Dilution Threatens Tech's Revival

Technology investors are understandably gleeful about the sector's long-running recovery. But the gray cloud of dilution threatens to rain on their parade.

Ironically, the seeds of this potential precipitation were planted after the bursting of the tech-stock bubble. In an effort to retain employees and help morale, many firms either repriced existing options or issued new grants in 2001 and 2002, when stock prices were lower than they are now.

As stock prices jumped in the past 16 months, more employees have been cashing in, watering down ownership for other shareholders. If prices continue moving northward, that dilution is only likely to grow.

"Dilution will be the key issue to watch in the coming months as employees begin to capitalize on options issued at depressed prices during the downturn," Citigroup Smith Barney software analysts Tom Berquist and Mark Verbeck wrote in a recent note.

Workers today are more likely to cash in their options following the publicity about Enron employees who lost their life savings when that firm imploded, said Bruce Brumberg, editor-in-chief and co-founder of myStockOptions.com, an online education source on employee stock options.

"Before there might have been pressure on some not to exercise," Brumberg explained. "Now you can say, 'I have to exercise sooner because all of my net worth is in the company stock.' "

The exercising already has begun. At Cisco(CSCO), for example, employees exercised 17 million options in the quarter ended Oct. 25, the latest figures available. That was more than double the 7 million options exercised in the same quarter a year earlier and represented 0.2% of total shares outstanding on Oct. 25.

Companies whose stocks suffered the most after the bubble popped represent one group particularly at risk of dilution.

Consider the case of Lucent , which granted its employees 162 million stock options in the fiscal year 2003 ending in September. Overall, the weighted average exercise price of options granted during fiscal 2003 was a modest $1.67, including 111 million new stock options with an exercise price of $1.78 granted as part of an exchange program in which employees tendered 214 million shares.