Stock options and optimal overhang.

• Author: KAY, IRA T.

Here are the key factors for boards to consider when instituting compensation policies that affect overhang.

AS THE STOCK MARKET continues to roller coaster -- and economic forecasts from experts vary -- business practices and policies will become more carefully scrutinized under the shareholder microscope. In such an environment, we will see continued debate over the always controversial issue of stock option overhang. This is an issue which needs careful evaluation by boards of directors. Although stock option overhang at the right level (with the correct combination of options and managerial ownership) is, overall, a healthy development, there is increased exposure and possible liabilities that executives must manage and boards need to monitor.

Defining overhang

Before we explore the debate, let's first define overhang and examine its possible effect on stock prices. The measure of stock option usage is called "overhang" -- defined as stock options granted, plus those remaining to be granted, as a percentage of the total shares outstanding at a given company. The use of stock options has two countervailing effects on stock price value. Stock options motivate employees to create superior financial performance, placing upward pressure or an "incentive effect" on stock prices. Conversely, stock options represent a potential future issuance of shares, creating dilution and forcing downward pressure. Stock options also increase the volatility of stock prices, which puts further downward pressure on stock prices.

Driven by the technology sector, employee stock options and stock ownership began exploding in the 1990s, when employees at all levels began to embrace the value of stock options and ownership. As the competition for talent escalated and the economy boomed during this decade, the use of stock options, as a competitive recruitment tool and performance incentive, became common practice. Consequently, stock option overhang increased at an annual growth rate of 10.3% -- from 5.4% in 1989 to 13.4% in 1999. Preliminary data from the Investor Responsibility Research Center shows overhang levels of 14.6% for 2000.

These and other data cited in this article are published in Watson Wyatt's 2001 report, Stock Option Overhang: Shareholder Boon or Shareholder Burden? In it we found that, though overhang increased dramatically during the past decade, the rate of increase has slowed since 1998. Further, there are dramatic differences in overhang level by industry. For example, technology and health care companies tend to have high overhang levels that are in line with others in their industries, while utilities and consumer staples tend to see much lower average overhang levels. The industry levels vary proportionately with the importance of human capital to the industry. For the purposes of our statistical analysis, high and low overhang companies were defined relative to their industry.

Generally, the increased use of stock options has had a positive impact on company performance -- as employees have an increased stake in the value of the company -- yielding positive effect on stock price, shareholders and, ultimately, the U.S. economy. During the same 1989-1999 period that saw the marked increase in overhang levels, stock values also soared. The S&P 500 Index grew at an annual rate of more than 14%. Although there have been many factors at the root of this spectacular market performance -- fiscal and monetary discipline leading to lower interest rates, dramatic technological advances, increased savings by baby boomers preparing for retirement, and increased foreign investment -- one of the key drivers has been the increased use of stock-based incentives. Even the stock market correction of the past year has not eliminated the overall positive impact from stock options.

The 'sweet spot'

While it is impossible to prove a cause and effect relationship, it seems clear that the considerable overhang increase did not impair the equity markets. However, stock options, like all scarce resources -- including financial and human capital -- must be allocated strategically by boards of directors for optimum usage. We call this optimum usage, or optimal overhang level, the "sweet spot." That is, some companies have too little (below optimal) overhang and some have too much (above optimal).

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