Technology investors are understandably gleeful about the sector'slong-running recovery. But the gray cloud of dilution threatens to rain ontheir parade.

Ironically, the seeds of this potential precipitation were plantedafter the bursting of the tech-stock bubble. In an effort to retainemployees and help morale, many firms either repriced existing options orissued new grants in 2001 and 2002, when stock prices were lower than theyare now.

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

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

Workers today are more likely to cash in their options following thepublicity about

Enron

employees who lost their life savings whenthat firm imploded, said Bruce Brumberg, editor-in-chief and co-founder ofmyStockOptions.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 becauseall of my net worth is in the company stock.' "

The exercising already has begun. At

Cisco

(CSCO) - Get Report

, 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 samequarter 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

(LU)

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

Lucent stock traded under $2 for the first eight months of fiscal 2003, but has since climbed as high as $5, roughly triple the average value of employee options granted in fiscal 2003.

As of Sept. 30, Lucent reported that 136 million, or 35% of the 388million employee stock options outstanding, had an exercise price rangingfrom zero to $2.25, well below Wednesday's closing rice of $4.20. Only 19million of those options were exercisable as of Sept. 30, but the potentialdilution of those 136 million options is about 3.4% of total Lucent sharesoutstanding.

Meanwhile, employees at other highflying tech companies such as

eBay

(EBAY) - Get Report

have virtually all of their options in the money. As ofSept. 30, 99% of eBay's 21.2 million exercisable employee options were inthe money, and the company's stock has climbed nearly $15 since then.

Those in-the-money figures are a byproduct of better stock performanceduring and after the downturn -- eBay stock soared 58% on a split-adjustedbasis in the first nine months of 2003.

In the first nine months of 2003, eBay employees exercised 21.8 million options, according to the latest

Securities and Exchange Commission

filings. That represented 3.4% of total eBay common shares outstanding as of Sept. 30 and almost doubled the number of optionsexercised over the same period in 2002.

Unintended Consequences

The exercising of options by employees ncreases the total shares outstanding, reducing the ownership of nonemployee shareholders. Companies often buy back shares to offset such dilution, but that takes away money that otherwise could have been used to pay a dividend or reinvest in the company todrive more growth.

"The more the stock price goes up, the more a bigger piece of the piegoes to employees than existing shareholders," says Ken Broad, a portfolio manager with Transamerica Investment Management. "We kind of view

options as an open-ended liability."

Broad's policy has been to steer clear of companies that are notoriously generous with employee options, including eBay,

Adobe Systems

(ADBE) - Get Report

, and

Siebel Systems

(SEBL)

.

Citigroup's Berquist and Verbeck also flagged Siebel, noting that thecompany's disappointing first-quarter guidance was in large part due toincreased employee option exercises. (The analysts rate Siebel a buy;Citigroup hasn't done banking with the firm.)

Siebel has taken steps to cut back its options, bringing them down froma whopping 53% of total shares outstanding in 2001 to about 31% on Sept.30.

Despite that drop, Siebel's so-called options overhang still is higherthan most tech peers -- high enough to prevent some from owning shares.

"When you think about the idea they gave away a third of the company and didn't tell anybody about it, it just doesn't inspire a lot of confidence, at least from my end, that these guys are going to look out for your best interest as a shareholder," said one buy-side analyst, who asked not to be named. (Options a company is

authorized

to grant are disclosed and sometimes approved by shareholders. But the actual number granted is not disclosed until 10-K filings are made after the end of the fiscal year.)

Meanwhile, offsetting dilution from options by buying back stock drains a company's cash. In a recent analysis of 11 tech companies, Merrill Lynch found on average that a full 100% of free cash flow would have been required to fully offset dilution from options exercises in 2000, 43% of free cash flow would have been required in 2001, and 12% would have been required in 2002.

But Merrill analysts Richard Farmer and Steve Milunovich predicted that this improving trend is likely to reverse in the coming year, especially if stock prices continue climbing. Most tech firms will divert "a

rising

double-digit percentage of free cash flow to employees through circular share repurchases now that stock prices are exceeding strike prices of options granted in the bear markets of 2000-2002," they estimated.

Investors may be overlooking this potential drain because accounting rules allow companies to exclude stock repurchases in their calculations of cash flow from operations, Farmer added. By not including stock repurchases in that calculation, investors are overestimating free cash flow and in some cases the value of a stock, he said, offering yet one more reason why the dilution dilemma could put a damper on some of the excitement about rising stock prices.