Weighing the options: employee stock options could encourage the wrong kind of performance. (Spotlight).

Last August, Cendant, a New York-based real estate and travel conglomerate, announced that it would soon begin to expense stock option grants. In doing so, the company joined a long list of businesses that were breaking with the traditional way of reporting a type of compensation. But on the same day, Cendant also made another announcement: It expected to reduce the issuance of employee stock options and instead utilize grants of restricted stock. That decision has placed Cendant, with revenues last year of US$8.9 billion, in the vanguard of a movement to reject option-based incentives and return to a more traditional way of rewarding performance.

Some experts, however, question this approach, warning that abandoning stock options altogether could ultimately hurt a company's performance. They say that despite recent allegations of abuse, stock options remain a valuable way to get managers to perform at their peak level. Yet they also add that the current model of awarding stock options should be tweaked to help ensure that top-level executives concentrate on turning in meaningful long-term performance rather than attempting to simply dress up short-term numbers.

STEPPING UP THE PRESSURE

For the most part, recent news stones about stock options have focused on the pressure that investors, politicians and board members like Warren Buffett have brought to bear on companies to reflect the value of compensation-based stock options on their income statement. Typically the disclosure has been relegated to footnotes which can be easily overlooked by users of financial statements.

Responding to that pressure, companies--ranging from Allstate and General Electric to General Motors and Coca-Cola--have indicated they will now expense the value of compensation-based stock options on their income statements.

Cendant's announcement that it would reduce the use of options apparently didn't get much exposure in the media. But that doesn't mean the movement away from stock options has no supporters. For example, Charles Peck, compensation specialist at The Conference Board, sees an emphasis among businesses and investors on returning to what he calls real financial performance. "There's a move to get away from the short-term vagaries of the stock market and stock option-based compensation," he said. "It should be replaced with a bonus or other incentive payment that consists of money or equivalents."

James A. Knight, a senior executive compensation consultant with Mercer Human Resource Consulting, argues that stock options encourage stock performance, which may not always be driven by operating performance. In a recent issue of the Journal of Business Strategy, Knight observed that, "Shareholders want executives to continue to drive operating performance, regardless of what the stock price does."

He said that while stock options are "performance pay," in that if the stock performs, the executive will be paid, a different model consisting of pay based on operating performance "may provide better opportunities to align executive interests with shareholders' interests."

Knight said that this doesn't necessarily mean that executives will be paid less, but rather, how they are paid will change.

BLAZING A TRAIL?

Operating performance refers to the financial activity, typically some measure of income or loss, posted by a company. In contrast, the rise or fall of a company's stock price--which could be influenced by external considerations, future expectations and other factors--may therefore not always move in tandem with the company's underlying operating performance. By moving to a compensation structure that relies more on stock grants and less on stock options, Cendant appears to be adopting a strategy that is at least similar to the one that Knight has championed. But will other companies fall into line?

Peck says he can't answer that question yet. "It's too early to tell if Cendant is a leader or if it is unique," he reported. "It wouldn't surprise me if other companies follow the example, though. Part of the push is the pressure to expense stock options, which may equalize, on financial statements, with other forms of compensation."

As well, he said, troubles at companies like Enron and Worldcom, although not directly related to options, contribute to the public's growing skepticism toward them.

Incentives to reduce the reliance on options also may get a boost from reports like the one carried recently at CFO.com, which quoted Bill Miller, manager of Legg Mason's flagship Value Trust fund, urging the total elimination of employee stock options. Saying it would improve investor trust, the publication noted that Miller supported a ban on stock options, "because anything that can be accomplished with options can be accomplished by giving stock directly. And it has none of the downsides of options."

The billions or dollars under Miller's s management, and the fund's reputation as the only one to beat the Standard & Poor 500 for each of the past 11 years through 2001, add considerable weight to his statements. Despite this, Wharton Finance Professor John Percival disagrees. In his view, stock options--when structured and utilized appropriately--are an effective way to compensate managers. "Stock grants reward managers no matter what happens to stock price because the stock is worth something," he said. "Options, if they are indexed properly, reward managers only for value creation."

He does say, however, that unlimited stock- and option-based compensation could lead to ineffective behavior on the part of management. "Managers who have lots of stock and lots of options are not diversified and therefore do not think like shareholders who are diversified," explained Percival. "There are certain risks that diversified shareholders would want managers to take that they will not take if all of their wealth is tied up in one company."

Similarly, Wharton Accounting Professor David Larcker believes it would be a mistake to eliminate stock options as a form of compensation. However, he believes that the current practice of granting stock options that are intrinsically valuable because they are "in the money," will eventually be replaced by a different model.

"Simply eliminating stock options as a form of compensation is a naive idea, and is a knee-jerk response to a perceived problem," he said. "First, improper corporate behavior is not entirely due to stock options. Further, research indicates that options provide important incentives to executives, and are an integral part of the compensation program."

But he does expect a rotation from "in the money" options to ones that are priced at a premium, or are "out of the money,"--essentially, options that carry an exercise price that is higher than the current market price.

The basic issue, according to Larcker, is to encourage managers to pursue growth. He notes that his recent research indicates that premium options provide a better incentive for executives than in-or-at-the-money options. "Lots of options should be awarded," he said. "But the exercise price should be well above the current price-higher by 50% or more."

MAKING IT WORTH IT

To realize the benefit of such options, managers would have to make profitable investment decisions and convince the market that the company-and, in turn, its stock-is worth intrinsically more than its current valuation. He notes, though, that even if a company's business model and strategy are solid, a drop in the overall stock market can also drag down the shares of a well-ran company. "It would be wise to have a competitive program with lots of incentives to shield against this scenario," he said. "It's a good way to discourage financial shenanigans."

The trend toward premium-priced stock compensation is growing, he adds, with about 50 companies including Air Products & Chemicals, Baxter International, Chubb and the Gap adopting this approach.

One way or another, a combination of factors-ranging from the shaky post-September 11 economy to recent scandals affecting former corporate icons-appears to be driving a variety of changes in the way that business is conducted and reported. It may be premature to say that stock options will either be eliminated or radically changed, but it also may be safe to say, as Mercer's Knight did, that, "Megaawards of stock options and special arrangements for executives, as was done at Global Crossing, are a thing of the past."

This article is reprinted with permission from knowledge@wharton.