Without a Plan for Replacing Options, Companies Could Lose Their Best People

When dot-coms ruled the universe, stock options were revered as the best way to snag a prized vice president of marketing or a promising engineer. That was so 20 minutes ago.

    Today, options are under fire, with accounting-rules changes, disgruntled shareholders and stocks trading under grant prices. What’s a company to do? Drop them. Roughly a third of 108 companies responding to a recent Mellon Financial survey said they’ve cut option-grant eligibility, participation and amounts. Hardest hit: nonexempt workers. Of companies dropping options for employees other than executives, more than half said they won’t replace them with anything.

But that kind of thinking could be shortsighted, as it may lead employees to leave for more lucrative pay packages, says Ted Buyniski, a principal in Mellon’s compensation consulting practice in Boston. In addition to helping with the Mellon survey, Buyniski participated earlier this year in roundtable discussions about upcoming accounting-rules changes affecting stock options sponsored by the Financial Accounting Standards Board. Here’s what he has to say about trends affecting options and companies’ stock-based pay plans in general:

Why will lower-level employees feel the brunt of companies’ granting fewer options?
    When options become an income-statement cost, the marginal cost to companies is going to skyrocket. When they look to cut costs, where’s the first place they’re going to look? Not at the top-five [officer] level, but across the rank and file.

If companies cut options, what will they offer instead?
    A minority aren’t going to cut back, and another minority, if they cut back, will increase salary or incentives or something else to make up for it. A majority of companies won’t replace them with anything. That’s a sound notion if you’re in an economy with a lot of unemployment because people are happy to have a job. But in today’s economy, you’re getting more start-ups and hiring is picking up. Those companies that dramatically reduce options and do nothing are going to lose people.

Why would a company do that?
    Because they think they can. But as a practical matter, if you cut pay, most people don’t react positively. Then the question becomes, do you provide something with the same perceived level of benefit, or do you hope employees are going to decide there’s enough other good in being here that they don’t mind?

You describe options as pay. Do employees perceive it that way?
    They may not assign a dollar value to it, but they’ll say, “You took something away from me; are you giving me anything in exchange?” If you take away options and give them a salary increase or a bonus, they may decide the value is worth more than the options, especially at a lot of companies where options have been underwater for two or three years. One of the real questions companies are dealing with is, “Where is the trade-off level?” For example, a company might take away $10,000 of options from an employee and give them a $2,000 salary increase. From the employee’s perception, the $2,000 is worth a lot more to them than the options because options have been underwater. The ideal situation is to create a win-win: reduce the cost to the company and improve perceived value to the employee.

Do you know of companies that have done that?
    A software company I work with significantly cut the percentage of employees receiving options in a given year in anticipation of upcoming accounting changes. Before, half the employees got them; now a quarter do. At the same time, they provided an across-the-board salary increase over normal merit raises. Employee response was good, and compared to keeping their old option program under expensing, they’ve eliminated a third of the cost, even with the salary increase.

Companies that cut options won’t talk about it because they don’t want to look like bad guys. But companies that replace options with something else aren’t talking either. Why not?
    They want to keep a leg up on the competition. If Company A comes up with a good response, the way they want other companies to find out about it is when they start taking good employees.

Some companies are committed to giving stock options even if it depresses earnings. Why?
    One thing that came through in the survey is that equity compensation isn’t dead. You’re still going to have a significant minority, 35 to 40 percent, that uses equity incentives, and options are still the primary vehicle up and down the ladder.

When will the accounting changes take effect?
    That’s the $64 million question. After the FASB roundtables in June, they announced there may be a delay. That may be in response to feedback we gave them that if changes aren’t released until the end of the year, people won’t have their systems up and running for Q1 reporting. I think FASB will make their release after the first of the year.

How could Congress affect the accounting rules?
    FASB is a non-governmental body, so Congress could overrule it. There’s a range of proposed legislation out there, from pro-option to anti-option. The bill [that has gone the furthest] passed the House in July. That would expense options only for the top five executives. It’s a compromise, and compromises are never good accounting. But the Senate Finance Committee said they wouldn’t take it up this year. Another bill says FASB can’t do anything for three years while the SEC studies the issue. Another says you only get a tax deduction to the extent that you take an accounting charge, which is even more onerous. Another bill says executives and directors can’t be granted stock options. If you wanted to put money on something passing this year, I’d be happy to bet against you.

Meanwhile, what’s a human resources manager to do?
    Get ready. Practically speaking, there will be expensing; it’s just a question of whether it’ll be in 2005 or 2006. A good compensation director or vice president of human resources is looking at what the cost would be of continuing the existing program, what they could do to deliver comparable perceived value at a lower cost, and whether their programs are already structured so that they could do that.