Have stock options run their course? Note to compensation committees: don't give up on stock options -- they can be better designed, in some bold ways, to accomplish your executive-reward and shareholder-alignment objectives.

• Author: Burchman, Seymour
• Position: Executive Compensation

THE FUTURE of stock options -- once considered critical currency for every company (and every employee) -- is in the spotlight. Questions abound: Are stock options just a lottery? Are stock options truly free? How many stock options are too many? Are stock options a 20th-century tool that no longer has any relevance?

These questions miss the point. The real question companies should be asking is: How can we assemble the right mix of long-term incentive vehicles and the right plan designs to get the best return from our long-term incentive dollars?

In our mind, there is no denying that stock options have been overused and misused. However, we believe they still have a meaningful role in executive compensation design. It is unlikely that stock options will (or should) continue to be the sole long-term incentive vehicle for the majority of companies. It is equally unlikely that they will continue to be structured across the board in their "plain vanilla" form (i.e., with exercise prices equal to market value on the date of grant, three- to four-year vesting periods, and 10-year terms).

Even so, when appropriately structured, stock options can be one of the best vehicles for linking executive and shareholder interests over the long term. What will be important going forward is for management and compensation committees to understand that the answer is not to give up on stock options, but rather to better understand how they can be redesigned and/or complemented with other long-term incentives. Here are some traditional and bolder approaches that can be used to improve the effectiveness of long-term incentives. They are summarized in the exhibit on page 40.

Mitigating effects of timing

Timing of option grants and exercises can mean everything. Companies tend to grant options once a year, placing undue emphasis on market and company conditions at a single point in time, a real "wild card" in volatile markets. There are three potential approaches to mitigate the problems associated with the timing of option grants and exercises.

Strike Price Averaging. More than 90% of companies grant options with a strike equal to the fair market value of the stock on the date of grant. One fix is to base the strike price on a 30- to 90-day trailing average, which significantly reduces the importance of the stock price on the date of grant. Although this is a logical and simple solution, it does have its drawbacks. If the trailing average is below the stock price on the grant date, then the option would be deemed to be granted at a discount, which would subject it to earnings charges under current accounting rules (although the impact of such an expense would likely be significantly diminished under new accounting rules). The grant might also be prohibited under certain shareholder-approved plans that forbid discounting. Special provisions would have to be included to satisfy 162(m), the million-dollar cap requirements for proxy officers. These provisions might include putting in extra performance conditions or not allowing the strike price to be be low the fair market value at grant.

Time-Averaged Options. Under this approach, new options would be granted quarterly at fair market value (i.e., each annual grant would be split into four equal awards). If a company used 25% per year vesting, then the first quarterly grant would vest on the first anniversary of this initial grant; the second quarterly grant would vest on the second anniversary of the initial grant (one year and nine months after the second quarterly grant), and so forth. All grants would expire 10 years from the initial grant.

A more radical...