The Magnitude of the Option Overhang

The use of options in management compensation packages is not new to firms. Many firms in the 1970s and 1980s initiated option-based compensation packages to induce top managers to think more like stockholders. What is different about the more recent option grants, especially at technology firms? One is that management contracts at these firms are much more heavily weighted towards options than are those at other firms. The second is that the paucity of cash at these firms has meant that options are granted not just to top managers, but also to employees all through the organization, making the total option grants much larger. The third is that some of the smaller firms have used options as currency to meet operating expenses and pay for supplies.

Market Wide Trends

There are a number of different statistics that we can point to that show the growth in equity option compensation. The simplest measure is the number of employee options outstanding as a percent of the total outstanding shares, also called the option overhang. The Investor Responsibility Research Center (IRRC), an independent watch dog for shareholders, estimated that the overhang was 17% for the 1500 companies it tracks (including the S&P 500, mid cap and smaller cap stocks) in 2003, up from 15.7% in the previous year; the median value for the overhang was 16.3%, up from 14.8% in the prior year. Figure 11.1 graphs the overhang, as computed by IRRC, from 1997 to 2003:

Figure 11.1: Option Overhang at US Companies

Figure 11.1: Option Overhang at US Companies

Source: Investor Responsibility Research Center (IRRC)

While smaller companies have higher numbers of options outstanding than larger market cap companies, even the larger market cap companies in the S&P 500 reported an option overhang of 16.4%. The pervasiveness of options can also be seen in the number of companies that grant options to management and in the number where options outstanding represent a very high percent of the outstanding stock. In 2003, for instance, IRRC reported that almost 90% of the firms in their sample had some options overhang and that 67 companies (about 4.6% of the sample) had more than a 40% overhang, up from 3.6% in 2002 and 3% in 2001.

Another measure of the reach of options is the number of employees who receive options as part of pay packages. The National Center for Employee Ownership estimated that almost 3 million employees received options as part of compensation in 2000, up from less than a million in 1990 and that about 10 million employees held stock options in that year. This is backed up by the national compensation survey of the Bureau of Labor Statistics in March 2003, which reported that about 8% of all employees received options as compensation. The number was much higher for white-collar employees (about 12%) than for blue-collar (6%) and service employees (2%). Notwithstanding recent attempts to widen option grants, they remained heavily loaded towards top management at firms. In 2002, for instance, the value of options granted to the CEO and the top 5 managers at S&P 500 firms accounted for about 9.5% of the total option grants.3

The decision by the Financial Accounting standards board to require all companies to begin expensing options, starting in 2006, has begun to have an effect on option grants. In 2004, IRRC reports a drop in the option overhang at all US companies and notes that companies are reexamining their option grant procedures in light of stockholder disapproval.

Who uses options?

The IRRC study, quoted in the last section, categorized firms into 10 economic sectors and examined the magnitude of the options overhang in each sector. Technology companies had the biggest average overhang of 24.4% in 2003, up from 20.8% in the previous year. Utility and energy companies had the smallest overhang, averaging less than 8% in 2003. These differences widened during the technology boom in the late 1990s, with the advent of internet and new technology firms. Hall and Murphy, in their study of the problems associated with the use of employee stock options, report on option grants at old economy and new economy firms from 1993 to 2001. Figure 11.2 summarizes their findings:

study of the problems associated with the use of employee stock options, report on option grants at old economy and new economy firms from 1993 to 2001. Figure 11.2 summarizes their findings:

Source: Hall and Murphy

The differences across sectors may not be surprising but it is worth examining why they exist in the first place. In general, we can outline three factors that may explain these differences:

a. Age and Growth Potential of firm: We would expect younger firms to use equity options substantially more than older and more mature companies. After all, if not having the cash to compensate employees is a factor behind the use of equity options, younger firms are far more likely to be cash constrained than more mature firms.

b. Riskiness of firm: Riskier firms should be more likely to use equity options than safer firms. While most securities become less valuable as risk increases, options become more valuable. This is especially true if the market is over assessing the risk in a

3 Hall, B.J.. and K.J. Murphy, 2003, The Trouble with Stock Options, Working Paper, NBER. They note that the CEO and top management share of options has dropped from about 15% in the early 1990s to less than 10% in 2002.

company, since this firm's options will be over valued by the employees receiving the options.4

c. Market Valuation of firm: As we will see in the next section, there is a tax advantage that accrues to firms that use equity options as compensation. Firms that trade at high multiples of earnings will get a much bigger tax advantage from using options as compensation.

None of these characteristics are static and they will change as firms move through the life cycle. We would expect to see option grants, as a percent of outstanding stock, to be greatest at young, risky firms, with high market valuations, and to decline as growth levels off, cash flows increase and valuations come down to earth. Cisco provides an interesting case study of this transition, with figure 11.3 reporting on options granted as a percent of the outstanding stock every year from 1993 to 2005.

Figure 11.3: Cisco Option Grants - 1993 to 2005

0 0

Post a comment