Some reports say there are as many as 9,000 “Microsoft Millionaires,” others say the number isn’t quite so high. But all attribute the vast wealth accumulated by managers and workers to one source: stock options.


So it was front-page news when Microsoft announced early in July that it was shutting down its options program and planning instead to award employees shares of stock, which do not offer the same potential for stupendous gains.


“There are a handful of companies like Cisco, Microsoft and Intel that are the high-profile, big, successful pacesetters,” said Wharton accounting professor David F. Larcker. “Microsoft has historically been a big user of options. So if they are changing their program, it’s the kind of thing that a lot of other companies will look at.”


To many corporations, especially technology firms, the move smacks of heresy. Options, their defenders say, are the best way to motivate employees to boost shareholder value and a low-cost way for cash-strapped startups to lure top talent. As many as 10 million Americans are thought to be holding employee options.


But options critics, among them many shareholders groups, cheered. They believe options fueled the corporate scandals of the past few years and argue that options actually undermine corporate performance.


For whatever reasons, more and more companies seem to be backing off of their love affair with options. A report in the July 30 Wall Street Journal noted that companies – ranging from Dell, Yahoo and Siebel Systems to Citigroup, Jones Apparel Group and Rohm & Haas – are cutting back the number of employees who are eligible to receive options. The Journal also cited a Mercer Human Resource Consulting study this month reporting that three-quarters of 33 large companies surveyed “are making changes in their stock-option and other long-term incentive plans. Of those, 64% are reducing the number of options granted and more than half are cutting the number of employees eligible to receive options.”


Stock Options vs. Stock Awards

Microsoft Chairman Bill Gates and Chief Executive Steve Ballmer are among the rare breed of American executives who have never received options. They argue that their enormous holdings of Microsoft shares already give them sufficient incentive to work on shareholders’ behalf.


But the company, which currently employs about 55,000, has given options to all ordinary employees and most managers since its founding in 1975, and the enormous run-up in share prices made thousands rich. Adjusted for splits, shares went from 7.3 cents at the initial public offering in 1986 to a peak near $60 at the end of 1999. The stock is currently around $26.50.


At a typical company, an options grant gives an employee the right to buy a set number of shares at a specified price at any time over a 10-year period after the options “vest” or become exercisable. If the share price rises from $50 to $100, for example, the employee can exercise the option to buy shares for $50 and then immediately sell them to realize a $50-per-share profit.


Under the new program, employees will receive shares of stock in blocks that will gradually vest over five years – that is, the employee gets a fifth of the shares each year.  Employees will still realize profits if the share price rises. (Technically, these are called stock awards or restricted stock units, since the shares are acquired over time but can be sold as soon as they are received. In another form, called restricted stock, all shares are acquired at once but the owner can only sell some of them each year. Restricted stock programs for managers sometimes issue shares only when performance targets are met.)


For Microsoft, what’s the difference between options and stock awards? Wharton accounting professor Mary Ellen Carter said one key difference is that fewer shares need be devoted to the program if stocks are used instead of options. “With stock, you don’t have to give as many to get the same value.”


The ultimate value of each approach depends on share price gains. If a company wanted to give an employee an options grant worth $5,000, it might assume, for example, that the share price would rise from $75 to $100 over the option’s 10-year life. It would thus take 200 options to create a $5,000 benefit over the decade. Since the employee would have to spend $75 a share to exercise the option, all of the benefit would come from the rising share price.


But if the company awarded stock, it would take just 50 shares to provide $5,000 in value. At a price of $75 when awarded, the 50 shares would be worth $3,750 immediately, and there would be $1,250 in gains as the price rose to $100.


But suppose the price rose to $200 over the decade instead of $100. In that case the 200 options would be worth $25,000, while the 50 shares would be worth just $10,000. Options are more profitable in a rapidly rising market. On the other hand, if the price fell to $50, options giving the right to buy at $75 would be worthless – “underwater” or “out of the money.” The 50 shares of stock, however, would be worth $2,500. Stock is better in a falling market.


Microsoft, Larcker said, appears to have concluded that the geometric price gains of the 1980s and 1990s are not likely to be repeated. With the shares trading at half their peak price, all the options granted during the past five years are worthless – the exercise prices are higher than the current market price. By switching to share awards, the company assures employees their holdings will retain some value even if the price sinks, though they would not make as much if the price soars.


“I think it’s a pretty overt statement,” Larcker noted. “Microsoft is saying, ‘Hey, look, we’re no longer a super-high-growth … super-innovative company. We’re a mature company.’ In a mature company restricted stock is probably a better incentive vehicle.”


(Employees will also be allowed to make small gains by selling their underwater options to JPMorgan Chase. An underwater option with a $33 strike price might fetch $2, the company said. The securities firm will resell the options or use them in hedging and derivatives strategies.)


Counting Options as Expenses

The options-to-awards switch was probably also influenced by widely expected changes in accounting rules, Carter said. Currently, employee options do not have to be counted as an expense, which is one reason they have been so popular with executives, directors and even shareholders. Critics have long argued this is misleading, since options inevitably represent a cost one way or another. To provide shares for options programs, many companies use cash to buy shares on the open market. Others issue new blocks of shares, diluting the value of shares previously outstanding.


Reformers say options motivate executives to cook the books to drive up share prices. Pressure to count options as an expense has mounted in the wake of the Enron, WorldCom and other corporate scandals, which many critics attribute in part to options abuse.


Within the next few years, regulators are likely to force companies to count options as expenses – just as stock grants already are, says Carter. Microsoft said it will begin expensing its existing options now, estimating that the move would reduce reported earnings by about 27% this year.


Without their accounting edge, options would then lose their luster and stock programs would become more attractive. Since stock awards typically involve fewer shares, it costs less if shares are bought on the market, and it causes less dilution if new shares are issued. With the soaring use of options in the past decade, dilution has become a serious problem. At many companies, existing shares would lose 5-20% of their value if all employee and executive options were exercised.


Wayne R. Guay, accounting professor at Wharton, noted that Microsoft may also have been motivated by the recent cut in federal taxes on dividends, to 15% from as high as 38.6%. The cut makes dividends more attractive to shareholders, giving companies more reason to pay dividends. Microsoft initiated its first dividend payment this year.


Dividends are of no value to people who hold stock options, since one must own actual shares to receive dividends. In fact, people who hold options oppose dividend payments because they undermine share prices. All else being equal, the share price drops by the amount of the dividend, because the dividend payout drains money from the corporation.


When the tax cut gave companies more incentive to pay dividends, it made stock grants more attractive to recipients than options.


Dreams of Staggering Wealth

Since companies have long argued options encourage employees to work harder, a key question is whether stock awards will work as well.


Microsoft employees holding underwater options are better off now than they were before. They will get a small payment for their worthless options and will look forward to stock awards that will have real value even in a weak market.


Because options generally offer greater value than stocks in a rapidly rising market, options in theory should thus provide employees a stronger incentive to work hard than shares will. But the research does not clearly show that companies with big options programs do better than those with stock award programs, or that either do better than companies that have neither.


Recent work by four Rutgers University researchers, Douglas Kruse, Joseph Blasi, Jim Sesil and Maya Krumova, found that companies with broad-based employee options programs had better productivity and return on assets than companies without them. But the research found no strong evidence of better return to shareholders.


Larcker, Guay and their colleague John E. Core did a broad survey of academic research and could not find compelling evidence that employee ownership, through options or shares, boosts shareholder returns. “Whether it translates to the bottom line is totally unclear,” Larcker said.


If employee ownership does make people work harder, that effect is probably more pronounced at small firms where an individual employee may feel he or she can really make a difference, Guay said. “Most of those Microsoft employees own a tiny fraction of the company. The typical employee will ask himself, ‘If I work really hard, can I increase the stock price and increase the value of my stock options?’ The answer is usually no.” Nonetheless, he said, options or stock awards can boost employee morale, which can benefit the company and its shareholders.


To boost the incentive for its top people, Microsoft will grant 600 managers stock on the basis of employee satisfaction and revenue growth.


Carter said employee ownership can serve as a useful tool for retaining valued employees. Options usually must be exercised or lost when an employee resigns, so a departing employee misses any future gains. Employees who get stock awards will be able to keep them when they leave the company, but they will have to stay with Microsoft to get any shares that have not yet vested on the five-year schedule.


Carter and Launn J. Lynch, of the Darden Graduate School of Business at the University of Virginia, recently completed a study of stock-option repricings, in which a company lowers the exercise price of underwater options to restore some value. The study, The Effect of Stock Option Repricing on Employee Turnover, found that repricings do help companies hold on to employees, though it does not help keep executives. Ownership, then, does encourage rank-and-file employees to stay.


So far there has not been a rush of companies emulating Microsoft’s switch from options to stock. Intel and several tech-industry associations followed Microsoft’s announcement with a statement defending the value of options and opposing expensing requirements.


Carter said she expects more companies to offer stock, simply because they believe options will lose their accounting edge.


But at many companies, the hope of staggering wealth will keep options programs alive, Guay said. He predicted that not many will switch to stock. “I would be very surprised if you saw this sweeping through the tech industry.”