BULLS & BEARS: Shift to restricted stock not always good news

In recent decades, companies accelerated their use of stockbased awards as a compensation method. The key argument for these compensation plans was that they align managerial interests with stockholder interests.

The modern stockoption plan originated at the young technology firms-which, short on cash, instead issued equity to compensate and motivate employees. As the riches began to flow, option programs escalated at larger firms that weren’t cash poor but proclaimed the alignment-of-interests theme. The option largesse was encouraged by accounting fantasy, since companies did not have to record an expense for option compensation in their income statements.

In the end, those mega-option grants often led to outsized rewards for management, and failed to provide shareholders with commensurate success. Further abuse has come to light in recent years, with option-backdating schemes being uncovered at hundreds of companies.

Now, with new accounting rules requiring that companies expense options, there is another change taking place in stock based compensation-more companies are moving away from granting stock options and toward the use of restricted stock.

Restricted stock is stock granted to an employee that vests over a period of time. Once the vesting requirements are met, the employee owns the stock outright. This is different from a stock option, which has an “exercise price,” or a price that the company’s stock must exceed in the stock market before the option has value to the employee.

The shift from stock options to restricted stock in some companies has been dramatic. Consider Amazon.com. In 2001, Amazon granted 46 million stock options to employees. A year later, it issued only 3 million options. Since then, Amazon’s stock awards have consisted primarily of restricted stock.

In 2003, the company granted three million restricted shares, and last year the company granted nine million restricted shares. Amazon’s restricted shares vest to employees over two to five years. In 2003, Microsoft abandoned granting options and switched entirely to restricted stock.

For the shareholders of a company, the move toward restricted stock may not be as noble as it appears, and shouldn’t necessarily be viewed as a panacea to excessive stock-based compensation. As it turned out, many of the stock options granted by firms at the top of the market bubble will never achieve their exercise price and thus will become worthless. A switch to restricted stock could be viewed as a way to make up that shortfall for frustrated employees who had come to expect option gains.

If so, shareholders may cry foul. After all, wasn’t this the whole intent of the alignment of interest argument? If the stock didn’t go up for investors, shouldn’t management-which typically received the lion’s share of stock option grants-feel the pain along with shareholders?

A stock-based compensation plan can be effective for both employees and shareholders if properly structured. We would argue that stock grants, whether in the form of options or restricted stock, should include an annual cost of capital applied over, say, a three-year rolling period. In other words, for the stock-based award to have value, the long-term performance of the company would have to exceed a simple, but meaningful benchmark.