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Consider all options for options.

Microsoft's recent decision to replace options with restricted stock overturns a host of market myths and paves the way for new thinking about incentives. But while the market seemed to like the new pay plan, it won't be the best approach for all companies. Boards must consider all the incentives tools at their disposal--and not simply take the path of least resistance.

Start with the fact that Microsoft's shares rose 13 percent versus the market over the month preceding the July 8th announcement, when Oracle's shares fell 4 percent and SAP's, 7 percent. Contrary to conventional wisdom, Microsoft's shares climbed even though share grants will henceforth be deducted as an earnings charge, and also despite the fact that Microsoft will restate prior earnings to recognize the cost of options granted under its former plan. Wall Street analysts estimate that expensing options would have cut Microsoft's net income last year by almost a third, from $7.8 billion to $5.4 billion. Similar-sized charges from restricted stock grants can be expected going forward.

But instead of collapsing along with its earnings, Microsoft's shares have, if anything, gained in value. Silicon Valley titans who warned that the sky would fall if equity incentives were charged to earnings have now been proven wrong. Multiples are revised upwards when earnings are stated with greater accuracy, integrity and transparency. As efficient market proponents have long asserted, the market sees through accounting fictions, and values the qua] ity of earnings as much as the quantity.

The question remains, though, what are the merits in Microsoft's shift to stock? After all, stock options still do give managers a greater claim in upside stock potential. They help to mitigate managers' tendency to be more risk averse than shareholders, a tendency that restricted stock does not address. The trouble is, option incentives shift with the stock price. If the sponsor's share price rises, options behave more like the underlying stock, rising and falling in value in tandem with the shares, prompting managers to become more risk averse and more desirous to preserve an embedded option gain. And if the stock price tumbles, options can fall so far out of the money that they no longer provide a meaningful incentive, making them worthless as an employee retention tool.

With restricted stock, however, the incentive to increase share value is always the same, whether the stock rises or falls. The incentive is linear and lasting, as opposed to curvilinear and capricious. There is less chance of losing good people in down times or running out of incentive steam, mad for Microsoft, consistent motivation and retention of its talented and mobile work force is key.

On the other hand, restricted stock may so downshift incentives that in the long run even Microsoft may be making a mistake. Given their relative valuations, an employee may receive only one share of restricted stock for every three or four options. The upside payoff is only one-third to one-half that of options.

The optimal strategy, therefore, may be to combine less risky restricted stock with riskier "leveraged stock options," or LSOs as I call them--options for which the exercise price is posted 30 to 50 percent over the grant date share price in order to set aside a required shareholder return before management participates. With their higher hurdle, leveraged options are worth perhaps only half as much as standard options, particularly if their term is limited to five years. As a result, eight standard options may be traded for, say, two restricted shares or, perhaps better, one restricted share plus eight premium options. Compared to standard options, the latter mix offers a manager the downside protection and continuing incentive of a share of stock, but also, the incentive to take risk and vault over the leveraged option hurdle. A variation worth considering is swapping eight ordinary options for, say, four "discount options" where the exercise price is half the grant date stock price.

The point is, the alternatives are not just restricted stock, but premium options, discount options and indexed options, or shifting equity incentives into bonus plans that can be targeted to measure and more precisely reward business unit performance. With the expensing of equity incentives, wise boards will use the full arsenal of incentive vehicles to optimally calibrate the tradeoff between pay and performance and not settle for the flavor du jour.

Bennett Stewart is senior partner at Stern Stewart & Co., a consulting firm that specializes in value-based management and incentives.
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Title Annotation:alternatives to employee stock options; Thought Leader
Author:Stewart, Bennett
Publication:Chief Executive (U.S.)
Geographic Code:1USA
Date:Aug 1, 2003
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