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ExecutiveCompensationRevisitingStockOptionsintheCurrentEnvironmentInthe1990s,stockoptionsshiftedfrombeingalong-termnetworthbuildertoashort-termcashgenerator.Therehasbeenmuchspeculationregardinghowstockoptionshavegrownoutofcontrolandwhattodoaboutit.Thebottomline:StockoptionsasLTIsshouldbedesignedtodrivelong-termbehaviorandthussustainedperformance.HAYVIEWPOINT
1ExecutiveCompensationRevisitingStockOptionsintheCurrentEnvironmentTheDebate1HowWeGottoThisPoint3IsanOptionExpenseontheHorizon?5So,WhatDoWeDo?6AboutHayGroup9Copyright©2002HayGroup,Inc.Allrightsreserved.
2TheDebateMuchhasbeensaidandwrittenaboutstockoptionsinrecentmonths.Yeteachpositionhasacounterpoint.Thesideyoutakemaydependonyourmotivesorwhoyourepresent.Themostcommonthemes—andtheircounterpoints—canbesummarizedasfollows:POINT:Stockoptionsaresaidtocauseexecutivestofocusondrivingupthevalueoftheircompany’sstockpriceintheshortterm.TheargumentStockoptionsareaccusedofthengoesontosaythatthisleadsexecutivestomakequestionabledecisionstoinflaterevenuesandunderstateexpensessothattheycanreinforcing“executivegreed.”cash-inontheoptiongain.Insum,stockoptionsareaccusedofreinforcing“executivegreed.”COUNTERPOINT:Institutionalinvestorsandmoneymanagersdemandnear-termprofitperformance;otherwise,theymayimmediatelypunishthestockbyselling.Theyarefreetodoso,butmostexecutiveoptionshavevestingrestrictionsandtopmanagershaveadditionalconstraintsimposedbytheircompaniesandsecuritieslaws.Inaddition,inthe1990s,anyshort-termmarketweaknesscouldthrowacompanyintoplay.Exactlywhohasthelonger-termfocus?POINT:Stockoptionsarenotaccountedforasanexpensetothebusiness.Oneviewisthatthisomissioninflatesreportedprofitsandtherebymis-leadsinvestors.COUNTERPOINT:DilutionofshareholdervaluebystockoptionsisalreadyaccountedforinFAS128—theso-calledtreasurystockmethod.Thataccountsforoptionsbydilutingthecompany’sreportedearningsperdilutedshare.Also,thepro-formaexpenseimpactofoptionsisalreadydisclosedinthefootnotesofthecompany’sForm10-K.Granted,mostpub-licdataavailablethroughthemediaandanalystsignorethefullydilutedEPS(earningspershare)data.However,sophisticatedinvestorsandmar-ketmakershavealreadydiscountedtheeffectintothetradedshareprices.Inaddition,webelievethatitisfaster,easier,andsafertohavepunditsspeakto“dilutedEPS”thanchangeanentireaccountingstructureandriskeconomicdislocations.1HAYVIEWPOINT
3POINT:Asecondaryclaimisthatthe“nocosteffect”ofoptionsallowsboardstomakeexcessivegrantsthatexacerbatethe“greedfactor.”COUNTERPOINT:The“nocosteffect”isafacilitatingfactorforincreas-inggrants,butthemoregermanequestioniswhethertheboardshavemadeexcessivegrantsand,ifso,why.Partofthereasonhadtodowithblindlyusingcompensationsurveys,whichhadaratcheting-upeffect.Also,useofthecommoncompensationphilosophiesof“mediancash”and“75thpercentiletotalcompensation”leadstoveryhighoptionMuchofthedilutionfromgrants.Thisismoreaproceduralissuethanitisbasedongreed.Inoptionshascomefrombroaden-addition,muchofthedilutionfromoptionshascomefrombroadeningeligibility,notincreasingtopexecutivegrants.ingeligibility,notincreasingPOINT:Somepointoutthatgainsfromnonqualifiedstockoptionsresulttopexecutivegrants.inataxdeductionforthecompany,althoughthereisnoexpense.Thisissaidtobeunfairtothetaxpayersandwillfurtherencourageexecutivestograntthemselvesmoreoptions.COUNTERPOINT:Thecompanyreceivesthattaxdeductioninthefutureandonlytotheextentthattheexecutivereceivestaxablepersonalincomefromtheoptionexercisetransaction.Sinceexecutivetaxratesaregenerallyhigherthancorporatetaxrates,thetaxpayersgaininthenettransactions.Also,notaxdeductionisavailablewithrespecttoanincen-tivestockoption.Ingeneral,themedia,politicians,and“buyandhold”investorsarecallingfortheendofstockoptions,atleastaswenowknowthem.Thecatalystispopularoutrageattheexecutivesatsomefailedcompaniesandaccountingfrauds.However,itisfairtoask:“IftheDowhadnotplummeted,howmanypeoplewouldcareaboutexecutiveoptions?”Nottoolongagooptionswerecitedasthereasonforthestockmarketboom.Venturecapitalistsandinvestmentbankersrequiredstrongoptionprogramsasaprerequisitefortheiragreeingtoinvestinstart-upsorunderwriteofferings.All-employeeoptionplansallowedstart-uptechnologycompaniestocontrolcashoutlaysandattracttalentthatwouldbeotherwiseunavailable.2Whilethedebateisinteresting,itshouldnotbethefoundationofanyreviewofHAYhowacorporationmanagestheuseofstockoptionsinthefuture.StockVIEWPOINT
4optionshavebeen,andcancontinuetobe,averyeffectivetoolforlinkingman-agementintereststothoseofshareholders(i.e.,thesuccessandgrowthofthevalueoftheircompany).Anychangetothedesignofstockoptionsandtheiraccounting/regulationshouldbebuiltonanassessmentofhowtomakethemmoreeffectiveatachievingthisgoal.HowWeGottoThisPointTherehasbeenmuchwrittenabouthowstockoptionshavegrownoutofStockoptionshavebeenaverycontrolduetolackofoversightbyboardsandexecutivegreed.Therealityofeffectivetoolforlinkingthecurrentstateofstockoptionsismuchmorecomplex.managementintereststothoseStockoptionshavebeenaroundforalongtimeandhavehistoricallynotbeencontroversial.Companiesarecreatedbyentrepreneursandinvestorswhoactofshareholders.likeownersbecausetheyare,infact,theowners.Ascompaniesgrow,profes-sionalmanagementisbroughtinbecausetheyhavetheskillsnecessarytorunandgrowalargecompany.Mostentrepreneursandindividualinvestorswanttheirexecutiveteamtohaveavestedinterestindrivingthevalueoftheorgani-zationandarewillingtoshareownershipinsomeform.Stockoptionsweredevelopedasacost-effectivewaytoallowexecutivestoparticipateinthefuturelong-termsuccessofthecompanywhileincreasingtheirownnetworthandownershipintheorganization.Thefocuswaspointedlyonlong-termwealthaccumulation.Forthisreason,moststockoptionplanshavebeenestablishedwitha10-yearterm.Untiltheearly1990s,mostcompaniesexpectedtheirexecutivestoretainthesharesthattheyexercisedaspartoftheportfolio.AggressivesellingofstockwasoftendiscouragedandrequiredatleastaconversationwiththeCEOorboard.Inthelate1980sandintothe’90s,theworldofoptionschangedintandemwiththelongestbullmarketinhistory.Optionsweregrantedtoanincreasingnumberofexecutives,extendeddowntothemanagementranks,and,inmanycompanies,wereprovidedtothebroademployeegroup.Atthesametime,thenumberofoptionsgrantedtoexecutivesexploded,withCEOsgettinggrantsof3500,000tooveronemillionoptionsayear.Themedianfacevalue(numberofHAYVIEWPOINT
5optionstimesgrantprice)fora$300,000salariedexecutiveincreasedfromtwo-timessalaryin1990towelloverthree-timessalaryin2001.Thischangeinoptionpracticewasdrivenbyseveralmajortrendsintheexecu-tivelabormarket:Asthelongbullmarketproceeded,optionsproducedsignificantshort-termwealthforexecutives.TheDowJonesgrewfromjustunder1000in1980to3000in1990to11,000in2000.ThisincreasedexecutiveinterestandThemarketrewardeddotcomsdemandforoptionsintheircompensationpackages.withstockpricegrowththatExecutivemobilitydramaticallyincreased.Companiesstartedtohireexecu-wassupportedbynothingbuttivesfromcompetitorsmoreaggressively.Optionsbecamecriticaltoincentrecruitstojointheorganizationandtomakeupforwhattherecruitswere“irrationalexuberance.”leavingattheirformercompany.Inresponse,othercompaniesstartedawardingmega-grantstoseniorman-agementandkeyemployeestoassureretentionoratleastmakethehire-ongrantmorepainfultotheraidingcompany.Thetechnologyboom—dotcoms,softwarefirms,andnewenergyindustryfirms—finallypushedthestockoptioncrazeovertheedge.Withtheprospectofseeminglyassuredinternalratesofreturnoncapitalinexcessof40%annually,venturecapitalinvestorsweremorethanwillingtogiveup20%toasmuchas30%oftheirownershipstake.Thisallowedforoutsizedgrantstoallemployees.Atthesametime,themarketrewardedthedotcomswithstockpricegrowththatwassupportedbynothingbut“irrationalexuberance.”Establishedcompanieshadtocompetetopreventanexodustostart-ups.Theyincreasedtheirowngrantlevelsandnumberofpositionscoveredbythestockoptionprogram.Changesinthetaxcodelimitedtheamountofexecutivecompensationthatisnotperformance-based.OptionswereadoptedasasafeharbortothepenaltiesunderthissectionoftheCode.Finally,theSECrelaxedtheshort-swingprofitconstraintsofSection16(b),4whichactedtofacilitatetheexerciseofoptionsfortopmanagers.HAYVIEWPOINT
6Theresultofthesefactorswastodramaticallychangehowoptionswereman-agedinthe1990s.Theyshiftedfrombeingalong-termnetworthbuildertoashort-termcashgenerator.Thenumberofoptionsgrantedbycompaniessky-rocketed,withaverageoptionoverhangincreasingfrom5%in1990to15%in2000.Somestudieshaveshownthatthevalueofexecutiveoptiongrantshasasmuchasdoubledoverthelastthreetofouryears.Executivesdemandedandreceivedtherighttoexerciseandselltheiroptionsjustlikeanyothershareholder.CompaniesshortenedvestingschedulesandThenumberofoptionsgrantedrelaxedtheexpectationthattheirexecutiveswouldholdstockgainedthroughskyrocketed,withaverageoptionexercise.Whilemanycompaniesintroducedstockownershipguidelines,mosthavenotenforcedtheserequirements(especiallyasstockpricesdeclined)optionoverhangincreasingormadeitveryeasytocomplybycountingunexercisedoptions.from5%in1990to15%in2000.IsanOptionExpenseontheHorizon?Attheendoftheday,noneoftheproblemsthathaveemergedrecentlyweredrivenbywhetherornotstockoptionsareexpensed.Thelongbullmarketandthebeliefthatitwouldcontinueindefinitelyweretheprimarycausesoftheoptionsboom.Inalllikelihood,therecentcompensationtrendsfavoringoptionswillsloworreverseasthestockmarketstabilizes.Nevertheless,thereisincreasingpressureandsentimenttowardchange.Fair-mindedobserversagreethatthereisroomtoimprovethedesignandreportingofstockplans.Goingforward,itisunclearwhattheregulatorswilldowithexpensingofoptions.Asmattersnowstand,itisnotapparentthatCongresswillmandatethisaction.AndwhiletheSecuritiesandExchangeCommission(SEC),thenewPublicCompanyAccountingOversightBoard,orFinancialAccountingStandardsBoard(FASB)mightwanttogothisroute,therearestrongcounterarguments,especiallyamongstart-upcompanies(whicharethemajorsourceofcreatingnewjobs).Thelastthingtheeconomyneedsisaneconomicshockfromstockpricedeclinesorlostjobsasaby-productofawell-meaningattempttoclarifytheaccountingofstockoptions.5HAYVIEWPOINT
7Dozensofcompaniesarenowreevaluatingoptionaccountingissues.CompaniessuchasCoca-Cola,GeneralElectric,BankOne,Amazon.com,Wal-Mart,GeneralMotors,ProcterandGamble,andTheWashingtonPostelectingtovoluntarilyexpenseoptionsmaymitigaterequiredexpensing.Ifenoughcompaniesfollowthislead,itwilltakethepressureoffoftheregulatorsasinvestorswillbeabletoconsidercompanies’willingnesstoexpenseoptionsasoneofthefactorsintheirinvestmentdecisions.ThereisalsoaproposalbeingfloatedbytheAdministrationtoletshareholdersapproveallstockoptiongrants.TheaccountingprocessmustWealsoknowthattheexpensingofoptionsisnotaneasilydefinedaccountinghelpshareholderunderstandingprocess.Shouldoptionsbeexpensedintheyearofgrantusingsomesortofratherthancreateconfusionorfuturevalue(i.e.,Black-Scholes)?Presentexpensingrulesrequiretheuseofhis-toricvolatilitiesandprohibitadjustmentsforvestingandterminationeffects.economicdislocation.Givenhistoricmarketvolatility,optionvaluescanapproach50%offacevalueevenin“oldeconomy”companies.Yetthelong-termappreciationofequitiesisnowdowntoonly7%perannum.Inmanycases,variableaccountingtreatmentwillyieldlowervalues.Theprocessmusthelpshareholderunderstandingratherthancreatemoreconfusionoreconomicdislocation.So,WhatDoWeDo?Giventhecurrentpoliticalenvironment,itislikelythattherewillberegulatorychangeofsomenatureonhowoptionsaremanagedinthefuture.Haybelievesthatthereareseveralcriteriathatcouldsubstantiallyimprovetheeffectivenessofoptions:Maketheproceduresuniformandmandatory.ThecompromisethatbecameFAS123allowedeachcompanytochooseitsownaccountingtreat-mentandvaluationmodel.Mostcompaniesoptedfornochangeratherthananunintelligibleaccountingentry.DonotuseaBlack-Scholes-typeofmodel,whichrequiresassumptionsaboutfuturevolatility,rates,anddividendyieldbasedonrecenthistory.Themarketshavechanged.Ignoringvestingandearlyterminationoftheoption6periodbiastowardover-valuation.Inmostcases,expensingoptionstheHAYVIEWPOINT
8sameasstockappreciationrightsorcashlong-termincentiveplanscanleadtomorerealisticvalues.Assurethatoptionswithperformance-basedvestinghavethesameaccount-ingtreatmentasfortime-vestedoptions.Presentprocessesactuallypenalizeperformance-basedoptions.Ifoptionsaretobeexpensed,thenthedilutioncalculationsinFAS128shouldbedropped.Otherwiseoptionswouldbedouble-counted.OnepositivesideeffectoftheWhatevermethodisselected,themainchangetoreportedaccountingresultsrecentbearmarketisthatwillbeashiftfromreportingdilutionofownershipovertime(asisnowdone)toareductionofstatedprofitabilitywithintheoptionlife.Balancesheetsandcompanieswillreconsidertheearningsstatementswillappeartobedifferent.Thereportinginaccountingdesignoftheirlong-termdocuments—aswellaspublicitybyanalystsandthemedia—willhavetoadapttoassurethatknowledge,ratherthanconfusion,results.incentiveplans.HayGroupbelievesthatonepositivesideeffectoftherecentbearmarketisthatcompanieswillreconsiderthedesignoftheirlong-termincentiveplans.Weareconvincedthatsomecompaniesusedoptionplans,notbecauseitwasthebestwaytomanageexecutivecompensation,butbecausetherewasnofocusonthedilutioneffectswithstockpricesgrowingatanannualrateoftenwellinexcessof15percent.OuradvicetocompaniesistothinkaboutwhatyouaretryingtoaccomplishwithyourLTIprograms.Theseprogramsshouldbeonceagaindesignedtodrivetruelong-termbehavior.Companiesshouldconsiderthefollowingideas:Lengthenvestingschedules.Anystockpriceappreciationthatoccursinthefirstthreeyearsofanoptiongrantisnotaresultofexecutivelong-termperformance.Vestingschedulesshouldbepushedoutandback-endloaded.Thisalsowillsupportincreasedretention.Forthoseorganizationsthatcannotlengthenthevestingschedule,shortenthetermtofiveorsevenyears.Haydatashowsthatmostoptioneesexercisesoonaftervestingifthestockappreciatesby50%.Ifanoptionishopelesslyunderwater,itwilllapsequickerandkeepthereportingcleaner.7HAYVIEWPOINT
9Requireexecutivestokeepamajorportionofthenetgainfromexercise—adjustedforacquisitionpriceandtaxes—intheirportfolioascompanyshares.Optionawardsarenotthesameasbuyingstock,soexecutivesshouldnothavethesamefreedomtotradeasinvestors.Ifacompanyisgoingtoexpenseoptions,gobackandreexaminethedesignoftheLTIprogram.Ifthereisgoingtobeachargetoearnings,therearemanydifferentprogramsthatcanbemorecloselylinkedtocom-Companiesshouldrebalancepanyandexecutiveperformancethantraditionaltime-vestedstockoptions.Thesecanincludeperformancevestingofoptions,indexedoptions,andtheircompensationportfoliosstrategy-basedperformanceunits.toreflectthechangeinJustasinvestorsarerebalancingtheirportfoliosforthechangeinthemar-themarkets.kets,soalsoshouldcompaniesrebalancetheircompensationportfolios.Boththeabsolutesizeofexecutives’portfoliosaswellastheproportionofoptionsincreasedduringthebullmarket.Itcanbearguedthatthisreflect-edtheincreaseinpotentialshareholdergainsandwaseconomicallyration-alinabullmarket.Withthebubbleburst,thesize,mix,andperformancemeasuresshouldchange.Wedonotbelievethatstockoptionsdriveinappropriatebehaviorinmostexec-utives.WhileworkingwithCEOsandtheirteamsacrosshundredsofcompaniesofallsizesandindustries,HayGroup’sexperienceisthatmostexecutiveswanttomaketheircompaniessuccessful,wanttoberespectedinthebusinesscom-munity,andhaveastrongsenseofethicsinrunningtheirbusiness.Thefactthatsomecompanieshaveaggressivelytakenadvantageofthegrayareasoftheaccountingoftheirbusinessisnothingnew.Thishashappenedinthepastandunfortunately,willhappeninthefuture,evenwiththenewaccountingoversightlegislation.Thatsuccessfulexecutivesexpecttobewell-paidisnothingneweither.Thecompetitivemarketforexecutivetalentchangedandthecosttoacquireandretaintalentincreased,justasoccurredwithfreeagencyinsports.Mostexecutivesweworkwithhavebothastrongdrivetobesuccessfulandlaudablevaluesabouthowtomanagetheirbusinesses.8Tostaywiththesportsanalogy,theballisnowinourcourttohelpdesignHAYVIEWPOINTrewardprogramsthatdrivemanagementtocreatesuccessfulbusinessesandfullyinformtheshareholdersaswell.
10AboutHayGroupHayGroupisaprofessionalservicesfirmthathelpsorganizationsworldwidegetthemostfromtheirpeoplebycreatingclarity,capability,andcommitment.Foundedin1943inPhiladelphia,todayweworkfrom71officesin35countries.Ourareasofexpertiseinclude:Compensation,benefits,andperformancemanagementExecutiveremunerationOrganizationaleffectiveness,roleclarity,andworkdesignManagerialandexecutiveassessment,selection,anddevelopmentCustomerandemployeeattitudesandbehaviorsWeprideourselvesonbeinganexpertise-drivenfirm.Allourworkissupportedbyprovenmethodologiesandglobalknowledgedatabases.And,wehaveover50yearsofspecific,documentedevidencethatpeople,notstrategies,drivelong-termcompetitiveadvantage.9HAYVIEWPOINT
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