Have you ever wished you could go back in time? Ever seen a stock go up big and say, “I wish I bought it when it was $10 cheaper?”
Well, if you were a top executive at many publicly-traded companies in recent years, all your wishes may have come true. In addition to keys to the executive washroom (and corporate jet), some received keys to the stock option time machine.
Stock options have become the main source of compensation for hired executives — especially at technology companies. When you read about some corporate hired hand earning $10 million — or even $100 million or more — chances are the bulk of the compensation is in stock options. Actual cash salaries are often in the mere single-digit millions (that's barely personal jet and yacht fuel money at today's prices!).
Note that the truly rich people at most companies did not make it on cash or even stock options — but actual stock they received when the company was founded. Bill Gates did not become a billionaire on stock options, but rather on actual stock he's owned from day one — founder's stock. Ownership stake in a new company is the most American of compensation plans — and the least questionable. Often it was all in place before a company earned its first dollar.
Stock options came into vogue partially to fix the wrongs of old-fashioned compensation run amok. Decades ago, shareholders (and reporters) screamed bloody murder when executives made millions in cash compensation, while their own company stock languished year after year. Think airlines. Certainly there must be a better way to tie management compensation to success. Stock options were supposed to “align” the interests of executives with actual shareholders in the company. You can do well, if we do well.
Stock options also offered a convenient way to share in the upside of a fast-growing company — it made mini-entrepreneurs out of all employees. Ownership is the very foundation of capitalism. In most technology companies, stock options are not reserved just for the ruling class (though it may seem so in the press). You've all heard about the many Microsoft millionaires. They are not all founders or officers in the company.
Stock options are at the very core of the startup boom in the late 1990s. Few would leave a safe job for a high-risk startup, even for an extra cash salary (which most startups couldn't afford to pay anyway). But a startup that could make you a millionaire in a couple of years because of stock options — well that's a different story entirely.
Instead of giving an executive $5 million in cash no matter what happens to a company's stock price, a modern compensation plan might have a base salary of $2 million, with the right to buy 250,000 shares of company stock at $10 per share. If the stock goes to $30 a share in the new few years, the executive can cash in the options for $5 million (250,000 x $20 profit per share).
Management now had an incentive to boost the stock price. A big, big incentive. This was good for shareholders. Even better, stock options were generally considered “free,” from an accounting standpoint.
In the above example, the company “saved” $3 million dollars in salary by cutting cash compensation and increasing the incentive compensation (options). Saving on salary means higher earnings per share in the here and now — which often means a higher stock price, which makes option packages more valuable. And they wonder why earnings growth rates were so high in the 1990s.
Anybody who has ever bought publicly traded stock options will tell you this is an absurd notion because the right to buy stock for several years into the future is valuable in itself. Google (GOOG) trades at around $420 a share. The right to buy a share of Google stock at $420 at any time in the next couple of years is worth about $100 per share. This means if you were offered a job at Google that paid $100,000 with no options, or $20,000 with options to buy 5,000 shares of Google stock at $420, you'd be smart to take the second package, which is worth five times as much as the cash-heavy package (though riskier — the stock could fall).
Even better, stock options let you defer taxes. The clock-watcher on the $100,000 pay plan is paying maybe $40,000 in combined state, local, federal, and payroll taxes. The $20,000 man is paying at most a few thousand bucks. Generally you won't pay taxes until you exercise your options and sell the stock — and even then you may be treated like an investor (capital gains) more than a mere employee (income and payroll taxes).
Getting good employees cheaply by converting current cash to potential upside on success (and lowering taxable income) was good for shareholders in the company.
But all was not great for shareholders. Companies got into trouble in the late 1990s with empire-building strategies and schemes used to boost the stock price. The dark side of options is they are a “heads I win, tails shareholders lose” plan. Taking gambles with a company could lead to millions if the stock takes off, yet cost executives nothing if the stock plummets. CEOs became hedge fund managers of sorts — with a big cut of shareholders upside and no part of the downside. It even appears many compensation plans were not light on cash compensation — the options became a little extra incentive without having to give away your running-around-town money.
There is no such thing as free money. While the taxes deferred or avoided are saved, the bulk of option expenses is ultimately paid by shareholders. If the stock goes up, the company is on the hook to deliver stock to the employee at a discount to market prices. This means buying stock in the open market and selling it to the executive, or watering down the stock by issuing more shares (often stock is set aside for future option expense).
This is why the number of shares outstanding at most tech firms climbs even though the company doesn't have follow-on stock offerings to the public. This is also why if a tech company earns $100 million this year, it may work out to less per share than it was the last time they earned $100 million.
But what if the stock goes down? When a stock drops below the exercise price on an option, the option expires worthless. This means no watering down of the stock. The employee takes a loss in that they earned less cash compensation, and never hit the jackpot with their incentive (option) compensation.
In the late 1990s, few stocks went down. When the surprising (down) turn of events took place in the market in 2000 (with a vengeance), many companies faced a dilemma: employee dissatisfaction. Stock options were mostly underwater (the market price was less than the price employees could buy company stock). This led to option “re-pricing” — essentially junking old options and doling out new options at a lower exercise price.
If you think this sort of move is not in the spirit of option compensation, you're right. If the executive doesn't lose something when the stock falls, why give them stock options at all? Heads I win, tails, well, I get another chance to win.
Weak stocks also led to actual stock grants in lieu of option plans. This was also the result of lower dividend taxes — you can't collect dividends on options. Notice how compensation plans tend to shift towards what is tax favorable.
But option re-pricing is not as sinister as the current scandal — spreading like wildfire — known as option back dating.
There are now well over 100 companies under investigation by the SEC or the Justice Department, and dozens of top executives — some with hundreds of millions worth of options compensation — have either been fired or voluntarily stepped down.
The idea behind stock options compensation is employees make money if the stock goes up. If the stock goes nowhere or falls, the options expire worthless. Besides the fact that this makes gut sense, there is solid tax reason for it — clearly if a stock trades at $20 a share, and you are given an option to buy that stock at $10, you have something of immediate value, like cash. In fact, your $10 gift should be taxed as income in the here and now. While it is not necessarily illegal to dole out options with exercise prices below current market prices, generally, they are handed out with the exercise price equal to the current market price. Otherwise, companies would have to expense the pay and reduce earnings per share.
But what if you could have the best of both worlds — a low-priced option that all but guarantees a profit no matter what the stock does, and the tax benefits of receiving something supposedly worth nothing today?
What has clearly been going on at many companies is just such a practice. Rather then giving options at current prices, companies (boards and top executives) cherry-picked dates in the past when the stock was lower then current market prices, and allocated options as if they were allocated on that day.
Say a stock is trading at $15 today, but was $8 two months ago. Some executives simply received options to buy 100,000 shares at $8 per share — as if they were given the options when the stock was $8, not after the fact when they should have received options with an exercise price of $15.
This unsettling development is bad for shareholders: backdated options are almost guaranteed to be exercised no matter what happens to the stock price, which hurts shareholders and leads to watering down stock even in “down” times for the company.
Losing a top executive over such flimflam can hurt stocks as well — every executive who loses his job is not a scoundrel, and some are actually good managers and presided over huge increases in share values. Less of a concern to shareholders (but a big one to executives) is potential IRS problems — it's doubtful much income tax was paid on these handouts.
While flagrant backdating is getting the attention, what I call favorable option allocation is almost as bad and a huge problem. Executives rarely run out and buy company stock before a good earnings release because regulators and shareholders would scream bloody insider trading. But what about dolling out options shortly before good news breaks? Then executives get to lock in a low price as if it was backdated. I've recommended stocks after noticing large option allocations at low stock prices because it's one indication management believes (and sometimes knows) a stock is cheap.
So what? Isn't this backdating hoopla just a lot of noise about nothing? America has some of the most profitable and best-run companies in the world because we pay executives more here than in other countries — a lot more.
Then pay them more in cash — fully-disclosed and fully taxable cash. Don't turn what was supposed to be incentive pay into a secret handout for merely showing up to work.
Funny how this practice picked up after stock prices stopped going up double digits year after year. Too bad ordinary shareholders can't backdate their tech stock purchases. The ones who bought these same stocks during the boom times with real money are still down about 50 percent.