Stock options vs stock grants

THE HUMAN FACTOR

Microsoft's decision last year to turn its back on stock options, and issue direct stock grants created a stir in the software industry, which relies on stock options to power risky ventures that are often short on cash but long on promise.

Software majors all over the world, however, are still debating what's better for employees "" stock options or stock grants. The debate has not been able to yield a cogent answer "" even in India, where the number of companies using employee stock option plans (Esops) as a reward tool has dropped more than 10 per cent in the past one year.

Consultancy companies like Watson Wyatt calculate that employees would be better off with stock options if a company's stock price went up more than 10 to 15 per cent annually.

On the other hand, stock grants are suited for those companies whose share price range from negative 99 per cent return up to a positive 10 per cent return.

First, the difference between the two. Stock options represent the right to buy a company's stock at some point in the future. Which means employees make money (remember the Infosys and Wipro crorepatis?) only if the stock rises above its current price at the time when the shares are allotted to the employee, and sold. Stock grants, on the other hand, are outright grant of shares, with certain limitations on when the stock can be sold.

The obvious advantage of stock grants is that they are always worth something: options, by contrast, can quickly become worthless if the company's share price falls more than expected.

But the other side of the argument is equally strong: no doubt, stock options are risky but the returns can be much higher in the long run. "Equity risk premium is an accepted concept the world over, which operates on the concept of higher the risk, higher the reward," says a consultant.

Votaries of stock grants also cite the following example: according to Forbes, Bill Gates, the world's richest man, never received options. Neither did Microsoft's co-founder Paul Allen, the fourth-richest man, nor Microsoft's chief executive Steven Ballmer, the 16th-richest man. Their wealth is based on the actual shares of stock they own in the company.

Microsoft, of course, took a decisive stop and overhauled compensation for the more than 50,000 employees. In the first stage, about 600 of the company's senior management received stock grants based on customer growth and satisfaction benchmarks.

But Indian software majors are not so sure on the next course of action, as was evident from Infosys and Wipro's decision to suspend Esops for the time being.

Both the companies have instead increased the variable pay component on the ground that employees prefer cash to stock options or grants. While Wipro has stopped offering options for close to four quarters now, Infosys has also done the same since May last year.

The reason is quite obvious. Options worked great in the late 1990s when stocks soared well above the pre-determined share price and employees profited from their stock options. But when the stock market crashed, options at many companies became meaningless because their stocks were trading below the value of the options.

The other problem is the confusion over how the options are valued. The Securities and Exchange Board of India, for example, requires prices to be taken at an average of two weeks value while according to US GAAP, at the rate at which it closed the previous day. This loophole, consultants say, needs to be plugged immediately.

The mandatory expensing of stock options was the main reason why Microsoft shifted to direct stock grants. Simply put, expensing means companies have to treat stock options as a regular expense to bring in the required transparency in accounts.

Here is how it works. On the day stock options are granted, they have an expected value. Whether they end up out of the money a decade later does not change what the expected value is on issue, nor would it matter if the stock goes up so much that they are worth substantially more.

Though there is a huge opposition to expensing, experts argue that not expensing options obscures financial results and does not account accurately for the total cost of a company's compensation to its employees.

Grants or options, the fact of the matter is heavy use of either of them has traditionally made top executives adopt overly risky strategies. A Watson Wyatt study found that CEOs whose pay is tied up in share grants or options are more likely to make lots of acquisitions.

If all these acquisitions worked out, there would not be much of a problem. But the study found that the executive pay of the worst acquirers was five times more reliant on stock options/grants than the pay of the best acquirers.

The point, however, is stopping Esops or stock grants is not the answer because they will remain a vital way of life in corporate India, as in the rest of the world. The trick lies in the right mix of variable pay, and stock options or grants.