon.com, whose paper wealth is somewhere in the neighborhood of $10 billion– despite a 1998 salary of $81,840. There’s Michael Dell, who’s worth acool $22 billion as founder and chairman of Dell Computer. And then there’sBill Gates, whose personal fortune resides somewhere in the galaxy of $105billion — almost all from Microsoft stock.

But behind the glitzy façade and the media hoopla, stock options havequietly become a way for companies to attract, retain and reward workers. They’realso a way for organizations to align the workforce with shareholder value. FromAmazon.com to Xerox, companies are turning to stock options in record numbers.And while the great bull market of the 1990s has unquestionably fed into thefrenzy, it would be a mistake to tag the phenomenon solely to the popularity ofstocks. To be certain, options have become an entrenched compensation strategy– and are profoundly altering the corporate landscape.

The idea for stock options is actually rooted in the 1930s, though thepractice didn’t take place in any real way until the 1960s. At that time,major corporations began offering top executives stock options as a way to boostpersonal income and tie performance to shareholder value. Then, in the 1980s,Congress slashed tax rates and the stock market awakened from a 10-year slumber.CEOs like Disney’s Michael Eisner and Toys “R” Us CEO CharlesLazarus began to garner headlines for receiving huge options windfalls, whichtotaled tens of millions of dollars.

Since then, the popularity of stock options — not to be confused withEmployee Stock Ownership Plans (ESOPs) which are geared toward retirementsavings — has zoomed along with the stock market. According to Sanford C.Bernstein & Co., the total value of shares set aside for options grants inthe United States increased from $59 billion in 1985 to $600 billion by 1996.More than 90 percent of public companies now have employee stock-optionprograms. And, recently, the practice has begun to spread to Japan and othercountries.

“Stock and stock options are becoming the preferred currency forcompensation programs in the U.S.,” notes Heidi Toppel, a regional practiceleader for Watson Wyatt Worldwide. “More employers are providing stockoptions beyond the executive management level. In most cases, the goal is toalign workers and shareholders, boost retention and allow employees to share inthe company’s success.”

Companies find stock options so attractive for a basic reason: they don’tcost them anything yet they boost pay. Thanks to a glitch in tax law, theoptions don’t have any cash value. What’s more, when workers exerciseoptions, the tax code allows the company to deduct the gain as an expense,despite the fact it hasn’t spent any money. Ultimately, the wealth is createdby the stock market itself and the company can boost its profit by reducinglabor expenses. “In a sense, it’s funny money,” says Mike Butler,who heads the employee ownership consulting practice for Hewitt Associates.

Employees like stock options because they can buy their company’s stocksometime in the future, but at the market price when issued. For example, aperson who is granted an option at $50 a share hopes the stock will rise. If theprice climbs to, say, $75 a share, the holder can exercise the option and net ataxable profit of $25 per share. However, if the stock drops to $25 and doesn’tbounce back, the options expire worthless. Ditto if a person holds onto thestock too long or it never rises.

Yet, despite their enormous popularity — and success — stock options cancreate problems. In some cases, companies have struggled to keep vestedemployees on the payroll once they’ve cashed in options to the tune ofmillions of dollars. In fact, companies like Oracle and Microsoft have hundreds,even thousands of employees that have joined the “millionaire” club asa result of stock options. Other firms have learned the hard way that if thecompany’s stock crashes or remains stagnant for a prolonged period, it canwreak havoc. “There are lots of issues to grapple with. It’s not assimple as starting a program and expecting it to succeed,” warns Butler.

Paula Flemming knows that fact well. As director of HR effectiveness at XeroxCorp. in Stamford, Connecticut, Flemming has struggled with an array of issuesto build a viable program. Although the company has had a profit-sharing programin place since the early 1970s, it opted to change the mix from 100 percent cashto 50/50 cash and stock in 1998. In January 1999, it awarded $8.2 million instock options to 48,000 of the firm’s 52,000 U.S. employees. After one year ofemployment, an employee is eligible to receive options, which are valid foreight years. An employee is considered vested a year after receiving the firstoptions.

A key in setting up the program, says Flemming, was ensuring that the rightunderlying metrics were in place. Instead of using return on assets as anindicator, Xerox opted to use growth and earnings per share. “We wanted totie the program into shareholder value,” she explains. Moreover, thecompany increased the maximum payout for the profit sharing program from 10percent to 15 percent of total wages.

“The biggest message the company is trying to send to employees centerson ownership. An employee who has a stake in the company’s performance is farmore likely to help it grow and boost its stock value. The program also letsemployees participate in the same wealth accumulation opportunity that has beenavailable to executives for years. Performance-based pay is an effective way tomotivate a workforce,” she adds.

However, Xerox is a prime example of the challenges and risks of stockoptions. Last May, the stock peaked at nearly $64 a share. After the companyannounced lower than expected earnings in October, the stock price plummeted tothe low 20s. Today, all employee stock options are underwater, meaning thatemployees are unable to buy them. And that, says Flemming, presents a barrier –especially if the company’s stock performs poorly over the next several years.

However, in the past, Xerox execs who have held options for extended periodshave enjoyed the greatest gains; the stock has always recovered from downturns.As a result, she and other human resources executives provide constant educationabout stock investing in general and the company’s options program inparticular.

Butler believes that the tremendous growth of stock-option programs is partlyan attempt to remain competitive and attractive in the labor marketplace. In anera of reduced stability and job security, “It’s a natural way toencourage employee loyalty. It’s a way of saying, ‘You might not work hereforever, but while you’re here, we expect 110 percent — and in return we’llshare the wealth with you.’” However, he also argues that these programsare partly a result of “executive guilt.” Over the last two decades,says Butler, “CEOs and senior executives have reaped millions of dollarsfrom stock options, and now many of them feel that stock options are necessaryat the employee level in order to avoid a feeling of inequity amongemployees.”

Of course, not all stock options are created equal — and the way differentcompanies approach the issue varies greatly by industry. High-techentrepreneurial companies — including many of the Internet high flyers thathave popped up over the last few years — depend heavily on stock options toprovide compensation. Many pay salaries far below market value. Yet “acertain type of person — often someone in their 20s or 30s, and usually withouta home and family — is attracted because of the opportunity to hit the optionsjackpot while doing work that’s interesting,” says Butler. In fact, somework at two, three or even five startups before making any real money in stockoptions — almost always through an initial public offering (IPO). Others neverhit pay dirt.

All that glitters isn’t necessarily gold. What happens to a company thatwinds up with dozens, even hundreds of millionaires who no longer need to comeinto work because they have all the financial security they’ll ever require?Do they run for the exits in droves — taking valuable intellectual capital withthem? Not necessarily, experts say. For one thing, a well-designed program willcontinue to grant options every year, so that a person can continue toaccumulate wealth through the company’s stock. For another, many of theworkers who are attracted to these high-tech, entrepreneurial companies find thework stimulating. “Pay isn’t the only issue, or even the primary issuefor some workers. It’s the ability to have an impact and do somethingexciting,” Butler explains.

Consider Broadcom Corp., an Irvine, California, company that manufacturesmicrochips and other components used in cable modems, DSL modems, digital cableset top boxes and high-speed networking gear. The company went public in 1998,and since then it has seen its stock rise six-fold. The net result? More than 75percent of the firm’s 800 plus employees are millionaires on paper. Yet thecompany only lost four employees last year, says Nancy Tullos, vice president ofhuman resources. “It’s a stimulating place to work, employees feel asense of ownership, and senior management has been smart enough to createongoing stock incentives to keep people at the company,” she explains.

Tullos admits that a downturn in the stock could present difficulties, butshe believes the reason for lagging stock performance is crucial. “IfBroadcom started missing key design wins and experiencing internal problems,then we would have a reason to be concerned. If it’s simply a reflection ofthe market, then we feel there’s no reason to worry. The key is that we don’twant to lose our edge and we don’t want employees to lose their edge,”she explains. Yet, as the firm matures and stock options represent less of apotential windfall, she points out that Broadcom will begin paying highersalaries and providing other benefits.

Indeed, there’s also the issue of pay equity, which can create headachesfor everyone. Because some employees join a company on the ground floor –before an IPO — they might receive a larger number of stock options thansomeone who starts later. However, the company might find it necessary to paythe latter employee more — in order to make up some of the difference. The netresult, particularly at these entrepreneurial companies: a manager might earn$50,000 a year in wages while a subordinate receives $75,000. Likewise, thosewho join a company later might not see the same kind of appreciation in thecompany’s stock as those who join a start up.

Of course, that’s a far different scenario than for mainstream companiessuch as Citicorp, Kodak, Merck, Starbucks, United Airlines and Xerox. In themajority of cases, workers at these firms aren’t looking to get rich fromstock options, they just hope to accumulate money for a down payment on a houseor a trip to Europe.

That’s the case for Jessica Gleeson, who works in the corporate trainingdepartment at Starbucks. She started at the company in 1990 — serving coffee ina Seattle store — while attending the University of Washington. A year later,CEO Howard Schultz announced Starbucks would offer stock options to employeeswho work at least 20 hours a week.

Gleeson purchased stock from the options, then sold it in 1995 for a $15,000profit. That became the down payment on a new home. Now, she’s preparing tofly to Paris for a year-2000 celebration — also funded from company stock thatshe sold recently. “Bean Stock has definitely given me a much strongerfeeling of ownership in the company,” she says. In fact, a couple of yearsago, Gleeson devised a way to save the company $1 million a year by reducingin-store waste. “People wind up treating the organization’s money like it’stheir own money,” she adds.

According to Helen Chung, a spokesperson for Starbucks, the stock-optionprogram fits into an overall HR strategy, which includes an array of otherbenefits. The Bean Stock program provides options based on the annual success ofthe company, and every year the board of directors decides how many options willbe available to workers. In 1998, for example, workers received stock optionsequal to 14 percent of their annual wages. After a year, an employee is 20percent vested; after five years a worker is 100 percent vested. The companyalso operates a separate stock investment program (SIP), which allows employeesto buy shares outright through the company every quarter at a 15 percentdiscount.

Despite the enormous success of stock options, potential storm clouds loom.One of the things that have made options so appealing is the stellar bull marketof the 1990s. In an environment of rising stock prices, options succeed.

However, experts agree that a prolonged bear market could it make it nearlyimpossible for companies to use options effectively. In addition, critics havecontinually lobbied Congress and the Financial Accounting Standards Board (FASB)to change the tax code to make options an actual expense — something that couldcost major corporations hundreds of millions of dollars a year. So far, attemptsto change the system have fallen mostly on deaf ears.

If fact, it’s a pretty good bet that the situation won’t change anytimesoon. “Stock options have clearly changed the corporate landscape,”says Toppel. “They have become a key form of compensation and an importantpart of the economy. When a program is successful employers and employees comeout ahead.”

Workforce, December1999, Vol. 78, No. 12, pp. 44-47 — Subscribenow!