They're chopping down the money tree. In the late 20th century, it produced a bumper crop of wealth, a low-hanging fruit known as stock options. In California's Silicon Valley, these options were renowned for giving not just top executives but also rank-and-file workers rights to buy company shares at a set low price, and sell them later at an almost-guaranteed higher price. As tech stocks soared in the '90s, one company alone, Microsoft ( MSFT), turned an estimated 10,000 option holders into millionaires. (For some stories of options boom and bust in Silicon Valley,
click here .) Fledgling technology companies, many without profits, could hand out options by the bushel, because, quite simply, they didn't actually have to pay for their generosity -- until now. In one of the most dramatic disruptions in Silicon Valley history -- perhaps rivaled only by the Nasdaq Stock Market collapse of a few years ago -- the options giveaway is almost over. On March 31, the agency that sets accounting rules proposed that all U.S. companies be required to show the cost of stock options on their quarterly income statements, instead of relegating it to little-noticed footnotes. This so-called "options expensing" is all but certain to become a standard and conspicuous cost of doing business starting in 2005. Most tech companies -- with the notable exception of Microsoft and Amazon.com ( AMZN) -- continue to mount a vigorous defense of stock options. The typical technology concern grants options to more than half its employees, and they've filed reams of testimony with the Financial Accounting Standards Board opposing any change to the status quo. Technology profits -- and employees -- will suffer from options expensing, according to the industry line. Keith Brister, a Cisco ( CSCO) employee with stock options, said he's counting on the money to put his two boys through college and fund his retirement. "Please, please, please don't pass this proposal," he implored in a letter to the FASB.
But pleas like this are increasingly futile -- and lonely, given the growing conviction among investors and accountants that options exact a high cost and should be accounted for in income statements. In part, the more critical attitude toward options follows a spate of scandals at the likes of Tyco, Qwest and Enron, where executives cashed in outsized options grants while presiding over ultra-aggressive or outright fraudulent accounting. Yet the early evidence suggests that the main upshot of options reform will not be dramatically diminished profitability for technology companies or more modest pay packages for executives. Rather, the biggest effect is likely to be the winding-down of a historic populist tradition in which tech companies have shared the wealth with workers at all levels. "I think it's absolutely certain that if the FASB proposal takes effect, we will see a dramatic and sustained decrease in the number of options granted to rank-and-file employees," said Rick White, CEO of Technet, a public policy organization for tech companies that has lobbied vigorously against the measure. To be certain, technology profits are bound to take a hit after the accounting shift is adopted. At firms with especially generous policies, options can mean the difference between a profit and a loss. Sun Microsystems ( SUNW), mired in red ink for two years in a row, granted options valued at just over a half-billion dollars in fiscal 2003 -- a sum equivalent to nearly 5% of its annual revenue that year. Factoring in the cost of Sun's options program would push out the company's profitability (now expected in 2005) by a year or more, estimated Merrill Lynch analyst Steve Milunovich.
The story is the same at countless tech companies, where options are used much more heavily than in other industries. In 2003, companies in the tech-heavy Nasdaq 100 would have seen their net income plunge 44% after accounting for the cost of options, compared to a mere 8% drop for companies in the broader S&P 500, according to Bear Stearns. But these arguments assume that tech companies will continue to grant stock options at the same heady pace that has prevailed for years. In fact, bellwethers such as Intel ( INTC) and Dell ( DELL) are quietly acknowledging the momentum of reform, cutting back the stock options granted to workers -- even as they continue to bestow rich financial rewards on their top executives. Already, more than 570 companies, including big names such as Coca-Cola ( KO), General Electric ( GE) and Washington Post Co. ( WPO) have moved to begin expensing options. Even a few tech stalwarts have joined the fold. In 2003, software giant Microsoft began replacing its options with restricted stock that vests over time. The software giant said it would begin expensing previously granted options. Amazon, the leading online retailer, began expensing options and shifted to restricted stock a couple of years ago. Tech investors, who for years looked the other way while companies handed out more and more options, also have soured on the game. When tech shares were constantly moving higher, few complained about generous grants for employees. But in the wake of the Nasdaq crash, many have grown critical of the massive cash-flow drain caused by options programs. The same companies that argue options don't cost anything may spend up to hundreds of millions of dollars a quarter quietly buying back their own shares in order to offset the dilution from option exercises. Ken Klapatch, one of many individual investors who wrote to the FASB in support of the accounting change, explained in a letter: "I am not happy with company execs getting huge chunks of my investment money essentially under the table. If it hurts a company's bottom line, then they need to address the issue by not granting so many options!"
In the past couple of months, shareholders of Texas Instruments ( TXN), Hewlett-Packard ( HPQ), PeopleSoft ( PSFT) and IBM ( IBM) all have voted to require the companies to account for the cost of options. Even stockholders of Intel, the world's largest chipmaker and a leading proponent of options, voted in favor of expensing at the company's annual meeting in May. It was a highly symbolic retort to Intel CEO Craig Barrett, who on March 31 penned a feisty editorial in The Wall Street Journal calling options "imaginary expenses" and complaining they are difficult to value. For now, these shareholder resolutions are nonbinding. Indeed, the board of computer maker Apple ( AAPL) declined to enact options expensing even after shareholders voted in favor of the measure last year. But investors are less inclined to take no for an answer. Angered by the Apple board's inaction, California's pension giant, Calpers, voted against the re-election of Apple board members at the company's annual meeting this April. Given the likelihood that FASB will finally pass the rule on options expensing late this year, corporate governance experts predict that boards will fall into line. "There will be some holdouts until FASB issues its final rule, but basically it's a situation where boards can run but they can't hide. Options expensing is here to stay, and some companies will recognize it sooner rather than later," said Nell Minow, editor of The Corporate Library, an independent investment research firm. That doesn't mean Silicon Valley will ease up on its lobbying efforts anytime soon. In the latest bid to press their case, technology companies have mounted a campaign that focuses on how options benefit the little guy rather than top-level executives. Of more than 2,600 letters received by FASB by the third week in May, more than 1,500 were from Cisco employees who were opposed to the proposal. (A Cisco spokesperson denied that the company has an orchestrated letter-writing campaign but said the company has sought to educate workers about looming changes in options policies through an internal Web site.)
Many of the letter writers said options allow them to enjoy a middle-class lifestyle they otherwise would be unable to afford, adding that they feared that the accounting change would prompt their employer to cut back on options grants. (For more on the shifting debate about expensing options,
click here .) "There is no way I could have afforded my modest home without having my options available to me," wrote Kristin Frost, who has worked at Cisco for nearly nine years. She said the prevailing "sense of ownership and commitment" at Cisco comes from stock options, helping explain why "the parking lot is still half-full at 7:30 p.m." In fact, Cisco is already reducing the number of options that it grants each year, with grants of 199 million options in the year ended July 2003 compared with 282 million the year before. And Cisco workers aren't the only ones who should be prepared to settle for fewer options. Publicly, technology companies that use options will only say that they're studying the draft proposal on options expensing. But the industry trade groups leading the charge against it say that if it goes into effect, companies will reduce the size of their options programs. And because tech outfits award most of their options to employees below the top rung of management, rank-and-file workers would be hardest hit. Semiconductor companies grant about 80% of options to rank-and-file workers, according to its industry association. But if required to expense options, Semiconductor Industry Association President George Scalise has said chipmakers are likely to cut programs that award options to more than half the workforce. A survey of 421 technology firms in January 2004 found that 7% planned to make fewer workers eligible for options grants within the first quarter of 2004. An equal portion said they would cut the size of their options grants, said Tim Brown, vice president at Aon Consulting/Radford Surveys.
But while the absolute number of options grants are clearly on the wane, few expect top-level tech executives to take a financial hit. Intel, for example, more than doubled the number of options awarded to CEO Barrett in calendar year 2003, hiking its award to 1.35 million options from 584,000 the prior year. (A spokesperson pointed out that 1 million of the options reflect a special long-term grant that doesn't begin to vest until 2009.) But Intel reduced its overall options grant to 110 million from 174 million, part of a longer-term effort to curb its outsize program. No one would argue with Barrett's performance as a corporate leader. Under his watch last year, the company showed an 81% gain in net income, to $5.6 billion, while its stock price rose 106%. And Barrett received only 1.23% of the total options awarded at Intel, less than the S&P average. Still, the bottom line is that while Barrett saw a big reward, average workers ended up with fewer options. A still-soft job market has shifted the balance of power away from employees and helps explain why they no longer can take options for granted. Take Dell, the computer hardware company. It started cutting back on its broad-based options grants several years ago, judging that it no longer had to award such generous compensation packages in the tech downturn. By fiscal year 2004, the company had pared its annual options grant to 51 million, down from 84 million the previous year and 126 million two years ago. But in fiscal 2004, CEO Michael Dell actually saw his options grant increase to 800,000, up from 500,000 the year before. Chief Operating Officer Kevin Rollins and Chief Financial Officer James Schneider likewise enjoyed an increase in options grants. Rollins went to 800,000 from 500,000, and Schneider went to 650,000 from 400,000. That's not to say Dell's top executives didn't deserve a payout. Last year the company delivered 25% profit growth, for net income of $2.6 billion on revenues of $41.4 billion. But recent events at Dell highlight that stock options are likely to be cut at the expense of workers, not higher-ups. (Dell spokesperson Maher said plenty of rank-and-file workers at the company also were awarded bonuses and options in 2003, based on performance.)
The developments at Intel and Dell fit with broader trends seen among S&P member companies, which have seen CEO pay jump even as average worker compensation has hardly budged. In 2003, pay packages for chief executive officers of S&P 500 companies jumped by a median of 27%, even though the value of their exercised stock options actually slipped 1%, according to a study by The Corporate Library. The decline in options was offset by increases in salary, bonuses and other perks like restricted stock. By comparison, the average U.S. private sector worker saw a salary gain of 3% in 2003, as measured by the Bureau of Labor Statistics. For investors demanding more transparent financial statements, of course, the move to expense options marks a welcome change. Yet so far, the shift seems to be having an effect that corporate governance reformers didn't expect, tilting benefits toward the top of the corporate ladder. Compensation experts say that's likely to accelerate if more companies begin expensing options. "If you take options away, net compensation to the rank and file will go down," said Corey Rosen, executive director of the National Center for Employee Ownership. "There's no indication at this point from surveys that most companies will do anything to replace options." The trend toward more prudent options policies -- and less democratic pay packages -- is one more sign that Silicon Valley is starting to act like everyone else. That's likely to please investors attuned to the bottom line. But for tech workers who came to view options as a virtual birthright, it could mark the end of a long and highly lucrative era. "I'm frustrated that in this push to punish executive malfeasance, it's really me and my colleagues who get whacked," said Jeff Solof, director of the editorial office for global communications at Sun Microsystems. "Executives will always be well-paid and that's fine; they work hard. But these are programs that reward the rank and file. I'd hate to see that go away."