Be wary of companies with too many options

Stories about executives reaping riches by selling company stock are frequent.

For example, The Wall Street Journal reported last week that a big shot at Microsoft, Paul Maritz, has sold 900,000 shares for $78.1 million so far this year.

Much of such profits come thanks to stock options, giving executives - and increasingly lower-ranking employees - the right to buy company stock at a set price. If the shares appreciate in price, they can be sold at a profit.

To compensation theorists, options encourage executives and other employees to work harder in the interest of all shareholders, including themselves. Their personal financial interests are in line with that of shareholders in general.

But many mutual- and pension-fund managers are expressing concern that options dilute the value of existing shares.

"It costs existing shareholders a significant amount," says Kurt Schacht, general counsel of the State of Wisconsin board which manages some $59 billion of public pension assets.

Dilution of ownership

Say a hot Internet company has a million shares outstanding owned mostly by 10 pension funds. To attract bright young techies and managers, the executives of "NETrich" award themselves and new employees options on another 1 million shares that can be sold gradually over three years.

At the end of that period, the pension funds own only about half the firm. The executives and other employees own - or could own if they haven't exercised their options - the other half.

The profit potential of the pension funds has been halved.

"It's giving away part of the company for less than market value," says Daniel Murray, an economist with Smithers & Co., a London firm that does research for mutual funds.

One of his calculations finds that if options were taken properly into account (full-cost accounting) at 145 of the largest 200 American firms, 1998 profits would shrink 50 percent.

Ignoring options is "another way of flattering profits," says Mr. Murray. "It is something serious investors should look at."

Calculating dilution is controversial.

Analysts at Bear Stearns & Co., a New York brokerage, reckon earnings of firms in Standard & Poor's 500 Index were diluted only 3 percent in 1997.

The dilution by options also varies greatly between companies. Dilution in high-tech companies can be 20 to 30 percent, notes Wisconsin's Mr. Schacht. "It is darn right greedy."

Regulation of options

Because executives have a self-interest in awarding themselves and other employees stock options, the regulatory system provides for two checks against overgenerous plans.

One is disclosure of details of option grants in documents companies must make public.

The second is approval by shareholder vote.

These two checks have been debated for nearly two years now by a 15-member task force set up by the New York Stock Exchange. The group, which met last Thursday, is divided between representatives of shareholders and reps of the NYSE and companies.

Sarah Teslik, executive director of the Council of Institutional Investors, a body representing 100 pension funds with $1 trillion in assets under management, sees "a lot of underhanded artfulness" within the task force.

She charges the NYSE and corporate members with wanting to appear tough publicly on options, but including enough easy terms and loopholes that few firms would need to seek shareholder approval or disclose details.

At stake are "broad-based" option plans that, presumably, give options to a wide swath of employees. Unlike plans for a few executives alone, these would not need shareholder approval.

A study by management consultants William M. Mercer Inc., in New York, finds that 39 percent of 350 major companies now have such plans in place. Some 17 percent actually grant options to half or more of all employees. The number of firms with plans has more than doubled since 1993.

At dispute in the task force are definitions of "broad-based" and the percentage of dilution that would need shareholder approval. "We have to watch every word," says Ms. Teslik.

The Big Board expects a dilution proposal by Oct. 15.

(c) Copyright 1999. The Christian Science Publishing Society