Stock Options and Restricted Stock:
Microsoft's Missed Opportunity

by Dennis Aust

Last year, Microsoft announced a new employee compensation plan that replaced stock options with restricted stock. Although the new plan reduces the risk associated with employee options, it fails to address the fundamental problems of stock-price-based compensation plans. In an era when incentive compensation is subject to increased shareholder scrutiny and public criticism, Microsoft missed a major opportunity to redefine the focus of their incentive compensation program to the fundamental factors that determine sustainable shareholder value.

Until recently, stock options had been widely perceived as a cost-efficient way of linking management compensation to increasing shareholder value. In determining the number of options issued, along with strike prices and exercise dates, the company (on behalf of shareholders) establishes the precise relationship between shareholder returns and employee rewards. If the shareholders get paid (through higher stock prices), the employees get paid (through their options). If the shareholders don't get paid, the employees don't get paid either.

What Determines Stock Prices?

The problem is that stock prices are determined by a number of factors. A company's operating performance is extremely important, but it is just one of many factors, and most of these other factors are beyond management's direct control. External factors influencing prices have often been dismissed as the concern of investors and academics, but for one critical problem: Billions of dollars of incentive compensation payouts are determined based on factors unrelated to management performance.

The biggest external factor affecting share price is overall market trend, as reflected in changes to the market's implicit discount rate, or cost of capital. When the cost of capital falls, the market advances, and vice versa. Empirical evidence from the past fifty years shows that the market's implicit discount is a greater source of variation for the S&P 500 than the underlying operating performance of the firms comprising that index (as measured by Cash Return on Investment). Other external factors, such as changing market expectations and the market's ongoing sector rotation, have a significant (and often unpredictable) influence on the market performance of specific stocks.

An old Wall Street adage warns against confusing a bull market with brains, but this is precisely what results when incentive compensation payouts are determined by stock price. In a rising market, the broad upward price trend masks sub-par performance for a significant number of companies and managers are paid, often handsomely, for performance in excess of what they really delivered. And in a bear market, when strong operating performance is outweighed by a general downtrend in prices, firms often find themselves changing the rules in order to retain and motivate management talent whose contributions aren't appropriately reflected in depressed stock prices.

Unless the broad market stays relatively flat, boards incur a significant risk of overpaying or underpaying their managers based on factors that have little or no relationship to the results those managers have delivered. Over the past decade, this has contributed to a "damned if you do, damned if you don't" aspect to incentive compensation. Despite the care that individual firms devote to structuring their compensation plans, the overall result is a broad perception that the "system isn't working": Overpaid executives are "having it both ways" by cashing in during good times, then "changing the rules" once the old system no longer works to their advantage.

Did Microsoft Change Anything Fundamental?

Within this context, Microsoft's move from options to restricted stock is just one more example of a firm tweaking the rules rather than dealing with fundamental issues. When one considers that a restricted stock grant can be viewed as an option to purchase stock at an exercise price of zero, Microsoft's move isn't nearly as significant as it first appears. All it does is shift the risk/return tradeoff in response to a down market. Microsoft's staff are reportedly (and understandably) happy with the move. Those who prefer a more adventurous risk/return tradeoff can still buy listed options through their brokers, while the more risk-averse are happy that what used to be a "performance" bonus is now substantially guaranteed. The options only had exercise value when the market price was above the strike price, but the restricted stock grants maintain their full value as long as the stock price doesn't fall. Even if the stock price does fall, the restricted stock grant will retain considerable value unless the stock price collapses totally. Restricted stock isn't "pay-for-performance." It's "pay-for-pulse."

The problems with restricted stock and options stem from the same root causes. From the employee's perspective, both represent a less-than-perfect currency which only partially correlates with the results employees are asked to deliver. Making employee compensation contingent on stock price saddles employees with market risks unrelated to their performance. The situation is analogous to the firm wagering the employee's bonus at the local casino; the inherent randomness of the market diminishes the intrinsic value of both options and stock. In a world where the most valuable talent is increasingly scarce, paying that talent with a currency devalued by market risk represents an inefficient (and increasingly expensive) use of corporate resources.

What Should Microsoft Focus On?

Microsoft's mistake is its failure to discriminate between a desirable source of risk (company performance) and an undesirable source of risk (overall market volatility). When the overall risk/return tradeoff proved unfavorable for their staff (due to a sustained bear market), they didn't refocus compensation on company performance. They simply backed off from risk entirely.

Ultimately, simple reliance on either options or restricted stock represents abdication of one of the board's fundamental responsibilities - setting objectives for management performance, and measuring results against those objectives. A compensation framework that depends primarily on stock price effectively says to employees, "we're not exactly sure what we want you to accomplish, but we'll be paying you so long as the stock price goes up." Instead of paying management for specific actions that create shareholder value, they pay (to a large degree) based on how the market is doing.

The Better Path for Microsoft

Microsoft's missed opportunity was the chance to link compensation to effective implementation of an appropriate strategic performance management framework. Many alternatives are available. Some widely publicized approaches, such as Stern-Stewart's Economic Value Added (EVA) or Kaplan and Norton's Balanced Scorecard, enjoy substantial followings. Others offer unique or specialized advantages beyond the more generic approaches. For example, the Callard/CharterMast framework is based on extensive empirical research detailing the relationship between operating performance and shareholder value. Accordingly, it provides an extremely powerful tool for understanding just what management needs to do to create value, eliminating the noise associated with market volatility, and paying management for the specific performance actually delivered.

Incentive compensation is a difficult and complicated subject, with issues ranging from relatively mechanical accounting and tax disclosures, to the subtle challenges of crafting incentives that reward productive behaviors while protecting against inappropriate "over-motivation." Shareholders expect the greatest benefit for every dollar they pay in compensation, while capable managers command compensation that fully rewards them for identifiable contributions to shareholder value.

Incentive compensation represents a major, and particularly visible, corporate expense. The financial impact is even more significant when one considers the operating consequences of giving management the wrong signals. In this environment, basing compensation primarily on stock price, whether through options or restricted stock, represents not only an ineffective use of resources but a potentially dangerous incentive policy. At one extreme, it's "pay-for-stock-market-speculation." At the other extreme, it becomes "pay-for-pulse." The responsible "pay-for-performance" solution is to identify precisely those factors that determine sustainable shareholder value, and to compensate management directly for their success or failures at delivering accordingly.


Dennis N. Aust is Managing Director, CharterMast Partners LLC. CharterMast Partners LLC helps directors and senior executives implement effective value management programs. Our insights are based on communicating a thorough understanding of how the market views a firm's fundamental economic performance. Through our affiliation with Callard Research LLC, a top-ranked investment research firm, we provide recommendations based on over three decades of empirical research. Typical projects include strategic planning, incentive compensation, merger & acquisition support, and investor relations & communications. Visit www.chartermast.com for additional information.

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