Companies that grant employees stock options are facing the wrath of institutional investors concerned about watered-down share values. Here are some innovative ways companies are tweaking options to soften the blow to current shareholders.

Institutional investors and compensation consultants are starting to tell finance executives that the stock options they have given employees may be too much of a good thing.

Stock options have become one of the 1990s’ biggest hits. Executive compensation specialist Towers Perrin reports that nearly all Fortune 1000 companies now include stock options in executive pay packages. And options are no longer exclusively an executive perk. The percentage of companies granting stock options to all employees jumped from 17 percent in 1994 to 46 percent in 1997, according to a survey of 1,000 public companies conducted by ShareData Solutions. Forbes magazine has estimated that between 1985 and 1997 the value of options granted rose tenfold, to $600 billion.

The concept of stock options is simple and by now familiar. To enhance their modest salaries, a valued workforce is given America’s favorite derivative — options to purchase shares of the company stock at some point in the future at close-to-current prices. For example, at the end of his first year on the job, an employee named Joe might be granted an option to purchase 100 shares of his employer’s stock in August 2004 (the "exercise" date). If the stock is currently selling at $100 a share, his stock option might specify that he can pay $120 a share (the "strike" price) five years from now.

The appeal of this type of compensation is obvious. Granting options costs the company no cash. Joe suddenly has a substantial incentive to stay with the company and work hard to see that it prospers and rewards its shareholders because, potentially, he is one.

Suppose that when August 2004 comes, the shares of Joe’s company are worth $280 each. Joe grabs his prosperity ticket, scrapes up $12,000 ($120 × 100 shares), exercises his options and walks away with stock worth $28,000. He can sell it or let it ride if he thinks he can help drive the stock price even higher. The company gets cash (Joe’s $12,000) and prints more shares to give to Joe. Shareholders are pleased because Joe has worked hard for five years to increase their stock price. His personal interests have been truly aligned with theirs. Moreover, friendly U.S. Generally Accepted Accounting Principles (GAAP) accounting usually does not require companies to take a hit to the income statement from the increase in option values, and it gives them a tax deduction when options are exercised.

Alternatively, if the stock price has dropped to $80 a share by August 2004, Joe just doesn’t exercise his option. That’s his worst-case scenario. And having granted the unexercised option costs the company nothing.

Heading off Dilution

So what’s the problem? In a word, dilution. When a company prints additional shares and sells them at a deep discount, it waters down the value of existing shares. More investors have to share the wealth of the company, and the new investors buy in at bargain prices. When the company sells Joe $28,000 worth of stock for $12,000, it loses $16,000. Of course, dilution is volume-sensitive. A little dilution goes unnoticed; a lot spoils the soup.

Dilution can be measured by multiplying an option distribution’s "overhang" (the number of options granted divided by the number of outstanding shares) by its "moneyness" (the market price minus the option strike price), explains Lynn Feintech, managing director, global derivatives, for Citicorp North America in San Franciso. A recent survey by Citicorp Securities found that large-cap companies in six industries have an average overhang of 7 percent and a share price that is 189 percent of their options’ strike price.

Institutional investors who once enthusiastically pushed stock option plans now grumble that overly generous programs have given employees a huge windfall because of the rising stock market. These investors are starting to vote down proposals that look like they might cause dilution.

Institutional Shareholder Services, a proxy advisory firm, now recommends that shareholders reject more than 20 percent of new stock option proposals because of dilution, and shareholders are heeding such advice. Watson Wyatt Worldwide found that shareholders rejected new option programs 15.8 percent of the time in 1997, compared with just 3.5 percent the previous year. The same research showed that certain key institutional investors have adopted a policy of voting against option grants that would result in an overhang greater than 10 percent.

"As investors start to say ‘Enough!’ companies will have to hedge or stop granting options," observes Paula Todd, principal and senior consultant on executive compensation at Towers Perrin, Stamford, Conn. "When you calculate how many years of cash flow it would take to buy all the options some companies have granted, you are looking at an obligation that is not inconsequential. Companies are starting to have second thoughts about using stock options so aggressively."

A Hedging Solution

Dell Computer Corp., Round Rock, Texas, is one of the most aggressive issuers of employee stock options, and its stock has been one of the top performers during the long bull market, so it has had to become adept at managing dilution. The company is often touted by analysts for its sophisticated hedging programs. "When you grant options and your stock price rises rapidly, you will have massive dilution that will certainly affect your earnings per share," notes Kendall Pace, Dell’s senior manager of corporate finance.

"Our investors would not want to be diluted for the sake of new employees," she observes, but neither would new employees want to be denied a share of the company’s wealth to protect investors. To meet both parties’ needs, Dell grants stock options on a rather large scale and then uses hedging strategies to "manage the dilution down to zero," Pace says. "We still see stock options as an important tool for recruiting and retaining the right employees," she adds.

"As investors start to say ‘Enough!’ companies will have to hedge or stop granting options."

— Paula Todd, principal and senior consultant, Towers Perrin

Each year Dell asks shareholders to approve option grants equal to 1 percent to 2 percent of its outstanding shares, and each year shareholders OK the grants. That’s partly because of Dell’s success at hedging the dilution. Dell uses some open-market repurchases but relies primarily on equity derivatives to avoid dilution, Pace explains. Dell’s instrument of choice is the equity collar, a paired selling of short puts and buying of long calls. (For a primer on the equity collar and other hedging tools, see Stock Dilution Hedger’s Handbook.)

"Our goal," Pace says, "is to recognize an exposure and then match it with an appropriate hedge. We try to separate economics from liquidity and hedge our dilution exposure just as we would hedge an interest-rate or foreign-exchange exposure. It has no effect whatsoever on our P&L. Not everyone understands that."

Dell’s aggressive use of stock options requires a portfolio approach to hedging. "We’re layering into transactions for every three-month, six-month and nine-month period," Pace explains.

The Hedger’s Arsenal

Companies like Dell can keep both their employees and their investors happy by hedging — by granting employees stock options and then entering into carefully selected financial transactions that neutralize the dilution the options create.

Companies can use cash to repurchase their shares in the open market, shrinking the number of available shares at the same time that they add shares by granting options, Citicorp’s Feintech explains, or they can use equities derivatives such as forward share repurchases, call options or equity collars to the same effect. What is the most cost-effective way to hedge against stock dilution due to option grants? That depends on circumstances, particularly on how much liquidity a company has and what it expects its stock price to do. "If you have a lot of liquidity and are quite bullish on your stock, then buying it back probably is the most effective strategy. But if liquidity is scarce and you are bullish on your stock, then you probably would hedge by buying the stock forward or by putting a collar on the stock," Feintech says.

Many public companies have stock repurchase plans, whether or not they tie the programs to stock-option grants. Fewer companies hedge stock dilution with derivatives, but the number is increasing broadly across all industries, Feintech reports. "It started about 10 years ago among technology companies, which were the most aggressive users of stock options and therefore had the greatest dilution to hedge. But it quickly moved into other industries like media companies, communications, consumer goods, retail and financial institutions.

"We’re seeing companies develop a point of view on their share price and then use the appropriate strategy, which can mean doing nothing, even if their overhang is quite large," she says. "If you’re not bullish on your stock, you won’t buy it either in the open market or by using derivatives."

Companies that use direct share repurchase programs instead of derivatives often also sell puts on the stock, as "a way to take in premium income," Feintech explains. "It’s a way to finance part of your buy-back program."

"We’re seeing companies like Microsoft Corp. and Dell issue stock options to employees and simultaneously sell puts against the company stock with the expectation that the stock will appreciate, the puts will expire worthless and the cash collected from the sale can be used to buy back shares," reports Martin F. Ellis, vice president of Stern Stewart and Co., a New York shareholder value metrics (EVA) and compensation consulting firm.

The most mathematically precise hedge — the mirror image of the option ceded to employees — is buying a call at the same strike price, but that is also viewed as the most expensive hedge, Feintech says. It requires the company to pay an immediate out-of-pocket premium to a counterparty for the calls. To reduce that expense, companies are likely to create a collar by simultaneously buying calls and selling puts, she says.

Companies that want to buy back a large number of their traded shares all at once can do so through investment bankers. "If I need to deliver 30 million shares of a stock that typically trades about 1 million shares a day, obviously I borrow the shares through a short sale and repay them over time," explains Joe Elmlinger, managing director of Citigroup’s Salomon Smith Barney subsidiary in New York, which offers an accelerated repurchase program called Accelerated Share Repurchase. "It’s good for companies that want to buy back a lot of shares near the end of a reporting period or before some anticipated merger and acquisition activity that could keep them out of the market," he explains.

Alternatives to Hedging

As an alternative to hedging, some companies are structuring their stock options in ways that make them less likely to dilute share values. They are indexing options’ strike price to a performance benchmark so that employees aren’t rewarded for a general bull market run-up in stock values but only for outperforming the benchmark.

"Companies now are moving to make their stock options less naked and to separate the factors the company can control from the factors it cannot," summarizes Patrick T. Finegan, managing director of Finegan & Co. LLC, a New York corporate finance advisory firm. "Stock options can be structured so that the exercise price is indexed to a basket of factors that filter out the uncontrollable factors like commodity prices and interest rates. By filtering out exogenous factors, a company can strengthen the real tie between stock option value and management’s contribution. We’re starting to see a few companies tie their option strike prices to interest rates or to the S&P 500 index or some other benchmark. In the future, we are likely to see more indexing." Companies can also link the number of options granted to outperforming a benchmark, Finegan adds.

So far, few companies have taken this approach. Indexed options are "something I read about in the press but don’t see many companies actually using," Feintech observes.

One way to technically avoid stock dilution is to grant "phantom" options that pay out a cash bonus linked to stock performance. The employee receives the same value he or she would from a stock option, but stock is used only as a value proxy. In effect, cash reserves are diluted instead of share value; however, the company still transfers shareholder value to employees.

Theoretically, employees holding phantom options have the same incentive as real-option holders to make the stock perform, but once the payout occurs, they are not shareholders unless they buy company stock with their bonuses. Phantom options are a popular incentive for employees of privately held companies that have no traded stock, Ellis points out.

Companies can also reduce the dilution, Ellis says, by issuing stock options with strike prices that are significantly higher than current share prices. For example, if the stock currently sells for $50 a share, you can grant options that allow employees to purchase future shares not for $50 or $55 but for $80. This tactic effectively sets the reward bar higher. Employees can still reap gains but only if the stock price rises considerably. Share appreciation between $50 and $80 would not lead to dilution. If share prices went above $80, employee stock options would create dilution, but with that large of an increase in share prices, investors would be less likely to object. Nevertheless, this out-of-the-money option is not widely used, Ellis reports.

Another little-used way to reduce dilution is to require employees to pay for their stock options. This approach would probably reduce the number of options a company has outstanding and would raise cash that could be used to buy shares for the employees who exercise stock options, Ellis adds.

Xerox Corp., Stamford, Conn., uses a variety of option structures, including long-dated options, S&P-indexed options, out-of-the-money options and at-the-money options. But the company has not yet used equity derivatives to hedge dilution, reports Margie Filter, vice president, treasurer and secretary. "We’ve looked at a variety of products but haven’t implemented anything yet," she explains.

Xerox does, however, have an active stock-repurchase program. The company has sold puts to help finance repurchases and hedged to protect the price it will pay when it buys back the stock, Filter adds.

For 10 years, employee stock options have been the magic compensation carrot, the mouth-watering incentive designed to make employees run faster to carry forward the interests of shareholders. Now the end of a prosperous decade is confronting finance executives with a new question: Has the carrot lost its value as an incentive for employees who’ve grown fat from feasting on rich carrot cake?