Rescuing drowning stock-option programs: despite congressional and shareholder backlash against excessive executive compensation, companies facing employee motivation and retention issues cannot afford to remain on the sidelines when it comes to restructuring their employee stock-option programs.

• Author: Ma, Cindy W.

Bailouts may be the flavor du jour amid the recent economic collapse, but companies looking to rescue stock-option compensation programs are scrambling to send a different message to shareholders in the wake of proxy season: Employees are not in for a free lunch.

In an environment where 80 percent of registered voters feel executives are paid more than they deserve, and 89 percent favor adoption of clawback policies--according to a Public Strategies Inc. survey conducted late last year--that task may be easier said than done. Nevertheless, some companies facing employee motivation and retention issues can ill afford to remain on the sidelines.

The Standard & Poor's 500 Index shed approximately 40 percent of its value between January 2008 and April 2009--its worst performance in decades--prompting a near evaporation in value of option-based employee compensation packages. By its latest count, executive compensation research firm Equilar reported 72 percent of Fortune 500 companies had outstanding options that were, on average, underwater; as of last December, nearly 99 percent of options held by chief executive officers of the S&P 500 companies were out of the money.

Despite the 8.9 percent unemployment rate posted in April, employee motivation and retention can be difficult to accomplish via a compensation portfolio awash with worthless options--especially in a market dislocation responsible for decoupling strategic and operational efficiency from a company's share price performance.

In a deposition to the U.S. Securities and Exchange Commission last year, for example, Apple Inc. CEO Steve Jobs admitted to feeling "hurt" when his board initially made no attempt to restructure his largely underwater compensation package following the dot-com bubble collapse earlier this decade.

What's more, in a liquidity constrained environment, companies forced into cash-conservation mode have little choice but to rely on stock-based compensation to retain skilled employees.

Employees, however, may be skeptical of the ultimate value of new grants if companies fail to take steps to rescue existing grants that are deeply out of the money.

Restructuring Strategies

Companies must also contend with other considerations, such as reestablishing the ability of a compensation package to align management and employee interests with those of other shareholders. Underwater options represent an inefficient allocation of resources that arguably serve the interests of neither party--as companies must continue to recognize accounting charges for awards that provide no value to the company or its employees.

In addition, with little likelihood of being exercised, these options represent a drag on the company's overhang--and in addition to being dilutive, count against share plan limits approved by shareholders, thereby restricting the number of new grants that can be awarded.

To be sure, not all situations warrant restructuring of employee stock-option plans. For example, companies in industries that have suffered a relatively light blow in the current downturn may consider delaying remedial...