Why stock options still make sense: news reports herald their demise, but two consultants argue that stock options--used by 90 percent of the largest U.S. companies--remain the cornerstone of U.S. equity compensation, and for good reasons.

• Author: Kim, James
• Position: Stock options

The new conventional wisdom is that stock options are on the way out, with restricted stock and other forms of long-term incentives replacing options as the predominant form of executive compensation. Microsoft Corp.'s abandonment of stock options in favor of restricted stock units received great attention in 2003. A similar shift by Amazon.com Inc. demonstrated that even growth companies are engaging in the trend.

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On the surface, the reasons for the shift are plentiful. Foremost was a new Financial Accounting Standards Board (FASB) accounting rule that imposes an explicit recognition of stock option expense. Investors were increasingly concerned about dilution levels and corporate governance issues linked to excessive option grants. The appetite for risk on the part of employees waned considerably following the collapse of overall share prices from 2001 to 2003. Changes in the tax law also enhanced the appeal of corporate dividend payments, which are generally available for restricted shares, but not stock options.

But, the reports of the demise of stock options have been greatly exaggerated. In fact, stock options remain the cornerstone of equity compensation in corporate America. Even among the largest of U.S. companies, option usage, at 90 percent, still remains well ahead of restricted stock, the second-most popular vehicle, used by two-thirds of companies. Overall, companies are rethinking but not eliminating the role stock options play in their total compensation portfolios.

Stock options will and should continue to be a major component of executive compensation, given the potential for superior long-term wealth-creation power for executives and the benefits for shareholders. There are shortfalls to the traditional use of stock options; obviously, they are not going to be an effective equity compensation vehicle for every company. But the decision to retain or drop, or to modify, the traditional use of stock options should be based on solid analysis and objective consideration, rather than reaction to trends and conventional wisdom.

The Power of Leverage

In March 2003, Apple Computer Inc. CEO Steve Jobs voluntarily turned in 55 million stock options, with a weighted average exercise price of $18.31, in exchange for 10 million restricted shares worth $74.5 million (based on a $7.45 share price). What seemed to be a great deal at the time may have turned out to be largest all-time individual opportunity loss.

The value of the restricted shares has climbed to $856 million (based on the closing share price on Jan. 13, 2006 of $85.59). But the original stock option grants would be worth $3.7 billion.

This example illustrates the...