OPTION-BASED COMPENSATION: PANACEA OR PANDORA'S BOX?

Journal of Applied Corporate Finance S U M M E R 2 0 0 1 V O L U M E 1 4 . 2

Option-Based Compensation: Panacea or Pandora’s Box by Stuart L. Gillan, TIAA-CREF Institute

115BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

OPTION-BASEDCOMPENSATION:PANACEA ORPANDORA’S BOX?

by Stuart L. Gillan, TIAA-CREF Institute*

During the past decade, investors havebecome increasingly concerned aboutthe proliferation and size of stock optionplans. Shareholder concerns center on

four main issues. First, the cost of option-basedcompensation may exceed the associated benefits,resulting in excessive transfers of wealth from share-holders to optionholders. Second, the current ac-counting for and disclosure of option-based com-pensation may not be adequate for valuation pur-poses. Third, although many companies submitoption plans to a shareholder vote, it appears thatsome companies may use exchange and market rulesto avoid the shareholder approval process. Given thepotential for stock option plans to transfer largeamounts of wealth from shareholders to optionholders,the ability of shareholders to vote on option plans isseen as a critical corporate governance issue.

Fourth and finally, with recent stock-price de-clines, many employees now hold out-of-the-moneyor underwater options. In order to retain and moti-vate employees, some corporations have respondedby repricing or replacing underwater options withnew grants. This replenishment has raised share-holder concern that the practice effectively rewardsemployees for failed performance, and that repricingundermines the rationale for using options as incen-tive compensation in the first place.

Along with increased shareholder concern hasbeen an increase in the perceived importance ofhuman capital—employees—in determining corpo-

rate profitability and shareholder returns at manycompanies. Proponents of option-based compensa-tion argue that it aligns employee and shareholderinterests. Moreover, it has been suggested that optionsare critical not only in motivating and retainingemployees, but also in fueling economic growth. It isdifficult, however, to measure the benefits of compen-sating employees with stock options.

Similarly, assessing the cost of stock options canbe complex. Although an economic transfer fromshareholders to employees takes place at the time anoption is granted, the option exercise occurs sometime in the future. This raises the issue of how tomeasure the potential wealth transfer from share-holders to optionholders resulting from option grants.One approach is to develop an estimate of theexpected value transfer at the time of the grant—using dilution measures or option pricing tools.Alternatively, given sufficient disclosure in corporatefinancial statements, one could focus on actualoption exercises and measure the realized valuetransfers.

Although recognizing that there are potentialbenefits of option-based compensation, the primaryfocus of the paper is on (1) measuring the “cost” ofoption-based compensation, (2) management actionsto deal with underwater options, and (3) share-holder concerns about the use of stock options.Shareholder concerns suggest that the use of option-based compensation will continue to be a hot-buttoncorporate governance issue.

*An earlier version was presented at the TIAA-CREF Institute CorporateGovernance Forum 2001: Executive Compensation, Stock Options, and the Roleof the Board of Directors. I would like to thank John Ameriks, Ken Bertsch, Jennifer

Bethel, Jay Hartzell, Jacob Rugh, Lelia Stroud, and Mark Warshawsky for helpfulcomments and discussions. The opinions expressed in this article are those of theauthor and not necessarily those of TIAA-CREF or its employees.

116JOURNAL OF APPLIED CORPORATE FINANCE

EXAMPLE 1: MEASURES OF DILUTION

Suppose a company has 100 shares outstandingand a current price of $30. Some time ago thecompany granted employees 16 options, and thecompany has an additional 16 shares available togrant as options.

BASIC DILUTION= (options granted / current shares outstanding)= (16/100)= 16%.

POTENTIAL BASIC DILUTION= ([options granted + options available for grant]/

current shares outstanding)= (32/100)= 32%.

DILUTION

One of investors’ primary concerns about stockoption plans is the extent to which shareholder valuemay be diluted—that is, transferred to optionholders.This section examines several dilution measures that canbe used to benchmark the potential value transfers.While commonly used, dilution measures implicitlyassume that each option granted will be exercised whenit is deep in-the-money. That is, the dilution measuresassume that the exercise price will be paid in exchangefor a share of stock with a much higher market value. Theactual value transfer from shareholders to optionholderswill depend on the difference between the optionexercise price and the market price of the share atexercise. This section illustrates how dilution measuresprovide an upper bound on the potential cost. Alternateapproaches to dilution are discussed later in the paper.

The term dilution is used in a number of differentways in different contexts. Basic Dilution provides anoverall measure of dilution from stock options bydividing options granted during a year by the numberof shares outstanding at year-end. Full Dilution esti-mates the portion of the current shareholders’ valuetransferred to employees if employees exercise theiroptions. Full Dilution recognizes that on exercise thereare additional shares outstanding. Potential Dilution,often referred to as the option overhang, which can bemeasured either in Basic or Full terms, incorporates thenumber of options the company has available forgrant into the numerator of the dilution calculation.

Once the options are exercised the company willhave 116 shares outstanding. Each share has anequal claim on the company’s assets.

THE FULL DILUTION IS:= (options granted/ [current shares outstanding + options granted + options outstanding])= (16/(100+16+0))= 13.8%

The original shareholders owned 100% of com-pany prior to exercise, but only 86.2% after exer-cise (100 shares out of 116).

POTENTIAL FULL DILUTION= ([options granted + options available for grant] /

[current shares outstanding + options granted +options available for grant])

= (32/132)= 24.2%.

Note that Potential Dilution can be measuredusing Basic and Full approaches by adding sharesavailable for grant to the options granted in eachcalculation.

Suppose that the company issues an addi-tional 10 options. The company has 100 sharesoutstanding, 16 options from the original grant,and 10 newly granted options. The potentialwealth transfer resulting from the new grant isborne by current shareholders and currentoptionholders.

Following the Potential Dilution example,current shareholders own 100 shares, so 100 /[100 + 16 + 10 ] represents the proportion of thepotential transfer from shareholders to new grantrecipients. Similarly, with 16 currentoptionholders, 16 / [100 + 16 + 10] representsthe magnitude of the potential transfer from cur-rent optionholders to new grant recipients.

To provide a perspective on how the exampleswork in practice, Table 1 reports on option grantingactivity at Microsoft during 1999. The Full Dilutionresulting from the new options granted is 1.32%. Putanother way, the 1.32% Full Dilution represents theportion of the company that new optionholders may

117VOLUME 14 NUMBER 2 SUMMER 2001

ultimately receive. However, as noted in the hypo-thetical example, the dilution falls on shareholdersand optionholders.1 The optionholders prior to thenew grant face a potential value transfer in theproportion of: [688/(766 + 5,141)] = 11.7%. Share-holders prior to the new grant face a potential valuetransfer in the proportion of: [5,141/(766 + 5,141)] =87%. For this reason, current shareholders have notreally given away a full 1.32% of their wealth in thecompany. Rather current shareholders face a poten-tial wealth transfer of around 1.17% of the value ofthe company—their 87% “share” of the 1.32% FullDilution.

Dilution in a Broad Sample of Companies

To examine the issue of dilution further, thefollowing table reports measures of dilution andpotential dilution using Basic Dilution (options as apercentage of shares outstanding) for a large sampleof U.S. companies. The sample is based on a set ofcompanies tracked by the Investor ResponsibilityResearch Center (IRRC) that includes the S&P 1,500

and approximately 500 other companies with broadinstitutional ownership. Complete 1999 data for thisanalysis was disclosed by 1,680 companies. Table 2reports summary statistics on Basic Dilution for the1,680 companies, including option grants in each year1997-1999, options outstanding at the end of 1999,options available for grant, and potential dilution.

The “Run-rate” (sometimes referred to as theoption “burn-rate”) is annual option grants as apercentage of shares outstanding. A constant ordeclining run-rate may indicate a stable compensationpolicy, whereas an increasing run-rate is likely toindicate increasingly aggressive granting of options.

As shown in Table 2, in 1999 companies onaverage granted options equal to 2.85% of sharesoutstanding, an increase from 2.7% in 1997. Mediangrants exhibit an increasing trend from 1.67% in 1997to 1.94% by 1999. Median grant levels are somewhatlower than the average, suggesting that companieswith a higher level of option use raise the average.Some companies were particularly aggressive intheir option granting practices, with those at the 95thpercentile making annual grants in the 8.6-10%

1. Jennifer Carpenter and David Yermack (2001) “Dilution from stock-basedcompensation,” working paper, New York University.

TABLE 1 DILUTION AT MICROSOFTThe table reports measures of Basic and Full Dilution for Microsoft during Fiscal 1999. Shares outstanding is reported as of fiscalyear-end. Option activity is as reported in Microsoft’s 1999 10-K. Note that options outstanding of 766 million include the currentyear grant of 78 million options.

Options (millions) Basic Dilution Full Dilution

Granted 78 (78/5,141) = 1.52% 78/(5,141 + 766) = 1.32%

Outstanding 766 (766/5,141) = 14.90% 766/(5,141 + 766) = 13.14%

Available 980 (980/5,141) = 19.06% 980/(5,141 + 766 + 980) = 14.23%

Potential Dilution 1,746 (1,746/5,141) = 33.96% 1,746/(5,141 + 766 + 980) = 25.35%

Shares Outstanding 5,141

TABLE 2 BASIC DILUTION IN A LARGE SAMPLEThe table reports summary statistics on Basic Dilution for a broad set of U.S. companies tracked by the IRRC. The sample comprisesthe S&P 1,500 and approximately 500 other companies with broad institutional ownership. Basic Dilution is measured in percentageterms as 100 × (Options/Shares outstanding as at year-end.) Statistics for potential dilution are reported only for companies whereshares available for grant at year-end can be determined.

Source: Author’s calculations based on IRRC data.

Options Available for PotentialGrants Grants Grants Outstanding Grant at Dilution1997 1998 1999 1999 year-end 1999 1999

Average 2.70 2.98 2.85 9.00 4.79 13.93

Median 1.67 1.78 1.94 7.65 3.42 11.83

95th Percentile 8.87 10.03 8.61 21.06 9.62 31.41

Number of Companies 1,517 1,589 1,655 1,680 1,340 1,340


range. At the end of 1999, the average level ofoptions outstanding as a proportion of shares out-standing was 9% (median 7.65%.) At the upper endof the distribution, the company at the 95th percen-tile had options outstanding equal to over 21% ofcurrent shares outstanding.2

The last two columns of Table 2 report on sharesavailable for option grants and potential dilution (thetotal of shares available for grant and optionsoutstanding) for the three-quarters of the sample forwhich the required information is available. Eachmeasure is reported as a percentage of year-endshares outstanding. Comparing shares available forgrant to past grants indicates that companies hadbetween one and two years’ worth of option grantson hand. This could provide an indication as towhether or not the company is running out of sharesfor option grants, and at what point the companymay need to adopt additional option plans.

Table 3 provides perspective on how grantpractices vary across industries by reporting industry-level Basic Dilution. Industry groups are based on 2-digit SIC codes. Table 3 reports option activity for threeindustries with a low use of option grants, and threeindustries with a high use of option grants. There isconsiderable variation in grant practices across indus-tries, with Electric, gas and sanitary services at the lowend of the scale and Engineering and management atthe high end. The median level of dilution from priorgrants (options outstanding) ranges from 2.35% to13.78%. Median grants during 1999 ranged from 0.88%to 5.03%, and dilution from options outstanding at the95th percentile ranges from 9.8% to 26.91%.

There is also substantial variation in grant practicesamong companies in the same industry. For example,the median company in the Food stores industry haddilution from 1999 grants of 1.28% and options outstand-ing of 4.25%. In contrast, the company at the 95thpercentile in Food stores had 1999 grant dilution at4.42% and options outstanding equal to 15.63%.

Estimated Value Transfers of Option Grants

Whereas dilution measures provide a basis forbenchmarking option use, the issue quickly turns to oneof the “cost” to shareholders. Although the dilutionmeasures discussed above provide estimates of the

upper bound of potential wealth transfers from share-holders to optionholders (as a proportion of the equitythat optionholders may ultimately receive), optionpricing tools are typically used to estimate the dollarvalue of grants, which may then be benchmarkedagainst market values. Typically, the deeper in-the-money the options are, the closer they are economicallyto a share of stock. This implies that if the majority ofoptions are deep in-the-money, the potential valuetransfer can be approximated by Full Dilution. To theextent that options are not deep in-the-money, valueestimates as a proportion of current market value will belower than the Full Dilution.

To illustrate, during 1999 Microsoft reported grantsof 78 million options to employees. The estimated valuetransfer at the time of grant (explained later in thissection) amounted to about $967 million, representingapproximately 0.2% of Microsoft’s 1999 year-end marketvalue. This is an estimate of the expected value transferat the time of grant, based on assumed inputs and theBlack-Scholes option pricing model. Consequently, theestimates are subject to criticisms of the model and theinputs used. For example, option pricing models aredesigned to value exchange-traded options, not em-ployee stock options. Employee stock options typicallyhave a much longer maturity than exchange-tradedoptions, vesting restrictions, non-transferability features,and other characteristics that may imply different valu-ations relative to exchange-traded options. Moreover,there is evidence that employees tend to exerciseoptions early, sacrificing a significant portion of thevalue. On the other hand, many employee stock optionsin practice have value-enhancing features not capturedby standard option pricing models. For example, em-ployee stock options are American options (whichpermit exercise before the expiration date), whereas thestandard Black-Scholes model is designed to valueEuropean options (which can be exercised only on theexpiration date). Some employee stock options alsohave reload features or may ultimately be repriced,which enhances their value relative to estimates usingstandard option pricing models. Similarly, at least forsome employees, informational advantages may addsubstantial value by permitting “fortuitous” timing ofoption grants and exercises.3 Moreover, it has beensuggested that, although option pricing approachesmay provide an estimate of the potential cost to

2. By way of comparison, John Core and Wayne Guay (2001) “Stock optionplans for non-executive employees,” forthcoming Journal of Financial Economics,report average options outstanding during the 1994-1997 period of 6.6% (median5.2%) for a large sample of firms.

3. David Yermack (1997) “Good timing: CEO stock option awards andcompany news announcements,” Journal of Finance 52, 449-476.


shareholders, risk-averse employees typically assigna much lower value to the option grant.4 There are alsoother potential, if even more difficult to quantify,costs. For example, options may provide seniormanagers with incentives to increase risk or reducedividend payments, which may not be in the interestof shareholders.

Despite such criticisms, the use of option pricingtools provides a useful alternative approach inbenchmarking the level of expected value transfersfrom shareholders to optionholders. To illustrate theapplication of option pricing techniques, the remain-der of this section follows the approach of MichaelMauboussin to value option grants at Microsoft.5

4. Brian Hall and Kevin Murphy (2000) “Stock options for undiversifiedexecutives,” NBER working paper 8052.

TABLE 3 INDUSTRY-LEVEL BASIC DILUTIONThe table reports summary statistics on Basic Dilution for selected industries. Industry groups are based on 2-Digit SIC codes. BasicDilution is measured in percentage terms as 100 × (Options / Shares outstanding as at year-end.) Panel A reports on three industrieswith low levels of options outstanding relative to other industry groups. Panel B reports on three industries with high levels ofoptions outstanding relative to other industry groups.

Options Available for PotentialGrants Grants Grants Outstanding Grant Dilution1997 1998 1999 1999 1999 1999

PANEL A: LOW OPTION-USE INDUSTRY GROUPSDEPOSITORY INSTITUTIONSMean 1.51 1.56 1.57 5.77 4.24 10.24Median 1.16 1.20 1.22 4.39 2.72 8.5995th Percentile 3.74 5.63 4.74 13.01 14.98 23.90Number of companies 85 92 91 94 72 72ELECTRIC, GAS, AND SANITARY SERVICESMean 1.08 1.18 1.47 3.84 3.58 8.23Median 0.51 0.57 0.88 2.35 3.12 6.4595th Percentile 4.03 2.96 4.15 9.80 11.83 18.96Number of companies 59 69 80 84 53 53FOOD STORESMean 1.55 1.45 1.53 5.14 1.82 6.94Median 0.85 1.02 1.28 4.25 1.74 6.1995th Percentile 4.01 5.96 4.42 15.63 3.42 17.60Number of companies 8 9 9 9 8 8

PANEL B: HIGH OPTION-USE INDUSTRY GROUPSSECURITY, COMMODITY BROKERS, AND SERVICESMean 2.69 2.85 3.09 10.38 8.23 18.1Median 2.2 2.14 2.43 9.35 4.93 14.2695th Percentile 10.37 6.97 9.1 19.7 40.87 49.86Number of companies 19 21 23 23 18 18BUSINESS SERVICESMean 5.64 6.03 5.40 13.96 6.42 20.40Median 3.98 4.53 4.28 12.51 4.62 19.1495th Percentile 18.04 14.99 13.04 25.56 20.62 41.49Number of companies 144 154 165 165 136 136ENGINEERING AND MANAGEMENT SERVICESMean 4.29 4.61 5.61 14.03 5.45 19.83Median 3.33 3.80 5.03 13.78 6.19 18.7295th Percentile 9.82 15.04 13.24 26.91 13.24 38.88Number of companies 20 20 19 19 15 15

5. Michael Mauboussin (1998) “A piece of the action: employee stock optionsin the new economy,” Frontiers of Finance, Credit Suisse First Boston.

Whereas dilution measures provide a basis for benchmarking option use,the issue quickly turns to one of the “cost” to shareholders.


Using the Black-Scholes option pricing formula,and the company’s assumptions for volatility, risk-free rate, average exercise price ($54.62), andweighted-average option life (6.2 years), the baseestimate of the value transfer from options grants on78 million shares during 1999 is $1.78 billion. Note,however, that as employees leave the company andtheir options expire, options are cancelled. Cancel-lations at Microsoft have averaged around 3.3% ofoptions outstanding per year. Using 3.3% as anestimate of the rate of future cancellations, the valuetransfer estimate declines to $1.71 billion.6

As noted in the earlier examples, if a companyhas significant stock options outstanding, the valuetransfer resulting from new grants is from sharehold-ers and current option holders. With 5.14 billionshares outstanding and 688 million options grantedin prior years, Microsoft notionally has 5.83 billionshares with a potential claim on earnings.7 After thenew grant of 78 million options, Microsoft notionallyhas 5.91 billion shares with a potential claim onearnings. Thus, future cash flows will flow to currentshareholders in the proportion of (5.14/5.91= 87%)and to current optionholders in the proportion of(0.69/5.91=12%).8 By implication, when new op-tions are granted, both current shareholders andcurrent option holders are diluted. The value transferfrom current shareholders is 87% of $1.71 billion, orapproximately $1.49 billion.

Finally, for tax purposes, Section 422 of theUnited States Internal Revenue Code allows compa-nies to expense the difference between the marketprice and the exercise price when employees exer-cise their options.9 Assuming that the tax benefit isthe tax rate of 35% multiplied by the estimated valuetransfer, the estimated after-tax value transfer fromincumbent shareholders is $967 million, which isapproximately 0.2% of Microsoft’s year-end marketvalue. Recall from the earlier analysis that the FullDilution approach resulted in an estimated valuetransfer of 1.17% of market value. The option pricingapproach captures the fact that new grants are notdeep in-the-money and provides a lower estimate ofthe expected value transfer.

There is considerable debate about how tomeasure the value transfers resulting from option

grants. This debate spans a number of issues,including the legitimacy of using standard optionpricing models and the appropriate time to estimateor measure value transfers (whether at grant date,vesting date, or exercise date). There is also vigorousdebate as to whether or not any estimates should betreated as an expense in the income statement. Thenext section focuses on an alternative to using optionpricing models at grant date by examining realizedvalue transfers on option exercise.

Realized Value Transfers

The value transfer approach based on an optionpricing model is, by its nature, a forward-lookingexercise. Moreover, the focus is on grant-date esti-mates of the potential value transfer. An alternateapproach is to use information at the time of exerciseto measure realized value transfers. This section firstpresents examples of measuring realized value trans-fers, and then examines realized value transfers in alarge sample.

Illustrating Realized Value Transfers

6. Ideally we would like to estimate cancellations as a proportion of annualgrants.

7. All numbers have been rounded for ease of exposition.8. This provides an upper bound as not all options outstanding are “in-the-

money.”

9. Under IRS regulations, some options do not qualify for tax deductions. Tothe extent that such options are granted by companies, calculations using thereported tax benefit will understate the potential value transfer.

EXAMPLE 2: VALUE TRANSFER

Suppose that a company has 100 shares outstand-ing and assets of $3,000. Some time ago the com-pany granted employees 16 options with an exer-cise price of $10. On exercising their 16 options,employees pay the company the $10 exercise priceper share for a total of $160. The $160 cash pay-ment increases the company’s assets to $3,160,and shares outstanding increases to 116 as employ-ees receive 16 shares. Each share has an equal valueof ($3,160/116) = $27.24.

CASE 1: LARGE MARKET VALUE INCREASE SINCEGRANT DATEThe employees’ net gain:= (value of shares acquired – total exercise pricepaid)= ([16 shares @ $27.24] – $160) = $276.


The value transfer from the original share-holders:Value before exercise – Value after exercise=$3,000 – (100 shares @ $27.24)= $3,000 – $2,724 = $276= ($276/$3,160), or 8.7% of the market value of thefirm.

CASE 2: ENORMOUS MARKET VALUE INCREASESINCE GRANT DATEIf the value of the firm prior to exercise were toincrease to say, $1,000,000, then on exercise eachoutstanding share would be worth ($1,000,160/116) = $8,622.07.

The employees’ net gain:=(value of shares acquired – total exercise pricepaid)= ([16 shares @ $8,622.07] – $160) = $137,793.

The value transfer from the original shareholders:Value before exercise – Value after exercise= $1,000,000 – (100 shares @ $8,621.69)= $1,000,000-$862,169 = $137,793.= ($137,793/$1,000,000), or 13.8% of the marketvalue of the firm.

As in the earlier dilution examples, any subse-quent option issuance transfers value from cur-rent shareholders and current optionholders tonew grant recipients.

The realized value transfer of $276 in Case 1 ofExample 2 equates to 8.7% of the market value of thecompany on the exercise date (which includes the $160employees pay to exercise their options). In Case 2, wherethe market value of the company increased dramatically,the wealth transfer was 13.8%. The potential valuetransfer is capped at the level of Full Dilution, in this case13.8% of the market value on the exercise date.

As noted earlier, for tax purposes companies arepermitted to expense the difference between themarket price at exercise and the option exerciseprice. As a result, companies may report the associ-ated tax savings in their financial statements. For

example, Microsoft reported in its 1999 10-K a taxsaving associated with option exercises of $3.1billion. The tax saving is equal to the tax Microsoft didnot pay—that is, the tax rate multiplied by the differencebetween the market price and the exercise price (0.35× (Market price – exercise price) = $3.1 billion). Thisimplies that the pre-tax amount was ($3.1 billion/0.35)= $8.86 billion, or $5.76 billion after tax. This $5.76 billionafter-tax figure amounts to a realized value transfer equalto 1.25% of Microsoft’s year-end market value.

Realized Value Transfers in the S&P 500

Table 4 reports realized value transfers for S&P 500firms during the period 1997-1999. Note that the taxbenefit from stock option exercise was readily availablefor less than one-third of all S&P 500 firms each year.10

Panel A of Table 4 focuses on after-tax value transfers asa percentage of year-end market value. Assuming a taxrate of 35%, the median estimated after-tax value transfereach year from option exercises ranges from 0.38% to0.44% of market value, with an increasing trend duringthe period. Average values are somewhat higher, in therange of 0.58%-0.62% range. In Panel B the emphasis ison measuring the aggregate value transfers at the samplecompanies. These aggregates, which would contrib-ute to any economy-wide measure of labor costs,range from $11.9 to $28.4 billion while averaging$19.7 billion a year during the three-year period.These value transfers reflect exercises of past optiongrants. It would seem reasonable to “allocate” aportion of the realized value transfer to prior yearsrather than view this as the “cost” of stock options ina particular year. Nevertheless, measuring realizedvalue transfers over time is analogous to measuringoption run-rates; it provides an indication of annualrealized value transfers, and may suggest a trend.

To evaluate the potential value transfers in the timebetween grant and exercises, one could take the follow-ing approach: At grant dates, use an option pricing modelto estimate the value transfer and the sensitivity of optionsgranted (and outstanding) to the price of the underlyingstock. As the stock price changes, estimate the changein the value of the options, and the resulting increase ordecrease in the expected value transfer. Upon exercisethere could then be a reconciliation between the currentestimate and the realized value transfer.

10. It has been suggested that the tax disclosures are “hard to come by” andare not plainly visible in the income statement, see Jack Ciesielski (2000) “1999 S&P500 stock compensation: The fluff grows,” The Analyst’s Accounting Observer.

There is considerable debate about how to measure the value transfersresulting from option grants.


Although we can estimate value transfers, suchestimates are imprecise by virtue of both the informa-tion available and the limitations of the models used.Many companies disclose information on optiongrants only in 10-K reports, which typically areavailable after fiscal year-ends and announcements offourth quarter earnings. Inevitably, the question thenarises as to whether option related disclosures aretimely and relevant for investment decision making.

GENERAL DISCLOSURE ISSUES

Under Generally Accepted Accounting Prin-ciples (GAAP) and Securities and Exchange Com-mission (SEC) requirements, two main types ofoption-based compensation disclosure are requiredin corporate financial statements.11 The first set ofdisclosures requires an estimate of compensationcosts at grant date. The second set requires a three-year summary of option granting activity.12

The primary accounting rule governing ac-counting for stock options is SFAS 123. Under SFAS123 companies must either take a charge to income

or, as almost all do, provide additional footnotedisclosures reporting net income and earnings pershare as if the costs had been charged to income.(The as-if estimates are referred to as “pro-forma”disclosures.) Companies are granted considerablelatitude in making assumptions about inputs intooption pricing models, including the expected life ofthe option, stock price volatility, dividend yield, andthe risk-free rate. Although such assumptions mustbe fully disclosed, different assumptions can lead toquite different estimates of the cost of stock options.Companies can then allocate estimated costs over theexpected life of option grants; that is, only a portionof the current year’s option grant is treated as anexpense in the current fiscal year’s as-if estimates ofnet income and earnings per share. The portions ofthe estimated costs from prior grants allocated to thecurrent fiscal year are also included in the as-ifestimates of net income and earnings per share.

The value of prior-year grants is not updated toreflect changes in the market price of the stock,which suggests that, everything else being equal, thefootnote values may over- or under-estimate the

TABLE 4 REALIZED VALUE TRANSFERS AT S&P 500 COMPANIESThe table reports on estimated realized value transfers at approximately 162 S&P companies for which information on taxbenefits from option exercise was available. Panel A reports on the after-tax value transfer as a proportion of current stockmarket value. Panel B reports on the aggregate dollar amount of the after-tax value transfers.

PANEL A: AFTER-TAX VALUE TRANSFERS AS A PERCENTAGE OF MARKET VALUE1997 1998 1999 3-year Average

% % % %

Mean 0.58 0.62 0.54 0.58

Median 0.38 0.40 0.44 0.41

Number of companies for which 155 161 162tax benefit information is available

PANEL B: AGGREGATE AFTER-TAX VALUE TRANSFERS $ BILLION1997 1998 1999 3-year Average

Tax benefit 6.4 10.1 15.3 10.6

Implied cost 18.4 28.9 43.7 30.4

Implied after-tax cost 11.9 18.8 28.4 19.7

Number of companies for which 155 161 162tax benefit information is available

11. This discussion relates to company-wide option disclosures, and notspecifically those required for senior executives under the proxy rules.

12. In addition, under SFAS 128, Earnings per Share, in-the-money options areconsidered to be shares outstanding when calculating the number of shares todetermine diluted earnings per share. Options “at-the-money” or “out-of-the-money” do not result in EPS dilution.

Source: Author’s calculations based on data from FACTSET and The Analyst’s Accounting Observer.

Stock-based compensation is viewed by many as being a critical component ofcompensation programs with many potential benefits.


“costs” conditional on the change in the stock pricesince the grant date. Recent research suggests,however, that perhaps “everything else” is not equalwhen it comes to the accounting estimates of optiongrants. For example, a 1998 study by David Yermackreports that companies choose methods that tend tominimize the reported value of option grants.13

The three-year summary of option activity in-cludes a statement of options: (1) outstanding at thebeginning of the year, (2) outstanding at the endof the year, (3) exercisable at the end of the year,(4) granted, (5) exercised, (6) forfeited, or (7) expiredduring the year. Specifically, for each item compa-nies are required to disclose the number of options,a “meaningful” range of exercise prices, and aweighted-average exercise price for each range.Additional information is required for options out-standing and options currently exercisable (items(2) and (3) above.) This additional disclosure entailsa breakdown into finer price ranges, with the numberof options, weighted-average exercise price, andweighted-average remaining contractual life reportedfor each price range. Finally, the number of sharesrepresented by in-the-money options must be addedto the number of shares outstanding when reportingfully diluted earnings per share.14

SEC rules also require disclosure of the materialfeatures of a compensation plan in the proxy statementwhen it is submitted to shareholders for approval.However, the disclosures need only relate to the planbeing voted on, not all plans at the company. Thus,shares available for grant under all company plans maybe difficult to ascertain. The SEC currently has a releaseout for public comment on this issue. Proposed changesinclude the disclosure of shares available for grant underall stock option plans and an indication as to whetheror not each plan was approved by shareholders.15

In the section on Realized Value Transfers earlierin the paper, disclosures of the tax benefit associatedwith option exercises were used to estimate realizedvalue transfers. However, not all companies have thisinformation readily available. In the earlier analysis, taxinformation was readily available for only one-third of

the S&P 500 companies studied. Similarly, in a sampleof 15 of the largest companies in the NASDAQ 100 index,Bear Stearns’ analysts found explicit disclosures on thetax benefit from option exercise for only six of the 15.For another five companies the analysts were able toestimate a tax benefit from other disclosures. Twocompanies had insufficient information available toascertain the tax benefit.16 It is apparent that companieshave some leeway in determining if, and how, theydisclose the tax benefit information. And, in July 2000,the FASB’s Emerging Issues Task Force (EITF) reacheda consensus in support of improved disclosure of the taxbenefit in the statement of cash flows.

SHAREHOLDERS AND CORPORATEGOVERNANCE CONCERNS: PANDORA’S BOX

As noted earlier, this paper focuses on the“costs” of stock options. But this focus is not meantto imply that options have no benefits. Rather it is anacknowledgement that the benefits of option-basedcompensation are difficult to measure. Stock-basedcompensation is viewed by many as being a criticalcomponent of compensation programs with manypotential benefits. Such benefits may include:

Incentive effects: Stock options may align em-ployee interests with those of shareholders. If anemployee holds stock options, then the value of thoseoptions increases as the stock price rises. Employeeswith significant amounts of options have a strongincentive to work to increase company value; that is,employee and shareholder incentives are aligned.

Employee retention: Stock options may helpcompanies retain employees, particularly in a com-petitive labor market. Fresh option grants over timecreate incentives for employees to stay, especiallywhen options are in-the-money and close to vestingor when employees must forfeit options whenleaving the company.

Financing: To the extent that options are substi-tuted for other forms of compensation, they mayreduce other labor costs, conserve cash, and providea form of contingent financing for the company. 17

13. David Yermack (1998) “Companies’ modest claims about the value of CEOstock option awards,” Review of Quantitative Finance and Accounting, 10, 207-226

14. Under the “Treasury Stock” method, the number of shares subject to optionincluded in fully-diluted shares outstanding can be reduced by the number of sharesthat could be purchased with the exercise proceeds. See John Core, Wayne Guayand S.P Kothari (2001) “The economic dilution of employee stock options: dilutedEPS for valuation and financial reporting,” working paper, Wharton School,University of Pennsylvania.

15. SEC Release No. 34-43892, Jan. 26, 2001, Disclosure of Equity Compensa-tion Plan Information Reference: File No.: S7-04-01.

16. See Pat McConnell, Janet Pegg, and David Zion (2000) “Accounting issues:Employee stock options,” Bear Stearns Equity research, Accounting and Taxation.

17. Edward Lazear (1999), “Output-based pay: incentives or sorting?” NBERworking paper 7419.

Companies with options deep underwater face pressure to reprice to addressemployee incentive and retention concerns.


Ultimately option-based compensationshould be used only so long as it increases themarket value of the firm. That is, the economicbenefits of option-based compensation shouldexceed the economic costs. It is also important toconsider what types of companies are likely tobenefit from option-based compensation, thetypes of employees that should receive option-based compensation, and the extent to whichcompanies should use option-based compensa-tion. These questions in turn raise issues as to therole of shareholders in approving option plans,the basis for their decisions, and any sharehold-ers’ concerns about the use of option-basedcompensation.

Shareholder Voting

Depending on a stock option plan’s character-istics, companies may need to seek shareholderapproval. In doing so, however, some companiesappear to “game the system” by taking advantageof exchange rules to garner votes. Specifically, ifbeneficial owners fail to vote their shares or toprovide voting instructions on some managementproposals, the NYSE and Amex permit memberbrokers to vote the shares. The NYSE and Amexpermit brokers to vote on management proposalsseeking the authorization or issuance of stock or

stock options to directors, officers, or employees inamounts that are less than 5% of outstandingcommon shares as routine. Although the NASDdoes not currently have a parallel rule governingbroker voting, many NASD brokers, who are alsomembers of the NYSE or Amex, vote uninstructedshares of NASDAQ-listed firms for beneficial own-ers. As a result, some companies will seek authori-zation for option plans by requesting a number ofshares less than or equal to 5% of current sharesoutstanding.

There is compelling evidence that brokers votein favor of management proposals, and, further, thatthe level of broker votes can be significant—often10-15% of shares outstanding.18 Thus, for somecompanies, “shareholder approval” of an optionplan may hinge on votes cast by brokers in favor ofthe management proposal. The use of broker votesto pass stock option plans has been characterized bysome as “ballot stuffing,” and is of concern toshareholders given high potential dilution at somecompanies.19 One indication of general shareholderconcern about stock option plans is illustrated inFigure 1, which shows the rising average percentageof votes cast against stock option plans during theperiod 1988-1999.20

In general, the higher the potential dilutionresulting from options outstanding and optionssought, the greater the opposition from shareholders.

18. Jennifer Bethel and Stuart Gillan (2001) “The impact of broker votes onshareholder voting and proposal passage,” working paper, TIAA-CREF Institute.

19. Council of Institutional Investors http://www.cii.org/brokervoting.htm.

20. Based on S&P 1,500 companies as tracked by the IRRC – see Drew Hambly(2000) “Management proposals on executive compensation plans,” InvestorResponsibility Research Center, Corporate Governance Service Background Re-port A.

FIGURE 1AVERAGE VOTES CASTAGAINST STOCK OPTIONPLANS 1988-1999

Source: Based on IRRC reported voting results.

Ave

rage

% V

ote

“A

gain

st”

Year

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

20

16

0

18

141210

8

6

42


This concern about dilution persists despite theearlier analysis suggesting that economic approachesto benchmarking option use result in lower esti-mates of the cost of stock options relative to thecompany’s market value (as compared with stan-dard dilution measures). It is perhaps surprisingthat corporations do not encourage an economicoption pricing approach to measuring dilution, asopposed to the standard dilution approach (al-though one would expect a high correlation be-tween the two measures). It is not clear, however,to what extent institutional voting thresholds wouldchange using an economic approach as opposed toa dilution approach.

The trend toward more votes against optionsplans, with some plans even failing on rare occa-sions, indicates that shareholders are apprehensiveabout levels of potential dilution at some companies.Past repricing of options at a company are especiallylikely to trigger “no” votes by many shareholders.

Concerns About Repricing

The rationale for voting against stock optionplans at companies that have repriced is twofold.First, it is perceived as rewarding employees forfailed performance, thus undermining the rationalefor using options as incentive compensation. Sec-ond, the repricing of employee stock options is oftencriticized as providing employees a benefit that is notavailable to shareholders who have suffered a de-cline in the value of their investment.

The counter argument is that, in a tight labormarket, failure to reprice may result in poorlymotivated employees and undesirable employeeturnover (as employees effectively reprice theirunderwater options by getting new options froma new employer). Thus, a failure to reprice maycost the company and shareholders more in thelong run.

To assess the degree to which companies haveunderwater options, Figures 2 and 3 report thecumulative distribution of option “in-the-moneyness.”Figure 2 reports on the degree to which optionsgranted during 1999 were in-the-money at the endof January 2001. In-the-moneyness is measured inpercentage terms as 100 × ([January 2001 closingprice – Weighted average price for 1999 grants]/Weighted average price for 1999 grants).

Negative in-the-moneyness indicates that op-tions were, on average, underwater. Specifically, a

negative 50% on the horizontal axis in Figure 2indicates that the January 2001 market price was50% below the weighted average exercise price ofoptions granted during 1999. Figure 3 is similar butreports in-the-moneyness for options outstanding atyear-end. In-the-moneyness is measured as 100 ×([January 2001 closing price – Weighted averageprice of options outstanding at fiscal year-end 1999]/Weighted average price of options outstanding atfiscal year-end 1999]).

Two features of Figures 2 and 3 are worthhighlighting. First, in many cases options issuedduring 1999 and outstanding as of year-end weredeep in-the-money, thus highlighting potentiallylarge wealth transfers from shareholders tooptionholders. However, as one would expect,options were underwater by a large amount at manyother companies. Figure 2 shows that grants madeduring 1999 were underwater for approximately 40%of companies. Similarly, based on the weightedaverage price of options outstanding, Figure 3suggests that approximately 35% of companies had1999 or prior option grants that were underwater.Some 10% of companies had either 1999 grants oroptions outstanding at year-end that were underwa-ter by more than 50%.

Table 5 expands the analysis by reporting onselected industry groups where there is substantialvariation in the degree of in-the-moneyness. Specifi-cally, Table 5 reports a set of industry groups inwhich some companies had outstanding optionsdeep in-the-money, whereas other companies hadoptions outstanding underwater by at least 30%.Take, for example, the Business services group,which includes a large number of hi-tech companies.Business services had 59 companies with underwateroptions, and 107 with options in-the-money. Com-panies where options are underwater had optionsoutstanding with an exercise price that was onaverage 46.4% above the stock market price at theend of January 2001. Options were in-the-money forthe other 107 firms by an average of 220.5%. Similarpatterns can be seen for other industry groups.

Such markedly different levels of in-the-moneyness suggest considerable variation in indi-vidual company performance, or in sub-sector per-formance. Companies with options deep underwa-ter face pressure to reprice to address employeeincentive and retention concerns. Such pressuresmay be heightened given that there are other firmsin similar industries performing well.

Ultimately option-based compensation should be used only so long as it increasesthe market value of the firm.


Breathing Underwater

When employees hold underwater options,companies typically worry about employee reten-tion and morale. Some companies consider repricingoptions, but doing so risks angering shareholderswho are apprehensive about dilution in general andrepricing in particular. Companies can undertake apure repricing by lowering the exercise price of priorgrants. This is usually implemented by cancelingunderwater options and simultaneously grantingreplacement options at the current market price. Insome cases, companies will make a grant equal inpresent value (using an option pricing model) to theinitial award rather than replace underwater optionson a one-for one basis. Recent clarifications by FASB

require that if a company alters the terms of a stockoption plan—in effect undertaking a repricing—theplan must be treated as “variable” for accountingpurposes.21 The FASB pronouncement, which isretroactive to December of 1998, requires that anestimate of the cost of the options at grant date bemade, charged as an expense to earnings, and thenmarked to market on a quarterly basis. Althoughsome companies such as Amazon.com have recentlyrepriced stock options, it is likely that repricing willbe used less frequently given the reluctance of manycompanies to take a charge to earnings.22

A key element of the FASB ruling is that anyissuance within six months of a cancellation consti-tutes a repricing for accounting purposes. Thisclarification has led some companies, Sprint being

21. Broadly speaking, stock option plans are classified as variable compen-sation if the full terms of the plan (e.g., number of underlying shares and / orexercise price) are unknown at the time of grant, or a pre-specified performancehurdle must be met. Such plans result in an expense recorded on the incomestatement.

22. For an analysis of companies that have repriced in the past see Mary EllenCarter and Luann Lynch (2001) “The effect of accounting on economic behavior:Evidence from stock option repricing,” working paper, Columbia UniversityGraduate School of Business

FIGURE 2CUMULATIVEDISTRIBUTION OFOPTIONIN-THE-MONEYNESS:GRANTS DURINGFISCAL 1999

FIGURE 3CUMULATIVEDISTRIBUTION OFOPTIONIN-THE-MONEYNESS:OUTSTANDINGFISCAL 1999

Pro

po

rtio

n o

f C

om

pan

ies

In-the-moneyness (%)

-100%

100

80

0

90

706050

403020

10

-50% 0% 150%50% 100% 200% 250% 400%300% 350% 500%450%

Pro

po

rtio

n o

f C

om

pan

ies

In-the-moneyness (%)

-100%

100

80

0

90

706050

403020

10

-50% 0% 150%50% 100% 200% 250% 400%300% 350% 500%450%


among the first, to adopt a “synthetic” repricingstrategy. Sprint announced that it would give em-ployees a choice to hold onto their current grants orhand them back to the company with the promisethat a replacement grant would be made in six-months and one-day at the then market price—thuscircumventing the definition of a “repricing.”

Alternatively, companies with sufficient optionsavailable for grant, such as Lucent and Microsoft,have simply issued employees replacement optionswhile leaving prior underwater grants outstanding.

While this may help maintain employee morale, thefact remains that underwater options do have valueand represent a potential value transfer from share-holders to optionholders. In the event that there isa dramatic increase in the stock price at suchcompanies, this doubling of grants could prove verycostly to shareholders.

In the face of insufficient shares available forgrant, some companies may take advantage ofexchange and market rules permitting the adoptionof plans without shareholder approval.23 In the

23. NYSE Listed Company Sections 312.01, 312.03 and 312.04 exemption ofshareholder approval for “broad-based” stock option plans which and NASD

Marketplace Rules Section 4310. The rules suggest that non-approved plans of upto 20% of current shares outstanding may be possible.

TABLE 5 UNDERWATER AND IN-THE-MONEY OPTIONS OUTSTANDING BY INDUSTRY GROUPThe table reports the extent to which options outstanding as of fiscal year-end 1999 are in- or out-of the-money. In- and out-of-the-moneyness are calculated as 100 × ([January 2001 closing price – Weighted average price of options outstanding at fiscal year-end 1999]/Weighted average price of options outstanding at fiscal year-end 1999].) The table reports on two sets of companieswithin each industry group: First, companies where outstanding options are underwater (Panel A), and second, companies in thesame industry where outstanding options were in-the-money (Panel B). Specifically, Panel A reports the average out-of-the-moneyness for those industry groups where average out-of-the-moneyness was 30% or more. Panel B reports the average levelof in-the-moneyness for companies within the each industry where options were in-the-money.

Panel A Outstanding options Panel B Outstanding optionsunderwater (out-of-the-money) in-the-money

Average amount Average amountunderwater in-the-money

Industry Group Number of (% relative to Jan. Number of (% relative to Jan.(2-digit SIC code Classifications) Companies 01 stock price) Companies 01 stock price)

Business services 59 -46.4% 107 220.5%Communications 14 -58.2% 48 186.4%Eating and drinking places 6 -41.6% 18 85.0%Electrical and electronic equipment 28 -35.2% 92 303.7%Engineering and management services 11 -50.7% 9 187.6%Food and kindred products 9 -38.2% 31 53.2%Furniture, home furnishings and equipment stores 2 -41.7% 7 91.5%General merchandise stores 9 -43.8% 12 163.9%Health services 5 -38.1% 14 140.1%Heavy construction contractors 1 -70.0% 5 101.2%Industrial machinery and equipment 35 -32.7% 63 159.7%Instruments and related products 13 -35.2% 43 139.6%Insurance agents, brokers, and service 2 -42.7% 8 177.0%Insurance carriers 20 -36.4% 46 64.7%Metal mining 5 -60.2% 1 123.7%Miscellaneous retail 16 -54.5% 17 92.7%Motion pictures 2 -91.7% 2 138.0%Motor freight transportation and warehousing 1 -76.6% 11 110.6%Nondepository credit institutions 6 -60.3% 13 108.2%Primary metal industries 25 -46.8% 10 114.9%Security, commodity brokers, and services 2 -62.8% 21 137.7%Transportation equipment 21 -39.1% 23 66.2%Wholesale trade—durable goods 20 -40.1% 20 58.7%

….underwater options do have value and represent a potential value transfer fromshare-holders to optionholders.


absence of any change to current rules, one wouldexpect the adoption of more plans without share-holder approval, particularly at those companiesfacing shareholder opposition to new option plans.Moreover, given current disclosure requirements, itis difficult to determine the extent to which compa-nies are using non-shareholder-approved plans.IRRC reported that, as of July 2000, 52 out of 1,157(approximately 4.5%) S&P 1,500 companies re-ported having plans in place that had not beenapproved by shareholders.24 This 4.5% estimate islikely to understate number of non-approved plansbecause it includes only those companies whereplan disclosures were readily available. More re-cently, the compensation consulting firm iQuanticreported that during 1999 more than 70 out of 200technology companies surveyed (35%) adopted op-tion plans without shareholder approval.25

In contrast, many companies seek share-holder approval for all stock option plans. Othershave adopted plan restrictions prohibiting futurerepricing without shareholder approval. Indeed,some companies have sought and received share-holder approval to reprice stock options. Repricing,however, remains a focal point of shareholderconcern, a concern exacerbated by what are per-ceived to be high levels of potential dilution.

CONCLUSION

Determining the “cost” of option-based com-pensation is a complex task, for shareholders andemployees alike. More importantly, to the extent thatthere is a difference between the value placed onoptions by employees and the economic cost ofoptions to shareholders, it raises questions about theeconomic efficacy of this form of compensation. Putanother way, are employees being paid in a currency

(stock options) that is significantly less valuable tothem than to shareholders?

Another valuation issue is that standard at-the-money options are “free” from an accounting per-spective; that is, they generally do not result in acompensation expense. This raises questions re-garding the extent to which accounting consider-ations may influence compensation policy. Forexample, do the current accounting rules result in apreference for standard options over potentiallysuperior alternatives (such as indexed- or perfor-mance-based options) simply because they do notresult in an expense? Similarly, does the absence ofan expense lead to the overuse of standard options?

Despite the difficulties in valuing options, share-holders monitor option use and have actively votedagainst management-proposed stock option plansthey believe to be excessive. However, exchangeand market rules allow companies to adopt somestock option plans without shareholder approval. Inthe absence of any change to current rules, onewould expect more companies to avoid share-holder approval, particularly when facing share-holder opposition to new option plans. A centralgovernance question, then, is whether exchangeand market rules permitting companies to avoidshareholder approval of stock option plans disen-franchise shareholders.

Focusing solely on dilution, repricing, and thecost of stock options begs the question on a numberof issues, notably: what types of companies maybenefit from option-based compensation, what typesof employees should receive option-based compen-sation, and whether or not the benefits of option-based compensation outweigh the costs. Neverthe-less, shareholder concerns suggest that option-based compensation will continue to be a focal pointfor controversy. Pandora’s box is open.

STUART L. GILLAN

is a Research Economist at TIAA-CREF Institute and formerAssociate Chief Economist at the U.S. Securities and ExchangeCommission. He holds a Ph.D. in finance from the University ofTexas at Austin.

24. Annick Siegl (2001) “Potential dilution 2000: Potential dilution from stockplans at S&P 1,500 companies,” Investor Responsibility Research Center.

25. Ted Buyniski and Daniel Silver (2000) “Trends in equity compensation: Anexecutive summary of iQuantic’s high-tech equity practices survey 1996–2000,”iQuantic report.

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Documents

OPTION-BASED COMPENSATION: PANACEA OR PANDORA'S BOX?