Restricted Stock or Options? Rethinking Equity Incentive Plans

Dodd S. Griffith (Gallagher, Callahan & Gartrell, PA)

The Debate Over Which Type of Compensation Is Best for Management, Employees and Investors Continues

This article originally appeared in the Fall issue of the New Hampshire Business Review

After the fall of Enron and WorldCom, many of the practices that contributed to their demise have come under criticism, including employee stock options.

Employee stock options are being scrutinized as a factor driving some of the short-sighted or fraudulent activities that led to the downfall of these companies, and others like them. As these cases, and others like them demonstrate, stock options can provide management teams with perverse incentives to engage in speculative growth strategies in order to inflate stock prices in the short-term, at the expense of long-term investors, and in some cases, the life of the company.

These problems, along with continued efforts by regulators to require companies to record stock options as an expense against earnings, have caused many companies to rethink their strategy for compensating and motivating employees using stock options. This trend has been punctuated by the highly publicized decisions of Microsoft and Amazon to end stock option programs in favor of restricted stock.

Do these recent trends mean stock options are dead? Clearly not. The choice to award options rather than restricted stock or some other form of equity will depend on a variety of factors, including the life cycle of the company in question, its geographic location, and relevant tax and accounting policies.

What's the difference between restricted stock and a stock option?

Restricted stock is normally an outright grant of shares to an employee, pursuant to an agreement that limits the employee's right to sell, transfer or pledge that stock until a vesting period has lapsed. The agreement typically permits the company to repurchase the stock at a nominal price if the employee ceases to be employed by the company before the vesting period has ended.

In contrast, a stock option is a contractual right to buy stock at some future date at a price established at the time the option is granted. Stock option agreements typically condition the employee's right to purchase stock on continuous employment until the lapse of one or more vesting periods. Stock option agreements also may include additional restrictions on the stock purchased by means of the option.

The better incentive?

Options and restricted stock provide different types of incentives to employees and can result in different pitfalls and benefits for investors. Options are high-risk, and potentially high-return. While stock options can give an employee a "home run" from a compensation standpoint, the employee runs the risk that the options will have no value, due to the possibility that the exercise price will be greater than the value of the stock. In contrast, restricted stock gives an employee immediate value, is less likely to become worthless, entitles the employee to all the rights of a shareholder.

Some criticize restricted stock as merely a reward for longevity and not for performance, since most restricted stock is earned merely as a result of continued employment. Traditionally, stock options were thought to be a better incentive, since management would have to grow the stock price in order to gain any value from their options. In reality, the attractiveness of these incentives to employees, and the benefit or risk to investors of such incentives will likely depend on whether a company is public or private and whether there is a bull market or a bear market.

In a bull market, the management team of a public company may be tempted to follow short-term strategic plans that inflate stock prices, and the value of their stock options, at the expense of positioning the company for long-term growth. In an extended bear market, stock options granted by a public company can become a liability because they lose their value as the stock price sinks and stays below the exercise price of outstanding options for an extended period, thereby contributing to poor employee morale.

For these reasons, as well as recent changes in federal tax policy toward dividends and likely changes to the mandatory accounting treatment for options, restricted stock may be a better choice for more mature companies with publicly traded stock.

As a result of the tax cuts enacted under the Bush administration, the tax on most dividends has been reduced to 15 percent. Thus, dividend-paying companies are now more attractive to many investors. A restricted stock plan aligns the interests of a company's management team and investors with respect to payment of dividends. Managers who hold restricted stock will benefit from dividends in the same manner as other investors, thereby creating an incentive to grow dividends. In contrast, managers and employees who hold options have a disincentive to cause the company to pay dividends, since option-holders do not receive dividends.

Cultural Expectations

Anticipated changes in the manner in which companies are required to account for stock options may also make it more desirable for public companies to issue restricted stock rather than options. Currently, the Financial Accounting Standards Board (FASB) permits most companies to avoid accounting for options as an expense against current earnings during the year granted, and requires that they be expensed only when they actually vest. However, it is anticipated that starting in 2004, FASB will require companies to account for stock options as a compensation expense that must be subtracted from earnings during the year granted. This change in accounting treatment could have a significant effect on a company's earnings, which might be unpalatable to many public companies.

While restricted stock must be accounted for as an expense against earnings, it is expensed only when it is no longer subject to forfeiture by the employee who received it. Thus, in the case of Microsoft, which reportedly has a five-year vesting period for its restricted stock, this means that restricted stock granted to employees in 2004 will not be fully expensed until 2009.

While such considerations may be appealing to mature public companies such as Microsoft, the equation is likely to be different for smaller privately held companies.

Younger start-ups do not have the cash to pay dividends. Thus the right to receive dividends holds little immediate value in this context. While employees may still benefit from voting rights, management and investors may not wish to have to deal with too many common stockholders if and when an opportunity for an exit strategy appears. In addition, most employees are likely to receive smaller grants of restricted stock, since it typically has more than a nominal value, even in the private company context. Thus, there is generally less potential for upside.

In contrast, the potential for high returns offered by stock options can, in the right market, give a young company the currency it needs to buy talent it could not pay for with cash.

As of yet, the accounting rules do not exact any penalty for the use of this currency. Moreover, the benefits of stock options to a young private company may outweigh any accounting issues. In fact, depending on a company's geographic location (i.e. Silicon Valley), cultural expectations may dictate the use of options.

In addition, private companies that do not have stock trading on public exchanges are much less susceptible to the problems associated with options, since their stock is illiquid. Management, employees and shareholders will not likely be able to sell their stock unless the company is acquired or is taken public.

Thus there is not the same incentive for management to take inappropriate actions designed to achieve short-term gains. Moreover, small privately held companies typically are much more actively managed by their shareholders, so there may be less opportunity for short-sighted strategic moves by management, regardless of the motivation.

The debate over which type of compensation is best for management, employees and investors is likely to continue. There is no one-size-fits-all approach. Equity incentive plans will provide a mutual benefit to a company's investors and employees only if carefully planned and implemented in light of a company's size, culture and market.