Options: Swimming Under Water

Market woes may further dampen the appeal of stock options as a tool for retaining executives.

The extreme volatility in the stock market likely will nudge some companies toward further reducing the weight of stock options in their compensation portfolios for senior executives.

Once virtually the sole compensation tool for motivating performance, options already had declined in importance over the past few years as new accounting rules, regulatory requirements, and shareholder unrest pushed many companies to add restricted stock, performance shares, and even cash to the mix. And the visceral experience of watching the Dow Jones Industrial Average lose 500 and 450 points on Monday and Wednesday, respectively, will do nothing to bring options back into favor.

With the market having its second-straight big upswing on Friday, some options that had appeared impossibly under water just a couple of days ago were suddenly looking better. But that will do little to ease the increasing distrust executives are feeling about options as a reliable component of their compensation.

“The perceived value of these awards has taken a huge hit,” Derrick Neuhauser, a senior manager in BDO Seidman’s compensation and benefits practice, told CFO.com. “Definitely, employees will view stock options as a less attractive compensation tool [because of the market volatility]. And companies will have to work a lot harder at convincing them of the value of holding on to their awards and sharing in their upside.”

There is still no better way to tie an executive’s pay to his or her long-term performance than granting options, according to Richard V. Smith, senior vice president and principal at Sibson Consulting. Still, he conceded, “It’s not going to be real attractive for a while.”

Peter Oppermann, principal and lead executive remuneration consultant for Mercer, also acknowledged that the recent market losses may have a dampening effect on companies’ inclination to grant options — but only temporarily, in his opinion.

“I think, based on past experience, everyone is going to realize again that options are for the long term,” said Oppermann. He pointed to October 1987, when the Dow lost more than 22 percent of its value, only to gain all of it back in less than a year. Referring to the common 10-year option length for awards to executives, he added, “If you got an option at $40 six months ago and now it’s at $20, it doesn’t look too good — but you’ve got nine-and-a-half years left.”

For Smith’s part, even the financial-services sector can be expected to come back eventually. While most options at those firms are way under water, he said he would not consider them worthless, except those that were granted to Bear Stearns and Lehman Brothers employees.

Of course, it all depends on how much of a time window remains in an executive’s option term and just how far under water the options are. If those factors are not positive, the options have no value to the company as a retention tool. “When can you reasonably foresee a stock going from $1 all the way back up to a $10 strike price?” asked Neuhauser. “It might take six or eight years of growth. That’s a real issue.”

In such cases, companies — especially healthy ones whose stock is depressed just because of the current widespread “sell” mentality among investors — may issue new grants at the lower price. However, Oppermann said there has been a strong trend toward companies trying to prevent employees from “timing the market” by awarding grants at the same time each year or, for new employees, at the same time each month.

Smith said, however, that companies can accomplish the same goal and still boost the value of newly awarded options by granting them at regular intervals but moving to a shorter cycle — say, from once a year to two or three times a year.

Another possible strategy is trading in underwater options for something of value, such as restricted stock, but Smith said few companies will do that.

One thing companies are even more unlikely to do is reprice existing options. “If you did that, you would have to reveal it in your proxy, and that would be the worst possible optic a public company could have with regard to compensating executives,” said Smith. Some companies tried that strategy a few years back and met with harsh shareholder reaction, he said.

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