Tuesday, August 23, 2005

How are Companies Responding to FAS123(R) and Option Expensing?

Over the next few months, Compensation Committees, CFOs, compensation professionals, consultants, accountants, and others will be preoccupied with the imminent adoption date (for most companies) of 1/1/06. The most common phone inquiry I receive these days is "what are other companies doing?" to which the response is "calling me to ask what other companies are doing."

Seriously, there is an obsession with the notion that someone, somewhere has figured out "the answer" to equity-based compensation under FAS123(R), and that consultants know the answer and just won't tell. The truth is, however, that there will not be a single solution along the lines of the simplistic 1990s "options for everyone, 4 year vesting, and an ESPP" approach. Companies relying on survey data to guide their strategy are going to be disappointed, misguided, and at a competitive disadvantage.

Are companies moving toward restricted stock and restricted stock units (RSUs)? Not to the extent the headlines would lead you to believe. Some companies have added restricted stock grants to annual option grants, but mostly at the executive level. Some have made a single restricted stock grant to a single executive, usually in a new hire situation, landing them in the category of "companies abandoning options for restricted stock."

In my presentation at the NASPP conference in November (www.naspp.com/Conference2005/) I will make the point that the media and those feeding the media frenzy (consultants and others) are erring on three points:

1. Causality - the assumption that adoption of FAS123 and the granting of restricted stock proves that the FAS123 adoption was the reason for the restricted stock grant. There are few companies where these two actions are even remotely connected.

2. Attribution - the inference that a company's adoption of a long-term incentive plan that allows for the granting of restricted stock counts as a company now using restricted stock. Much of the survey data being bandied about today is measuring the wrong thing and reporting data submitted by individuals who don't really know the difference.

3. Single Variable - most of all, the conclusion that changes in long-term incentive plan design and grants are the result of accounting rule changes, rather than a confluence of factors including flat stock prices, companies that are not creating any value for shareholders, corporate governance pressures, and the interesting interactions of these three.

A quick look at the 2-year, 3-year, and 5-year stock price charts for the companies that pioneered the aggressive use of stock options tells the real story. When stock prices were rising during a bull market with technology stock glamour, stock options were guaranteed to deliver pay in most of those companies. But when these glamour companies have matured, lost their growth potential, and spent time and money fighting accounting rules rather than innovating technology solutions, stock options become impotent - a bonus plan with an unrealistic target.

Growth companies will continue to pursue growth company strategies which will include a central role for stock options but not to the exclusion of other pay tools, such as restricted stock, which have always made sense in certain situations. Mature and declining companies will make use of the corresponding strategies which will include more cash, more restricted stock, and other forms of pay that compensate people for working at a company that is not delivering returns that exceed the cost of capital and thus have flat stock prices. Smart companies will end up, after this next FAS123 frenzy, with compensation programs that rely on sound strategy, rigorous analysis, and effective execution rather than mimicry of questionable survey data.

That is what "other" companies are doing.

Saturday, August 06, 2005

Will Cox Delay Option Expensing?

(originally published as a Practice Alert at www.naspp.com prior to his confirmation)

The resignation of William Donaldson as Chairman of the Securities and Exchange Commission (effective June 30) and the timely nomination of Christopher Cox as his replacement has caused speculation about the fate of FAS 123(R). Congressman Cox is on record as being a staunch opponent to option expensing.

The 6-month delay decreed earlier this year by Chairman Donaldson was viewed by most merely as additional planning time to address the inevitable change. Yet some companies interpreted this as a harbinger of a defeat of the new rule, and the change in leadership at the SEC has added another reason for those firms to extend their "wait-and-see" thinking regarding compensation planning priorities.

Chairman Donaldson and some of his predecessors have observed, however, that opinions and viewpoints held prior to taking the helm of the SEC often change after assuming that role. In time we will see whether Congressman Cox’s opposition to option expensing will find a fast track or will be rethought. Regardless of the outcome, we believe it would be unwise to table current equity compensation planning efforts for several reasons:

  • Hundreds of companies, representing the majority of U.S. equity market capitalization, have adopted FAS 123 and many of those have significantly altered their compensation plan design. The resulting impact on market compensation practices could not be unwound for many years.
  • If FAS 123(R) was nullified, there would be significant technical accounting issues required to achieve consistent reporting among companies. The timeline for this likely would be in years rather than months during which time companies that have adopted FAS 123 will continue to operate under the "level playing field" it creates for alternative long-term incentives.
  • If option expensing was eliminated we still might find that a change in perspectives has occurred over the past few years regarding the impact of non-cash compensation expense. The FAS 123 era may have permanently softened resistance to forms of equity-based compensation that create expense – restricted stock and restricted stock units, performance shares, and similar instruments may be deemed less "costly" after the past 10 years of analysis and reconsideration.
  • The FASB and SEC cannot avoid addressing global pressures for fair value accounting for share-based payments. With the International Accounting Standard Board’s (IASB) International Financial Reporting Standard governing companies across the globe, an American about-face on this issue would be contrary to Congressman Cox’s stated concerns about the status of US capital markets in the world economy.
  • Finally, FAS 123(R) is only one, and arguably a less significant, influence on current compensation re-design efforts. If APB 25 returned as the law of the land tomorrow, investor pressure, corporate governance trends, the movement toward pay-for-performance and other factors would continue to keep companies focused on alternatives to stock options.
Whether FAS 123 continues on its current timetable; or option costs get moved from the income statement to the balance sheet as the Chairman-appointee has previously proposed; or stock options again become "free" under APB25, the changes in compensation strategy and design that have occurred over the past few years have a momentum fueled by diverse forces and are unlikely to be reversed. Companies should not discontinue the assessment of total compensation strategy based on a multi-disciplinary approach in light of all financial perspectives – financial reporting, taxation, cash flow, value creation, dilution, corporate governance, and marketplace practices.

Valuation of Full-Value Long-Term Incentive Awards

(originally published on www.CompensationStandards.com)

The recent interest in alternatives to stock options – fueled by corporate governance concerns, imminent changes in accounting rules, and changes in equity markets – has led to the discussion of the appropriate "conversion rate": how many units of the new form of award should be given in lieu of a stock option.

Because options have been the "currency" of long-term incentives for decades now, most survey data, grant guidelines, and measures of usage (overhang and run rate) assume that all grants are option grants. As companies consider restricted stock, restricted stock units, performance shares, and long-term cash incentive plans, many look to the few companies that have completely (for now) abandoned options. Microsoft, Amazon, Expedia and others become the new reference point.

The one-for-three number currently is making its rounds as the "right" ratio. This has its roots in several places including the rumored average conversion rate in Microsoft’s restricted stock unit program and the average fortune 500 Black-Scholes value of 33%.

An issue that has not been addressed is the assumption that a full-value grant is equal to its face value. This is because forcing the Black-Scholes valuation (by treating a restricted share as an option with a strike price of $0.00, or $0.000001 to make most models return a value) yields a number equal to face value. But option pricing models, which have an implicit stock price growth assumption, were never intended to value employee stock grants (let alone employee option grants) and their use further distorts the data needed for compensation decisions.

For example, a company with a Black-Scholes value of 60% of face value (the average in the technology sector) might give a 25% "haircut" and thus grant a number of restricted shares equal to 60% x (1-25%) = 45% -- 450 restricted shares in lieu of 1,000 options. But a Black-Scholes value of 60% has an implicit growth rate (over a four-year vesting period) of 12.5% per year. A restricted share will thus grow to 160% of face value at that rate. So, in lieu of an option granted at $10.00 that provides a gain of $6.00, the company is granting .45 restricted shares that grow to a value of $7.20 (.45 * $16.00), a 20% premium over the option gain value. . .with no downside risk. Without the haircut, the premium is even greater.

The FASB Exposure Draft and its endorsement of the binomial model (and implicit avenue for reducing reported option value) is highlighting the inappropriateness of these models for compensation planning. While growth-based models require assumptions as well, the availability of analysts’ growth targets and investors total return expectations provide a more rational basis for assumptions than required by option pricing models.

Responsible compensation planning requires abandoning theoretical option pricing models as a basis for compensation allocation among alternative vehicles under the newly emerging "portfolio" approach to long-term incentives. Not only does the gain model provide a more reliable basis for these decisions, it is a method with greater face validity among Board members, employees, and investors.