Options reward staff at investors' expense

Friday 19th January 2001

By Neville Bennett

A secretary with seven years' service at Microsoft is a multi-millionaire, thanks to that company's generous employee share option scheme. She is far from unusual as some 65,000 of Microsoft's former and current employees are millionaires because of this form of compensation.

Shareholders have done badly in comparison. Their dividends are derisory and their share's value has fallen in the past year from $US119 to $US43.

Indeed, new evidence shows Microsoft, and several other market leaders, would never have made a profit if employee share options were counted as a cost on the balance sheet.

London consulting firm Smithers & Co reveals that of the largest 100 US companies, 11 would have no net corporate earnings if stock options were an employee cost.

They include Microsoft, Cisco, Dell, Intel, Texas Instruments, Hewlett-Packard, Bristol-Myers Squibb, Eli Lilley, Monsanto and AOL Time-Warner.

Another 13 companies would have seen their profit halved, including Chase Manhattan, Coca-Cola, Gillette, Merrill Lynch, Sun and Walt Disney.

While the data is somewhat dated (1996-97) the general point remains broadly valid as the FASB (Federal Accounting Standards Board) regulatory authority has not seriously modified its policy on the handling of stock options.

An immediate implication is to make price/earning ratios look much better than they would be under different regimes. The Smithers report was concerned by the real cost of stock options and used the phrase "mortgaging the future" to draw attention to its scale and potential risk.

It lists 14 major corporates whose option allocations are greater than 25% of their shares outstanding. They include Microsoft and other "new economy" leaders but also almost all of the big names in finance.

This practice seems unsustainable. For example, Lehman Bros in 1996-97 allegedly granted share options to the value of 10.08% of its weighted average shares outstanding on a fully diluted basis. The percentage for some other companies were Bankers Trust (8.8%), Merrill Lynch (6.8%) and Dell (5.7%).

An evaluation of American stock option practice is somewhat problematic as the economics profession, if judged by research literature, regards stock options as beneficial for they provide incentives to employees to improve their firm's performance.

A paper by B Hall in the Quarterly Journal of Economics is typical: Hall finds a strong relationship between a firm's performance and the level of CEO compensation.

"This relationship is generated almost entirely by changes in the value of CEO holdings of stock and stock options."

So, for Hall, stock and stock options seem to be not only effective incentives but are also better than salary. If Hall's point is valid, high and increasing salaries are superfluous.

I searched a database of all academic economic literature published in 2000 and found almost no anxiety about stock options. The 350 academic studies were overwhelmingly concerned about the problem of setting a fair price for stock options and derivatives. Taxation is also an issue.

Some writers praised boards that had reset exercise prices after market prices had gone underwater in the dot.com holocaust. In short, economists did not seem at all concerned about non-employee shareholders' dividends.

An exception was a paper by Fenn and Liang for the US Federal Reserve that indicated how option-owning managements used their influence to encourage their boards to use profits to buy back shares rather than increase dividends.

Managers with stock options consider share prices respond better to share repurchases than increased dividend payments.

It must be concluded the large profits being generated by the most innovative firms are not being passed on to their shareholders as was the case in "old capitalism."

Indeed, one prominent feature of the new economy is that profits are often passed primarily to employee shareholders.

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