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.

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