Executive stock option plans are rife with problems. But at the behest of the California State Teachers' Retirement System, or Calsters, compensation expert Graef Crystal has developed his ideal solution.Calsters, with $90 billion under management, the nation's third-largest pension fund, is a frequent advocate of improving corporate governance and an energetic proxy voter. While Calsters says it won't necessarily make investment decisions on the basis of how a company grants options, Crystal's recommendations will provide Calsters with fodder for determining its position on future executive compensation proxy votes. In his report for Calsters, Crysal runs off a litany of problems and potential solutions regarding options -- including repricings and the timing of options -- but the solution that will do the most good, Crystal says, is happily the one that will be implemented the soonest: requiring that corporations expense their stock option grants. "That will go a long way towards fixing all the other issues," says Crystal, who also writes a column for Bloomberg. "It will cut the mega-grants and force companies to realize that options have a cost." Crystal points to Apple ( AAPL) CEO Steve Jobs and his 20-million-share options grant in 2000. "Would Apple's board have made that grant had it been required to charge Apple's pretax earnings by $471 million?" Crystal asks. "I strongly doubt it." And now that the biggest opponents to expensing stock options -- technology companies -- have effectively been silenced by the brutality of the markets, Crystal says it's likely that accounting standards will change by the end of this year. "Silicon Valley is toothless now," he says. "They fought the good fight in the 1990s when they saw robust stock price growth, but lost traction and have no moral ground on which to make their point." Indeed, the Financial Accounting Standards Board, or FASB, has said it will revisit the issue of requiring companies to expense their options. The board has made several attempts to do so in the past, but intense pressure from the corporate community prevented such measures from going forward. But now, Crystal says, "It's a slam dunk."
Though forcing companies to recognize the actual cost of their option plans will go a long way towards rectifying a number of abuses, Crystal also offers the following wish list of reform: Grant options at prescribed times. Shareholders should demand that companies issue grants on a regular basis -- rather than whenever it's most beneficial for the executive. "Regular" doesn't have to mean annually, Crystal adds. Quarterly grants would help to "dollar average" strike prices, providing a more stable platform from which to measure true performance over the long term, he says in his Calsters report. (By "dollar averaging" option grants, options would be granted in regular amounts at regular intervals, regardless of which direction the underlying share price is heading. As prices of securities rise, fewer options are granted; as prices fall, more options are granted.) Limit repricings. Ideally, Crystal says, options would never be repriced. But he acknowledges that to retain talent the practice is sometimes necessary. But when companies do opt to reprice an executive's options, the new options should be economically equivalent. The company should use the Black-Scholes model to determine the estimated present value of the "underwater" options being turned in. Then, to determine an equal option grant to replace the underwater options, it should divide that value by the present value of a new option share, carrying a strike price equal to the current market price. The result: Executives get fewer options, but the grant has the same present value as the one turned in. Say a CEO was granted 1 million options with a strike price of $50. Now, the stock is at $25. Rather than receive another 1 million options with a strike price of $25, as is common practice today, he or she would receive something like 350,000 options with a strike price of $25.
Indexed options. If options are to be linked to performance, there should be some mechanism to ensure that's the case. Crystal's solution: Index the strike price. Ideally, the strike price should be indexed to the 25th percentile of a basket of relevant companies, be it the S&P 500 or a basket of companies in the same industry. That way, CEOs wouldn't be penalized for not performing at the top -- rather, only truly poor performance will be punished. Comparisons should be made on a total return basis, including dividends, and not on price appreciation alone. Crystal also finds troubling the difference between what standard accounting measures would say an option costs a company and the value executives place on it. What options cost, he says, is easy to determine at any given time. But executives discount the future value of their holdings much more than Wall Street would. "There's a dichotomy between value and cost," he says. "Companies could sell to Wall Street something that closely resembles an executive stock option, but employees put a substantial haircut on what FASB says the cost of the option is. It raises questions as to why they use a vehicle when employees don't value it at what it costs."