A Question of Options By Stephen Goebel :: Restaurant Supply Resource

A Question of Options By Stephen Goebel

The Financial Accounting Standards Board is proposing a change in the way companies must account for stock options awarded to employees. Will this affect the industry and what are the alternatives?

The use of stock options has been an important part of executive and director compensation for the past three decades. The potential value of the options granted is only realized when the company's stock price is raised, thereby tying executive pay to the fortunes of the firm's shareholders. To date, options are considered to have zero value at the time of issuance, hence recipients pay no taxes and the company incurs no expense until the options are exercised. A good situation for everyone it would seem.
However, there are those who do not believe that the practice is an entirely good thing, since the "zero value" grants do have the effect of diluting shareholders. If the options truly have no value, this view argues, why would anyone want them? The Financial Accounting Standards Board has listened to this argument and amid much controversy, has unveiled a preliminary plan that will force companies to place a value on options, incur the expense and recipients pay the taxes. The rule is expected to be adopted permanently at year's end. Proponents of keeping things as they are point out that the options truly do not have any immediate value to the recipient, as they can not be exercised in most cases for a specified term (frequently ten years.)

Since this move has been seen coming for some time, I decided to take a look at whether it has had an impact on how the gaming industry has awarded options to it's leaders. Though historically the gaming industry has not made as many "mega-grants" as the high-tech industry for instance, it has nonetheless utilized options freely in compensation packages, particularly for it's C-level executives.

The Trends

Option grants to CEO's were down in our 2003 HCE Gaming Corporate Survey by an average of 15.5% compared to the results of our 2001 survey (see comparison table). We found the CFO option grants down even further, 36.4% on average when compared to two years ago. However option grants to Chief Operating Officers do not follow the downward trend. Those were up an average of 44.1% compared to option grants in our 2001 survey. However, when you look at the maximum grant to a COO/President (see comparison table), we notice that it is more than twice the maximum grant in our 2001 survey. When I eliminated that one grant and recalculated the average grant to COO's it is only up 16.6% over 2001. Overall it seems the industry was more conservative with option packages, though not necessarily in anticipation of the new regulation. Certainly stock options still represent an important part of executive compensation and cannot be dispensed with lightly. Board compensation committees will definitely have some decision making to do when planning and executing their compensation strategies.

So what are the Options?

Will this mean that the days of stock options are nearing an end? Clearly if the benefit to companies and the recipients of this type of compensation are eliminated, there will be a search for alternative methods of long-term compensation. It is doubtful that senior executives or company directors will be eager to receive large option grants if they are obliged to pay taxes on a sum they may never realize.

The industry may want to consider following the lead of large tech firms like Microsoft and Amazon.com who have already announced that they are eliminating option grants and will use Restricted Stock Awards in their place.

The Advantages

Restricted stock awards have a vesting period but they are granted free and clear with no exercise price, so even if the company stock is trading for less than when you received the award, your stock will still have value. It is equally motivating to executives to build their company's price per share since they are now truly owners of the company is and will ultimately benefit from the higher stock price.

The advantage is that because they do not have the same risk factor, restricted stock grants are typically much smaller (one-third, to one-half) in size than stock options. Less expensing, less affect on the company financials.

In summary, we at HVS believe that effective long-term incentives are a very important part of senior executive compensation and that companies must find the best way for them to tie executive compensation to company performance. Restricted stock awards are not the only method, stock appreciation rights, or even full-value grants may be considered as well. We present this as a good alternative knowing that the subject will be hotly discussed in boardrooms everywhere.

About the author
Vice President of HVS Executive Search, is responsible for managing the firm's gaming industry practice. Goebel runs an office in Las Vegas and serves the gaming industry's growing need for executive talent.

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Date Listed: 2004-06-02

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