With stock option grants increasingly seen as a magic elixir for motivating employees, keeping the cost from hurting shareholders has required more and more financial alchemy. The latest trick? As they buy shares in the open market to soak up the dilution from option grants, more and more companies have launched put-warrant and other derivatives-based programs to reduce the cost.
Not surprisingly, technology firms that have granted massive amounts of employee stock options have been particularly heavy users of this tactic, with Microsoft Corp. and Dell Computer Corp. among the heaviest. And more companies can be expected to join the crowd as long as stock options remain the incentive of choice.
The financing technique typically involves private contracts with investment banks. In return for granting the bank the right to sell, or “put,” company shares back to the company at a predetermined price at a set time, the company receives a premium. If, as has been the case until recently, the shares blow past the exercise price before the exercise date and stay there, the put warrants expire worthless. The company simply pockets the premium for selling them, and it owes the government no income taxes on that money.
It gets better. Many companies also have simultaneously bought call options on their stock, which give them the right to purchase their stock at a certain price. If the stock runs up, these call options, financed from the premium income on the puts, allow the company to buy back its stock at a price lower than the market’s.
Since Microsoft instituted its put-warrant program in 1995, it has pocketed premiums worth $2.1 billion and reduced the cost of its buyback program by an average $2.74 a share. Dell contends that its program, which includes both selling puts and buying calls, has helped drive down the average cost per share of repurchased stock to $6. The stock is currently selling at around $38 a share.
But what happens when stock prices go down instead of up? Therein lies the rub. If puts expire in the money–that is, a company’s shares fall below the strike price of the warrant–the company has to buy back its shares above the current market price. Moreover, notes Robert Willens, a tax and accounting analyst at Lehman Brothers Inc., if
an issuer chooses to settle the contract with its own stock in order to preserve cash, it will have to issue new shares to honor the put obligation, thereby creating even more dilution than the buyback program was intended to offset.
Granted, there’s little or no evidence yet of such an unhappy outcome, despite the recent sell-off in technology shares. But critics say it may be only a matter of time before such programs implode. “It turns into a death spiral,” notes Michael Murphy, editor of the California Technology Stock Letter.
The Prime Candidate
Consider Microsoft. The company has seen its stock pummeled in recent months, yet by the end of June, Microsoft had 157 million put warrants outstanding, with strike prices ranging from $70 to $78 a share. In mid-August, the company’s stock was trading in the mid-$70s. The expiration dates for these contracts range anywhere from September 2000 to December 2002. If the stock were to fall below the strike prices of the individual puts on the day they expire, Microsoft would find itself having put warrants exercised against it.