The Use of Options in Compensation

The Use of Options

Packages in Compensation
Packages
by Jeffrey A. Williamson and Brian H. Kleiner

Abstract

Stock options, once exclusive to executives, are now becoming more broad
based to include middle management and non-management employees. In
2000 an estimated 10 million workers’ compensation packages contained
stock options. In today’s competitive environment, firms are looking for
ways to attract and retain workers, reward outstanding performance, and re-
turn value to shareholders while minimising costs. Stock options provide
such a vehicle. The paradox is that while stock options are intended to tie
pay to performance, many employees lack the knowledge of how the op-
tions actually work. Employees need to be educated as to the different types
of plans and how it affects their total compensation. A contentious debate
exists over whether firms actually benefit from stock options plans and the
reasons why some prosper while others fail. Researchers and experts agree
that the success of a stock option plan lies largely in how effective firms are
at managing the plan and communicating it to its employees.

The use of stock options in corporate America is growing at a rapid pace.

As many as 10 million employees now hold stock options, up from one mil-
lion in 1991 (Simon, R. & Dugan, J. 2001). The term “stock options” has
made it into the American lexicon through repeated stories of young entre-
preneurs and technology wizzes in Silicon Valley becoming instant million-
aires by exercising their stock options, then using the stock options to
purchase “starter” homes for a half a million dollars or more. In fact, last
year, more than 160,000 employees became millionaires through stock op-
tions (Tate, E.A. & Wilson, T.E. 2001). In some industries, particularly with
respect to start-up companies in information technology, biotechnology and
other high-tech enterprises, stock options are a normal part of the compensa-
tion package offered to employees. In the past few months, however, stock
options for some has become a soured topic, resulting from meltdown of
technology company share prices, leaving some of these instant millionaires
penniless, or in debt.

Stock options are not new to corporate America, nor unique to the tech-
nology sector. They have been in use since the 1940s and 1950s as bonuses
for key executives and until recently were restricted to top management.
Testifying before the House of Representatives Committee on Education
and the Workforce, Patrick Von Bargen of the National Commission on
Entreprenurship noted, “Options use is occurring across the board, and 90%
of large publicly traded companies have stock options programmes”. Testi-
mony to the same committee by Deputy General Counsel of Human Re-

Volume 27 Number 4/5 2004 23

 sources at Honeywell, Jane F. Greenman, went on to say that broad based
stock option plans were being offered by a wide range of industries, includ-
The Use of Options ing manufacturing, banking, shipping, household products, food products,
in Compensation retail, to name but a few. Firm size also has little to do with whether or not
Packages stock options are part of the compensation package, although they are more
prevalent at publicly traded companies than closely held corporations.

The recent trend of particular interest is the increase in so-called “broad

based” stock option plans, that provide ownership to executives and non-
managers alike. According to the National Centre for Employee Ownership,
an organisation that closely tracks stock options plans, a “broad based” plan
is one that grants stock options to over half a company’s employees. Struc-
ture and allocation can vary by firm from options down to certain levels of
management, ranging to all full-time employees of a firm. In a 1997 survey
of 1,100 public companies conducted by Share Data, Inc., and the American
Electronics Association, 43% of companies with 2,000 to 4,999 employees
offered options to all, as compared to 10% in 1994; and 45% of firms with
5,000 or more employees offered options to all as compared to 10% in 1994.

Employers have recognised the potential gains in productivity resulting

from an employee ownership environment. Workers, knowing their fortune
is tied to the stock performance, are more likely to work harder and better, so
the argument goes. However, according to a survey commissioned by Op-
penheimer Funds, while workers view stock options as an important factor
in accepting a job, 39% of those surveyed had little or no idea how they actu-
ally work (Block, 2001). The lack of knowledge of how stock options work
resulted in 11% of employee owned profitable options expiring, rendering
them worthless (Block, 2001). According to Roderick (1999), one of the
most important elements in making a stock options plan successful is an ef-
fective communication programme. Linking employee interests with those
of shareholders may produce unintended results such as higher turnover and
potentially lower productivity when the employee feels disenfranchised by
ignorance resulting in loss of wealth. Von Bargen, in his testimony before
the U.S. House of Representatives (2000), highlighted employee education
as one of the key challenges of corporate America in addressing the issue of
stock options.

How Do Stock Options Work

A stock option is a security that represents the right, but not the obligation, to
buy or sell a specified amount of stocks at a specified price within a specified
period of time. Stock options are typically granted to employees when they
are hired, and during employment for past performance and/or conditional
upon future performance, such as attaining a certain business or unit per-
formance goal. The specified price is set when the grant is offered, and is
commonly referred to as the “strike price”. The “strike price” is generally
the market price of the stock at the time the option is granted. For instance,

24 Management Research News

say that Bob Jones accepts employment with ABC, Inc., and is granted a
stock option of 1,000 shares. On that day, the stock price is $10 per share;
this is the strike price of the stock. Mr. Jones hopes the stock will appreciate The Use of Options
so that he will be able to “cash in” by exercising (purchasing) the stock at the in Compensation
“strike price”, and then selling for a higher price on the open market. At Packages
some date in the future, if Mr. Jones sells the stock for $12 dollars, then his
profit is $2,000 (1,000 shares times the difference between the selling price
and the “strike price”). If the stock falls below the “strike price” then the op-
tion is worthless.
Turning the Stock Option into Cash
The risk in the stock options market is that the owner of the option must first
purchase the stock outright at the strike price. He can then immediately sell
it, to realise the profit, or hold on to the stock. Many companies that have
broad based employee stock option plans recognise that many of the non-
managerial staff lacks the cash to purchase the stocks. In many cases, firms
use broker-assisted services, where the broker will temporarily lend money
to the employee to purchase the stock and then immediately sell the stock to
another party. These types of transactions are called a “cashless exercise” or
same day sale (Rodrick, 1999: 199).
Specific Terms and Conditions
Stock options are not that simple, however. They carry a number of caveats
including when the option can be exercised, the marketability of the stock,
the taxable rate (determined by a number of factors including what type of
stock option plan he is participating in), and any other restrictions such as
“lock-up” periods imposed on the grant. When the stock can be exercised
(purchased) depends initially upon two factors, the vesting period and the
exercise period.
Vesting Period
The vesting period is the restricted time period between the issuance of the
grant and the date in which the option can be exercised. Firms use the vest-
ing period to keep employees from immediately cashing in on the stock and
then leaving, clearly contrary to the firm’s intended motivational purpose.
Firms want to attract and retain talent, therefore they set vesting periods that
average about four to five years, which come in a variety of ways. The two
most common are “cliff vesting”, where the shares are exercisable all at
once after the vesting period (such as four years after the grant), or “straight
vesting”, where the employees options become exercisable at the same per-
centage each year. Under a straight vesting period of five years, the em-
ployee would have the right to exercise 20% of the total granted shares in
year one, 20% in year two and so on. The other major time constraint to be
concerned with is the exercise period. Ten years is the most commonly used
exercise period for stock option grants (and is required if it is an ISO plan,

Volume 27 Number 4/5 2004 25

 which will be discussed later). The employee must exercise the options
within ten years of grant issuance, or they will automatically expire (worth-
The Use of Options less). If the employee is granted options with a four year “cliff vesting” and
in Compensation an exercise period expiring in ten years, then he/she can only exercise the
Packages option four years after issuance, but not later than 10 years.
Marketability
Marketability is a consideration for stock option owners in privately held or
closely held corporations, where there is no public market for the security.
The owner of the option has few choices in turning the security into cash; he
can sell it to another employee or potentially to someone outside the firm. If
the firm is privately held and is negotiating an initial public offering (IPO),
then the Securities and Exchange Commission (SEC) will impose a 3-
month period after the IPO whereby employees are limited or prohibited
from exercising or selling their shares.
Taxation
One of the most commonly misunderstood aspects of stock options is how
they are taxed. This largely depends upon the type of stock option plan. A
simplistic analysis of the differences in taxation is presented in this section.
Under a non-qualified stock option plan (NSO), once the option is exercised
it is taxable as ordinary income and is taxed at rates as high as 39.1% (Si-
mon, R. 2001). Under an ISO, the shares are not taxed when they are exer-
cised, but when they are sold and are taxed as capital gains which carries a
20% effective tax rate. In order to take advantage of the lower capital gains
rate under the ISO plan, the shares must be held at least one year after exer-
cising and at least two years after the grant is issued. A more detailed de-
scription of the differences between an ISO and NSO, and other more
specific tax considerations are presented later.
Reasons Firms Offer Stock Options to Employees
Firms’ Objectives in Offering Stock Options
The most commonly cited objective for implementing a broad-based stock
option plan is “to attract and retain employees” (Roderick, 2001: 201).
Greenman echoes this sentiment in her testimony to the U.S. House of Rep-
resentatives, where she adds, “contributing to the retirement security for
employees, and aligning the interests of employees with the goals of the
firm”, as additional objectives. Stated another way, linking the interests of
the worker to that of the shareholder by tying pay to performance. From a
purely rational and theoretical standpoint this makes sense.
Linking the Interests of the Worker to that of the Shareholder
The fundamental measure of the value of a firm and it’s expected earnings
over a period of time, or earnings multiple, a statement that is repeated time

26 Management Research News

and time again by stock analysts and theorists. It is the objective of company
management to maximise the wealth of its shareholders. The most reported
and indicative measure of firm performance is earnings per share. Stock The Use of Options
brokerage houses predict earnings per share as much as a year in advance in Compensation
and investors await quarterly earnings reports by company executives with Packages
great anticipation. Missing earnings estimates by a penny can sometimes
trigger a steep decline in the share price, and conversely beating earnings es-
timates can produce a significant and immediate appreciation in share price.
Consequently, over the long term, share price appreciation is correlated
with earnings per share growth. Shareholder wealth increases when the
share price increases (all other things constant), likewise increasing the
value of employee stock options. Since stock options are only profitable
when the share price has appreciated, the pay out to employees does not
harm investors. The underlying incentive is for employees to take steps to
increase share value, such as driving sales growth, achieving greater effi-
ciencies, controlling costs. Through proper management and development
of an employee ownership culture efforts to improve the performance of the
company could potentially permeate all levels of the organisation under this
scheme.

Reduced cost to employers

The challenge for firms to recruit and retain skilled workers forces them by
labour markets to pay higher wages, enrich their fringe benefits pro-
grammes, or provide bonuses in cash or common stock. These options can
be costly to employers. Higher salaries beget higher employer contributions
for OASDI, Medicare and other payroll deductions. Annual cost of living
adjustments to workers salaries further increase the cost structure of a firm’s
human resources. Conventional fringe benefits such as health and welfare
insurance are costly. According to the Bureau of Labor Statistics, annual
percentage increases in benefits have outpaced percentage increases in sala-
ries. In traditional employee stock ownership programmes (ESOP) such as
401Ks most employers contribute matching funds after vesting.

Stock options, by contrast, can be offered to employees as an additional

benefit with complete pass through, potential tax savings benefits and cost
less than issuing common stock outright. When an employee exercises op-
tions, they have to pay for the shares. These options are not considered
wages for FICA or FUTA purposes and therefore eliminate employer paid
contribution. Other than the administrative costs of managing the plan, the
benefit is completely passed through to the employee. If the company uses a
non-qualified stock option plan, the employer can get a deduction equal to
the income recognised by the employee. This can benefit a firm greatly, for
instance, Microsoft has received $10.3 billion in options-related tax benefits
over the past three years (McLean, 2000).

Volume 27 Number 4/5 2004 27

 Issuing stock options is also less costly than handing out shares of stock,
because the employee only received the incremental value above the strike
The Use of Options price (exercise price). By comparison, an employee receiving common
in Compensation stock from the employer gets all of the value of the stock, including the divi-
Packages dends. An article in the Harvard Business Review lends further credence to
support this claim:
“For a company with an average dividend yield and a stock price that
exhibits average volatility, a single stock option is worth only about
one-third of the value of a share" (Hall 2000:124).
Types of Stock Option Plans
There are two commonly used types of stock options plans, the incentive
stock option plan (ISO) and the non-qualified stock option plan (NSO). Ac-
cording to a 1998 survey by the National Centre for Employee Ownership,
44% of firms surveyed reported using only non-qualified stock options,
whereas 28% responded using exclusively incentive stock options. The re-
mainder cited using a combination of both (Roderick, 1999: 196). The plans
differ in many respects as to the restrictions imposed, tax treatment, and eli-
gibility.
Incentive Stock Option Plan (ISO)
The incentive stock option plan (ISO) carries special tax treatment for the
employee, by treating the income from the stock option exercise and sale as
capital gains, subject to 20% tax rate, instead of ordinary income which can
be taxed up to 39%, In order for a stock option to qualify as an ISO it must
satisfy requirements set by the Internal Revenue Code, which carries a
number of restrictions in order to qualify for this tax savings. ISOs are lim-
ited to employees only, and must be exercised by the employee while they
are still an employee or no more than three months after leaving the firm.
Other limitations is that they are not transferable, except in the case of a will
(death benefit), and the employee to whom it is granted cannot have more
than 10% of the voting stock in the firm. Another important requirement, is
when the stock option is granted it must (the strike price) be equal to or
greater than the fair market value of the stock.
Non-qualified Stock Options (NSO)
Non-qualified Stock Options by comparison to ISOs are much more flexible
for both the employer and employee and for this reason are the plan of
choice for most who offer stock options. Firms who issue stock options
whose shares are not publicly traded have difficulty in ascertaining the fair
market value (ISO requirement) and therefore predominately use NSO
plans. The trade off for the employee is a higher tax rate, the employer, on
the other hand benefits more through NSOs than ISOs from an accounting
perspective, because they can claim tax relief equal to the ordinary income
received by the employee through the exercise of the option. The ugly face

28 Management Research News

of reality presents itself to the employee when he exercises the option in the
form of the Alternative Minimum Tax (AMT). AMT is calculated as the dif-
ference between the strike price and the fair market value of the shares at the The Use of Options
time the option is exercised. In order to avoid this costly penalty, the em- in Compensation
ployee would have to sell the shares by year-end. The worst case scenario Packages
for the employee is when they exercise the option in one year (pay the
AMT), and then hold the shares to see them plummet in subsequent years,
making them worthless and resulting in a net loss to the employee.

Do Stock Options Serve Their Intended Purpose

A question as to whether or not stock options achieve their intended purpose

of tying pay to performance is the subject of recent debate among scholars
and practitioners. This debate is warranted due to the fact that stock options
now account for more than half of total CEO compensation and 30% of op-
erating managers’ pay, at the largest U.S. companies (Rappaport, 2001: 91).

Linking Stock Options More Closely to Performance

Detractors argue that a causal link between employee and executive per-
formance to share price (and stockholder wealth) is weak at best. They sug-
gest that share price gains, more often than not, are the result of external
factors such as business sector cycles and the overall equity investment cli-
mate. The shortcoming lies in the fact that an increase in share price will re-
ward the holder of the stock option without distinguishing between good
and bad performance (Rappaport, 2001: 92). For example, a company could
have positive share price growth, but be performing at the bottom of its peer
group, and below common barometers such as the S&P 500. In the case of
front line workers and business unit managers Rappaport argues (2001),
they could be harmed if their unit performed well while other units per-
formed poorly and, conversely unduly rewarded if their unit failed to carry
its own weight. One contemporary practice is to issue indexed-options as
opposed to fixed price options (which have been the subject of this report
upto this point) to employees. An index could be any measure such as 10%
above the S&P 500 annual growth or that of the firm’s competitors. In this
scenario, the exercise price of the option would be dependent upon the mar-
ket price of the indexed value. For example, if a firm indexed its stock op-
tions to a percentage growth rate equal to the S&P 500 annual growth rate
plus 5%, and the corresponding S&P 500 growth rate for that year was 5%,
then the strike price of the option would be last year’s share price (of the
firm) plus 10%. Anything over 10% would be profit for the stock option
holder. This obviously presents a greater risk to option holders. Since the
prime motivation for most firms is to recruit and retain talent, they may need
to consider offering more of the index options than they would have offered
using fixed-price options. Rappaport (2001) suggests for front line workers
and business unit managers that stock options be granted based upon meet-

Volume 27 Number 4/5 2004 29

 ing operating unit goals such as cost containment, order turnaround and
overall business unit contribution to net income.
The Use of Options
in Compensation Ownership Culture
Packages
From a practical standpoint if the employees are not empowered to act as
owners, then tying pay to performance may be a moot point. “What is clear
is that in companies that demonstrate a true commitment to creating an own-
ership culture, stock options can be a significant motivator” (Roderick,
1999: 175). The net impact of employee ownership is a mere 1% on sales,
however when coupled with an employee ownership culture studies have
shown the impact to be 8%-11% annual growth rates (Roderick, 1999). For
example, if a front line worker sees a process that if improved that will result
in cost savings or greater value to the customer, then it should be imple-
mented without unnecessary delay from management. In other words, the
employee should have a mechanism to effect positive change.
What Lies Ahead
Expectations of slower growth in the U.S. economy and softening of share
prices in general may have serious implications on how companies view
stock option plans. External factors will most likely shape future thinking on
this subject. If the economy continues on a path of consistent growth, and
low unemployment, firms are likely to stick to using options to attract talent.
Slower growth, on the other hand, may turn the focus away from recruitment
and retention and more towards business performance. The structure of
stock options plans are likely to change depending upon the overall objec-
tive.
References
Arreglado, E.R., Peck, C. 1992. Restricted stock for employee motivation,
reward and retention. The Conference Board.
Block, S. 2000. Many don’t understand stock options. USA Today. Re-
trieved: June 11, 2001 from the World Wide Web: http://www.usato-
day.com/life/cyber/invest/ina037.htm.
Brown, K. 2001. “Now, some hope for their stock to tank”. Wall Street Jour-
nal. CCXXXVII No. 108: C1, C2.
Hall, B.J. 2000. “What you need to know about stock options”. Harvard
Business Review. Vol.78 Iss.2;pg. 121, 9pgs.
McLean, B. 2000. “The bad news about options”. Fortune. Vol. 142 Iss. 11,
pg429; 4 pgs.
Rappaport, A. 1999. “New thinking on how to link executive pay with per-
formance”. Harvard Business Review. Vol. 77 Iss. 2; pg. 91, 11 pgs.

30 Management Research News

Risher, H. 1999. Aligning Pay and results. New York, NY: AMA Publica-
tions.
The Use of Options
Rodrick, Scott S. 1999. The stock options book (3H@ ed.). Oakland, CA: Na- in Compensation
tional Center for Employee Ownership. Packages
Schneider, C. 2000. Employees still crave options. Retrieved June 11, 2001
from the World Wide Web: http://www.cfo.com.
Simon, R., & Dugan, I.L. 2001. “Use of stock options spins out of control;
Now a backlash brews”. Wall Street Journal. CCXXXVII No. 108:C1, C17.
Simon, R. 2001. “Options about options and a geography of pitfalls”. Wall
Street Journal. CCXXXVII No. 108: C1, C17.
Tate, E.A. & Wilson, T.E. 2000. Stock options: A bear for employers in a
bull market. Morrison & Foerster LLP. Retrieved June 11, 2001 from the
World Wide Web: http://wwwmofo.com/mofocgi/getpractlong?LA-
BOR,054ELC1000.
One Hundred Sixth Congress 2000. The wealth through workplace act:
Worker ownership in today’s economy. Washington, DC: U.S,. Govern-
ment printing office.

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