The Employee Ownership Update
March 8, 2001
New Study Says Options Improve Performance When Targeted at Mid-Level EmployeesA new study of 217 new economy companies by Christopher Ittner, Richard Lambert, and David Larcker at the Wharton School of Business at the University of Pennsylvania finds that returns to shareholders increased when the ratio of options to salary increased for mid-level employees. Increased ratios for executives and hourly employees, however, did not improve performance.
Data for the study were collected in surveys in 1999 and 200 by iQuantic, a compensation consulting firm. The surveys provided detailed information on options and compensation practices. The researchers hypothesized that deviations up or down from the sectoral norm in terms of the ratios of option grants to salary would result in lower returns to shareholders than would be the case for companies closer to the norm. Their analysis focused on shareholder returns in 1999 and 2000 as they correlated with equity grants for 1998 and 1999. All the sampled companies made grants to a broad cross-section of employees. Almost all the companies (97.2%) made grants at least annually. Option grants were valued using a simple discounted expected gain model that assumed a 15% per year stock growth and five-year holding period. The expected spread between grant and exercise price at the end of the five-year period was discounted using a 5% risk-free interest rate assumption.
The researchers found that larger firms have lower dilution from options but higher ratios of option value to salary. Companies with more cash and less debt also provide larger grants. Other variables, such as volatility, tax rates, and research expenditures, showed no consistent relationship to the size of grants.
To look at the results, the researchers constructed a model with a variety of variables that might have an impact on performance (company size, industry, R&D expenditures, etc.), including the ratio of the value of options to annual salary. The model then used multiple regression (a statistical technique that shows the relationship between two variables holding all the other variables in the model constant) to see how much each factor correlated with stock price performance. The study found no relationship between "burn rates" (the percentage of shares made available for grants each year) or higher stock option overhang (the potential dilution from options) and stock price performance. By contrast, grants to non-executive level managers, technical employees, and "individual contributors" (individuals getting discretionary performance-based options) show a positive relationship to performance. Grants to executives and directors make no difference, while grants to hourly and sales employees had a somewhat negative correlation, although many of these companies would have a relatively low number of such employees. The amount of dilution caused by grants to hourly employees would also be nominal, so its not clear how any change in option grants to this group could effect stock price performance.
The study did find that a 20% increase in the ratio of equity grant value to salary for managers below the senior executive level resulted in a 4.7% increase in the following years stock return. A 20% increase in the equity to salary ratio for grants to all technical employees yielded a 5.1% increase in stock value, while a 20% increase in the equity to grant ratio for all non-technical, non-executive employees produced a 2.7% increase. This calculation was not made for grants to hourly employees. 20% increases in grants to top management had no impact on share performance.
The authors make it very clear that these findings do not establish causality. The findings could be a marker for some other practice; companies that grant options to hourly employees, or make high grants to executives, may be systematically doing other things that affect performance. The period studied was obviously an unusual one in stock market history, the study period was short, and the performance measure (stock prices) is subject to all sorts of fickle, random variation outside the impact of what a company is actually doing. A previously reported study by Sesil, Krumova, Blasi, and Kruse on this site looked at a before and after analysis of companies with broad-based plans and used several measures of performance, finding that broad options do seem to improve company performance.
Nonetheless, this is an important contribution to our understanding of the impact of stock options and, as the authors conclude, shows that the conventional wisdom that it is grants to top management that really drive performance may be unsupportable, while lower-level grants may have a significant impact. The complete Wharton study is available online at Wharton's Web site.
British Study Shows Perfomance Related Pay and Stock Ownership Plans Improve Corporate PerformanceA new study of British companies by Martin Conyon at Wharton and Richard Freeman at Harvard shows that companies with stock option plans and profit sharing improved their performance over a four-year study period. The study was based on two sets of data, one encompassing 2,191 companies and one with 882 publicly traded companies. The larger sample provided only respondent assessments of whether their companys performance had improved; the second sample provided usable data on 299 companies and included actual productivity data. The study found that 45% of the companies in the public company sample used a "Save as You Earn" plan (a kind of stock purchase/stock option plan similar to U.S. Section 423 stock purchase plans), while 30% used such a plan in the larger sample. Option plans were in place at 43% of the listed companies and 21% in the larger sample. The option plans ranged from broad-based plans to executive-only plans.
Looking at the smaller sample where actual performance data were available, the study found that option plans and increased productivity 12.2% over the four-year study period, compared to 18.9% for profit sharing plans and no significant effect of SAYE plans. The study did not specifically break out companies that had ESOP-type plans that in Britain are primarily reported as profit sharing plans. The SAYE results are not surprising given that they function more like savings plans. Participation in the plans varies widely between companies and the amounts invested vary considerably within companies. Employees accumulate savings over a three-year period, then can buy shares at a low price and quickly "flip" the shares back into cash.
Discharged Executives Options Can Be Valued at Time of DischargeIn Scully v. US WATS Inc. (3rd. Cir., No. 99-1590, 2/1/01), an executive, Mark Scully, argued that the options he was given at the time he was fired should have been valued effective as of the date the options were to expire, not when he was terminated. The Third Circuit Court of Appeals upheld a lower courts ruling that the companys decision to value them at the earlier date was legitimate, but that the companys contention that it should also be able to take a 30% discount for the lack of marketability of the shares at the time of termination was not sustainable.
Scully was hired by US WATS as its president and given options that vested over two years. He was fired after 18 months. US WATS told him his options now expired because he was fired. Scully contended that he was improperly terminated and successfully sued to have his options restored. At the time he was fired, his options were valued at $531,000. Six months later, when the options would have vested had he not been fired, they would have been worth $1,078,000. A Pennsylvania district court agreed on the unlawful termination, but disagreed that the value of the options could be put forward to the time he normally have vested. The company then contended that it should be able to value the shares at a 30% discount because, at the time, the shares could not be exercised. The court rejected this argument, saying that the restriction period on the shares should not have been a factor in pricing them, a finding that seems at odds with the holding that the restriction period did matter in terms of the ultimate price. The appeals court approved the lower courts findings, however.
Arizona Denies Request for Automatic Exemption from Securities Registration for Stock Option PlanThe Arizona Securities Division has denied a request for a no-action letter from World Internet Holdings, Inc. on its stock option plan. The company was seeking an exemption for the plan from securities registration requirements. The company said its plan would meet the requirements of Section 701 for exemption under federal 1933 Securities Act. The state gave no reason for its denial. The action does underline the fact that just because a plan qualifies for a federal exemption does not mean that it will be exempt under each state's laws.
Qualcomm Settles Stock Option LawsuitQualcomm has settled a lawsuit with former employees whose division was sold to Ericsson. The employees contended that the terms of the sale failed to provide them with all the benefits their option plan had promised. The settlement will provide 840 employees with $11 million.
The employees had sued Qualcomm in 1999. They contended that their options should have been fully vested on sale; instead, the agreement provided that employees could get a cash bonus equal to a portion of the unvested portion of their options, to be paid if employees stayed two years with Ericsson. They would also be eligible for Ericsson options. Qualcomms plan was ambiguous on whether the options should have been vested. It fully vested options on a change of control of the company, but did not specify what would happen if a division were sold. After the sale, Qualcomm stock increased from $25 to $175 by the end of the year; Ericsson went from $31 to $66. Employees claimed that if their options in Qualcomm had fully vested, they would have owned shares that would have been much more valuable.