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At companies like Verity ( VRTY), the magnitude of employees' property grab via stock options is nothing short of stunning. The title of my earlier column on the subject, "Corporate America's Dirty Little Secret," is unfortunately all too appropriate: It's the stealth transfer of wealth, under the guise of aligning employee interests with shareholder interests through stock options.

Before we look at Verity, let's break the case down in the simplest terms possible. Stocks represent shares of ownership in a publicly traded business. To use a metaphor, the company is a pie, and the number of slices that you have, relative to the total slices, represents your ownership interest.

When a company issues more shares via stock options, it is essentially creating more slices in the pie. If you own shares in such a company, your property interest then changes: The pie is the same size, but it has more slices. Sure, the company can go into the open market and buy back shares to keep the number of pie slices at the same level. But that still involves taking your property: Corporate cash that belongs to shareholders is used to buy back those shares.

Tough Truths

The most aggressive option issuers (and the most ardent and vocal option defenders) tend to be in the technology sector. Verity, a software concern with a $750 million market cap, is an example of a company that is aggressively effecting a transfer of ownership from shareholders to corporate employees.

After reviewing Verity, it's hard to miss the obvious irony: The word verity means truth. The truth is, the number of options granted each year is outrageous:


The Hard Truth About Options
Here are the grants relative to share base
Fiscal Year 1998 1999 2000 2001 2002
Shares Outstanding Beg of Year 22,036 23,130 25,612 31,606 35,158
Annual Option Share Grants 5330 5604 6567 8418 7164
Annual Grants as a % Shares 24% 24% 26% 27% 20%
Source: Alsin Capital Management, SEC filings

The grab for shareholder property at Verity, via stock options, is at jaw-dropping levels. As you can see in the table above, options grants as a percentage of total shares have hovered around the 25% mark since 1998. That's potentially diluting one-fourth of shareholders' property interest each and every year!


Such Generosity
The company gives away its income via options faster than it can make it.
2000 2001 2002
Net Income - as reported $33,010 $33,760 $1,409
Net Income - (when expensing options) (25,148) (67,098) (77,474)
Source: Alsin Capital Management, SEC filings

The fundamental flaw of a stock option is that it links compensation to swings in a short-term stock quote (the average NYSE stock fluctuates 50% per year) -- not to the creation of long-term business value. That's why option holders can generate windfalls of tens of millions of dollars or more in a single year on the basis of nothing more than a volatile stock quote. In an earlier column , I listed several $100-million option-windfall recipients, most of whom generated their gains with no corresponding increase in business value at their respective companies.

Shareholders suffer when their stock falls precipitously, but option holders, such as those at Verity, can benefit from drops in their stock price. That's because options are granted each and every year at Verity. As you can see below, a bad year is a good year for option holders, because new grants, like those at Verity in 2002, are at a low price.


When Bad Is Good
New option grants sport a low price tag
Year 1998 1999 2000 2001 2002
Weighted average grant price $2.65 $9.78 $31.99 $23.69 $9.47
Source: Alsin Capital Management, SEC filings

Other forms of compensation, such as restricted stock or outright stock ownership, better align employees with shareholders. There are also ways to tie incentive compensation to long-term business value creation -- not to short-term fluctuations in a stock quote.

Ultimately, the board of directors must protect shareholders' property and must design compensation that incentivizes workers without harming shareholders. I doubt this will happen at Verity, where board members are actively feeding at the trough to the tune of 40,000 options each per year. The current system of profligate stock-option issuance is not the answer. Any rational, objective observer would admit to the verity of that.
Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to arne@alsincapital.com. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.