RECENT DEVELOPMENTS IN EQUITY-BASED COMPENSATION
By Jeff Wolfstone
Reprinted with permission from Oregon Business Magazine
In the last three years, the business agenda has been reset by Congress, the Securities and
Exchange Commission, state attorneys general, private litigants, regulatory bodies, securities
exchanges and institutional investors. A great deal of attention has been given to the widespread
use of stock options to compensate corporate directors, executives and employees.
In the wake of the dramatic decline in the equity markets, critics have identified stock options as
having a corrupting influence on executive behavior, encouraging earnings manipulation. The
accounting treatment of stock options also has been criticized as having created the illusion of
greater earnings because companies have not been required to reflect an expense charge until the
options are exercised.
A widely held perception that supported the expansive use of stock options was that they would
align the financial interests of management with the shareholders’ goal of maximizing enterprise
value. An option affords the right to buy a share of stock in the future at a predetermined strike
price. Options typically vest over time, commonly over a four- to five-year period. In a rising
market, the employee enjoys the opportunity to profit from the spread between the strike price
and the market value of the underlying shares at the time of exercise.
In the face of recent criticism, some bellwether companies have declared their intention to
continue to use compensatory options, but to account for them as a compensation expense.
Other companies have decided to de-emphasize or eliminate the use of options. Perhaps most
notably, Microsoft - long a leader in the use of options - recently announced that it would grant
restricted stock (rather than options) as a part of employee pay packages.
In brief, restricted stock involves the actual grant of shares to the employee, rather than a right to
buy shares. The shares are restricted in that the employee’s rights in the shares are subject to
forfeiture until the shares vest with the passage of time or the fulfillment of performance
benchmarks, or both. Generally, the value of the underlying stock is taxed as compensation to
the employee when the stock is no longer subject to a substantial risk of forfeiture or when the
stock can be transferred free of forfeiture risk, whichever first occurs. Because the stock has
value at the time of grant, companies generally will grant far fewer shares of restricted stock as
compared to options.
Some commentators have lauded the switch by Microsoft and others to the use of restricted
stock, but question whether company performance will be properly linked to financial reward.
Other companies, including Oracle, Cisco Systems and Dell Computer, have indicated that they
intend to stick with stock options; they continue to believe that the higher risk/reward profile
associated with options will provide a necessary competitive edge in attracting and retaining
highly sought-after employees.
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In this shifting landscape, each company will need to carefully reassess the design of its
incentive programs in light of the stage of the company’s development, its desired financial and
cultural profile, and the competition for talent.
The author of this article, Jeffrey C. Wolfstone, has more than 25 years experience in corporate, mergers and acquisitions and
finance matters, and in representing domestic and foreign companies in a general counsel advisory capacity, from the start-up
phase through maturity. E-mail: wolfstonej@lanepowell.com
For more information on these or other business issues, please contact our Business Lawyers at:
Lane Powell Spears Lubersky LLP
(503) 778-2100 Portland
(206) 223-7000 Seattle
businesslaw@lanepowell.com
or visit our website at http://www.lanepowell.com
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