Stock options take a hit

Now that high tech's hopes for a reprieve from FAS 123, the accounting standard that requires treating stock options as an expense, have been dashed, tech companies are reluctantly—and perhaps, belatedly—considering alternatives to stock option grants.

"Unfortunately,

there's no silver bullet—no magic solution—that will make this easy for high tech," says Marlene Zobayan, senior manager, global compensation solutions, at consultancy Deloitte Tax, a division of accounting firm Deloitte & Touche. The high-tech industry has strongly resisted expensing stock options, because doing so will negatively affect company earnings. High-tech companies are the biggest users of stock options as a way to attract and motivate employees. Currently, companies are required only to report stock options as a footnote on their financial statements, not as an expense on their balance sheets.

The industry had hoped that new Securities and Exchange Commission Chairman Christopher Cox—a former California state representative friendly to high tech—would delay or even reverse the measure (see "Industry Eyes SEC Nominee," August 2005, page 10). But Cox said in late July that he would support FAS 123. Now, with a deadline looming, public and private companies will have to adopt the standard by January 1, 2006, and tech companies may be scrambling to find options to … well—options.

The high-tech industry has largely delayed making any changes to equity compensation plans, hoping that FAS 123 would go away. A majority of companies, in fact, said they'd expense options only if they were forced to. In the second quarter of 2005, Deloitte surveyed almost 350 companies on FAS 123: Among the technology, medical and telecommunications (TMT) respondents, 85 percent said they'd adopt the measure "only when absolutely required to do so."

The net result? Companies are cutting back on the number of options they grant. Overall, 75 percent of respondents to the Deloitte survey said they'd reduce the number of options they granted. In the TMT sector, 71 percent said they would do so. In both cases, most of those cuts would occur below the executive management level: in other words, among the folks stock option plans were designed to attract.

It remains to be seen what, if anything, will replace stock options. A few high-tech companies, notably Microsoft and IBM , are trying to strike a balance between worker motivation and the bottom line (see "Premium-Priced Options Are Not Right for Everyone," May 2004, page 22). But few of their smaller peers have followed suit. "Right now, a lot of companies are playing a 'wait-and-see' game," says Zobayan. "They know that this may become a competitive market for labor and are waiting to see what everybody else is doing."

High-tech companies are so far favoring time-vested restricted options (which are awarded to employees after they have worked for a company for a predetermined period of time) and performance-vested restricted options (which are awarded to employees after they have met predetermined performance criteria). In theory, according to the Deloitte report, performance-vested options or restricted options are the most direct route toward recruiting and motivating employees, as long as the potential payout is viewed as sufficiently big and achievable.

But performance-based systems—more popular in Europe than the U.S., according to Zobayan—are hard to set up and require companies to determine not just how performance is measured but also over what period of time. Time-vested awards are simple to execute but doubtful as a strategic motivator: They reward continuous, but not necessarily exceptional, service. Technology companies may have to try various alternatives on for size before a clear winner emerges. Says Zobayan, "I think we are going to see a shifting compensation environment for the next three to five years."