Let's say your father is the chairman and controlling shareholder of a publicly traded company. Your two brothers are on the board. You've been an executive there for 15 years, the last seven as CEO.How much extra incentive do you need to stay in your job and work your hardest? Well, every little bit counts, apparently, if you're Jim Dolan, CEO of cable TV system operator Cablevision ( CVC). Dolan was perhaps the biggest beneficiary of a voluntary program at the New York-based cable operator that enables managers and executives to trade underwater options for restricted company stock that vests in four years -- a program that an employee compensation expert calls "a good deal" for participants. The options exchange program, and Dolan's participation in it, illustrate some of the complexities of employee compensation in an environment in which once-popular stock options have lost their luster. Though observers once praised stock options as an effective combination of incentive and compensation, they've changed their minds amid two major issues: renewed arguments over whether stock options should be expensed on a company's profit-and-loss statement, and the declining effectiveness of options that have bull market-era strike prices. Thus, companies such as Cablevision have either exchanged out-of-the-money options for other compensation, or repriced them to bear market levels, in the hopes of restoring their effectiveness. Meanwhile, critics of these trade-ins have commented that executives were happy to benefit, via options, from rising stock prices, but many have shown themselves unwilling to live with the consequences of falling ones.
Only rights and options with a strike price above $20 were exchangeable in the plan, which was open to all options-holding Cablevision employees. If employees participated in the exchange, they had to trade in all of the qualifying options and rights. The swap became final in March, when Cablevision stock was trading at $17.54. Judging from Cablevision's disclosure, the options exchange was a popular one. Employees turned in 79% of qualifying options and rights -- a quarter of those from Dolan and other top executives. As Cablevision explains in its proxy filing, it awards options and rights to help employees increase their proprietary interest in the company, "thereby creating a stronger incentive to expend maximum effort for the Company's growth and success and encouraging them to continue their employment with the Company." But the decline in Cablevision's stock price over the past two years left many employees holding options and rights well above where the stock traded; "thus, many of the outstanding options and stock appreciation rights were not achieving the purposes for which they were intended," says Cablevision. That being said, it's difficult for an outsider to believe that Jim Dolan, with all his family ties to Cablevision -- and considering his 2002 compensation of $1.9 million plus 430,000 stock options -- traded in his underwater options because he felt insufficiently motivated or loyal. Cablevision says the program was in the interest of company shareholders, and was attractive to the investment community.
A key issue here, says Murphy, is the value of the options at the time of the exchange. (Cablevision's shares, which have ranged between $4.67 and $22.75 over the past year, fell 18 cents Tuesday to close at $21.78.) The value of the vested and unvested options likely varies with each participating employee, based on factors such as the options' strike price and their expiration date. But a standard method for valuing options is using the Black-Scholes formula -- the same method that Cablevision uses in its annual report to estimate the theoretical impact of options expensing on its financial reports. Using Black-Scholes to value Dolan's options, and using the latest assumptions about interest rates and Cablevision's volatility from Cablevision's 2002 annual report, one can roughly estimate that Dolan is trading in securities ranging in value from $14.94 to $27.53 for each of those $17.54 restricted shares. Yet though that looks like an even trade from Cablevision's point of view, or even slightly advantageous -- and even though restricted stock isn't immediately saleable -- the exchange is a good deal for Cablevision employees, says Murphy. That's because the Black-Scholes model doesn't take into account how much more value employees assign to restricted stock than they do to stock options, says Murphy. As Murphy explains, the problem with options for employees is that they can lose their value. But unless a company goes bankrupt, says Murphy, restricted stock can't go under water. "Restricted stock will always be worth something," he says. Murphy also points out that the volatility assumptions that Cablevision used to calculate the fair value of stock options in 2002 -- the same volatility that TheStreet.com plugged into an options pricing calculator to estimate the value of Dolan's options -- comes in at a relatively high 63.5%. Murphy, who consults on compensation himself, says he rarely uses a volatility figure over 50%. Using Cablevision's own Black-Scholes assumptions for 2001, which include 39.1% volatility, Dolan appears to be trading in securities worth $5.64 to $20.18 for the $17.54 restricted shares.
Addressing how the trade-in ratio was set, a Cablevision spokesman says the company used the Black-Scholes method "to determine an appropriate exchange rate that would be in the best interest of Cablevision shareholders by reducing potential dilution, and would provide ample employment incentives to the eligible managers and executives." Murphy says he's ambivalent about Cablevision's exchange deal. He prefers the use of restricted stock over options, a switch that has gained momentum in recent months. "But the question is, 'At what price?'" In an interview Monday, Murphy said, "Sixty-three percent volatility is higher than anyone will use with a straight face in a Black-Scholes formula," though he later said, "It's certainly going to pass muster with the SEC or FASB. ... There's certainly nothing criminal about these numbers." And while the exchange appears to be a good deal for Cablevision's executives and employees, that's not necessarily a bad thing, says Murphy. "Whenever we can make one party no worse off and the other party better off, that's what we refer to as a mutually beneficial exchange."