Microsoft switch on options revives debate

Microsoft Corp.'s surprise announcement last week that it plans to replace stock options with restricted stock grants in employee pay packages has revived a debate over how to best link employee compensation to the interests of company shareholders.

Stock options have been sharply criticized as an undeserved ticket to vast riches for corporate executives focusing on quick increases in the bottom line. But compensation experts contend that replacing options with handouts of restricted stock is no guarantee that employees' interests will be any more aligned with those of investors.


"Restricted stock is only a good compensation tool if it's tied to performance," said Paul Hodgson, senior research analyst with the Corporate Library, a corporate-governance research and information service.

"I would be quite happy to see more rewards like Microsoft's, if they are performance-related. But I'm not convinced that compensation committees have the guts to impose challenging performance targets on them at the moment."


Restricted stock grants are not new, said Jack Marsteller, leader of the executive-compensation practice at Towers Perrin in Los Angeles. In the past, however, restricted shares have played a limited role - mainly as a means to retain certain key executives.

"It used to be a bit player in the compensation program. Now it's the lead," Marsteller said. "This is quickly becoming the fad du jour."

Unlike stock options, which only gain value if the company's stock price rises, restricted stock represents an actual gift of shares. Traditionally, all executives had to do to have these shares vest - or become fully theirs - was remain employed long enough for the restrictions to fall away.

"It's the lay low and don't get fired award," said Matt Ward, chief executive of WestWard Pay Strategies in San Francisco.

By contrast, stock options are - in theory at least - an award for performance. Options are rights to buy a company's shares at a set price in the future. The exercise price is typically set at the market value of a company's stock on the date of grant, so they become valuable only if the company's stock price rises, presumably as the result of good financial performance.

Microsoft's decision to dump stock options hasn't led to a flood of imitations in Silicon Valley, ground zero of the stock-option culture.

Big-name technology companies such as Oracle Corp., Cisco Systems Inc. and Dell Computer Corp. were quick to say they remain committed to options as a method of attracting and retaining talented employees. For fast-growing companies, options can provide a much greater upside potential than restricted stock grants.

"My hypothesis is that you get a very different character with restricted stock than the guy who is willing to stay up all night to create the next great thing to get the price of their stock options to go up," Ward said.


Microsoft is proposing to tie vesting of the restricted shares, given to 600 key officers, to performance targets - a move that many compensation experts see as the beginning of an encouraging trend. However, under Microsoft's plan, most of the software maker's employees will receive restricted shares without having to hit particular performance targets.

Although tying restricted stock grants to performance can be a tricky proposition, many corporate-governance experts see such stock as preferable to the sometimes "perverse incentives" created by stock options.

"Stock options can be structured to reward any type of performance that you'd want, but historically, they have rewarded short-term performance," said Jack F. Williams, a corporate-governance expert and professor at Georgia State University College of Law.

Sarah Anderson, director of the global economy project at the Institute for Policy Studies in Washington, said companies have slashed research-and-development budgets - their ticket to future growth - to boost short-term earnings, and thus the value of executive stock options.

Many experts believe that the alleged financial wrongdoing at Enron Corp. and WorldCom Inc., among others, was partly motivated by executives intent on boosting the value of their option packages.

Options also can give a misleading impression of a company's financial results because accounting rules have allowed companies to issue options without recognizing an immediate cost - a situation that may soon change, Anderson said.


"Restricted stock is better because it will show up as an expense on the company's financial statements," she said. "There is wide agreement that if companies have to record [stock compensation] as an expense, executives will not be getting these extreme compensation packages that we've seen in the past several years."

Companies can still boost paychecks through restricted stock or unique pension arrangements, Anderson said.

Keeping a lid on restricted stock grants will require corporate compensation committees to "just say no" to corporate chieftains, experts say. If companies simply replace vast stock option grants with huge grants of restricted shares, shareholders are sure to suffer, Hodgson said. But if restricted shares are used more modestly and tied to performance targets, they may prove a real value.

"Our hope depends on the balance of power moving in the right direction," said Diane Doubleday, compensation consultant with Mercer Human Resources Consulting in San Francisco. "I am optimistic that we won't have another run on the bank."

The Los Angeles Times is a Tribune Publishing newspaper.