Commentary

Variety Spices Pay Plans

This article was published in the Washington Times, July 20, 2003.

In a seemingly bold move, Microsoft decided to give employees restricted stock rather than stock options in the future. Past earnings will be restated (reduced) by estimating the value of old stock options at the time they were granted. Some were too quick to see this as a pattern that other high-tech companies will or should follow. Yet Microsoft’s chief financial officer John Conners disagreed, saying, “There’s no one-size-fits-all approach when it comes to equity compensation programs and the resulting accounting for them.”

Mr. Conners is right. Flexibility in pay plans is critical to American business. Unfortunately, powerful reformers (interest groups) are lobbying to impose a one-size-fits-all approach through politicized accounting rules. That would benefit some companies but damage others. Allowing each company’s employees and employers to arrive at sensibly diverse and unique agreements requires stifling any political urge to impose one-size-fits-all accounting mandates.

One critical difference between Microsoft and other tech companies is that Microsoft pays a dividend. Because the federal tax on dividends was slashed to 15 percent this year, collecting dividends from restricted stock suddenly became far more attractive to Microsoft employees. But the prospect of receiving lightly taxed dividends on restricted stock has zero appeal to employees of younger start-up companies that have no spare cash with which to pay dividends. Equity-based compensation at such companies has to rely on the hope of a rising stock price, even though gains from customary stock options are taxed at regular income tax rates of up to 35 percent.

Another big difference is that Microsoft’s stock options have been granted to nearly all employees except top executives. The opposite pattern is more common and arguably more efficient. Top executives usually get the lion’s share of stock options because those options are mainly intended to attract and keep the best executives, and motivate them to act in the interest of stockholders. Microsoft never had to worry about managerial incentives because founders Bill Gates and Steve Ballmer always kept a big chunk of Microsoft’s stock.

The critical difference between stock options and restricted stock is that stock options pay off only if two things happen: The employee cannot quit or be fired before the vesting period is over and the stock price has to go up. Restricted stock has only one of these conditions: The employee has to stay on the job for a few years, but restricted stock remains valuable even if the stock price goes down. Because there is much less risk, employees generally receive about a third as many restricted shares as they would have received in options.

Restricted stock is less risky than options if the stock price falls but less lucrative if the stock price rises. Reducing both risk and opportunity may be a sensible compromise for lower-level employees. For companies in which top executives are not major stockholders, however, reducing the risk faced by top executives is equivalent to increasing the risk faced by all other stockholders. If most CEO stock options were replaced with restricted stock, CEOs would be wealthier if the stock price fell and other stockholders would be poorer.

Restricted stock is “expensed” (subtracted from earnings) only after employees are vested. In Microsoft’s case, one-fifth will become vested each year for five years. That means restricted stock granted in 2004 will not be fully expensed until 2009.

Proponents of expensing stock options, by contrast, want the estimated value of options to be expensed immediately when they are granted, rather than years later when vested. If the Financial Accounting Standards Board (FASB) makes good on threats of requiring options to be expensed when granted, that will create an accounting bias in favor of restricted stock. The recorded expense of restricted stock will fall, for example, if the stock price falls between the time stock is granted and the time it is vested. The estimated fair value of options, on the other hand, would be treated as an immediate cost even if those options later turn out to be a mile underwater.

Many options granted in 2000 had a huge value on paper but are now unlikely to ever be worth a dime. To base reported earnings on such ephemeral estimates is to convert earnings into a maze of meaningless estimates. Amazon.com is already responding to demands of sophisticated investors by showing what its earnings would look like if the company had not capitulated to the FASB-inspired ritual of treating a flaky estimate as an actual expense.

Critics of executive stock options get the new Microsoft story exactly wrong. The fact that Microsoft is replacing stock options with restricted stock shows that cutting back on stock options is more likely to rearrange the form of compensation than to reduce the amount. The faddish assault on stock options would not reduce the size of executive pay but rather reduce the risk faced by failed executives if their company’s stock price falls. If the noisiest critics of executive pay got what they have been clamoring for, they would end up transferring risk from mediocre executives to innocent investors.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.