Remember how Congress tried to slow down executive pay by limiting tax deductions for compensation to $1 million, excluding certain performance-based pay? Well, companies simply paid their executives a salary of $1 million and made the rest up out of bonuses and stock awards, heavy on the stock. This pushed executive compensation even higher, as CEOs were then focused on getting the stock prices to rise as quickly as possible, increasing the value of their pay packages.
Since the economy took a nose dive, however, many executives are now finding themselves looking up at a big fat zero when it comes to their stock awards. In a study of the 100 largest public tech companies, executive compensation consultants Steven Hall & Partners found that as of July 31, 2009, 90 of the firms had stock options that were underwater. When all the outstanding options held by the top five executives at each company were averaged out across the 100 companies, 57% were underwater. The average underwater option was down 42% from its exercise price.
For the most part, these companies are not responsible for their plummeting stock prices. They got dragged down with everyone else when the financial sector imploded. So this pay that was supposed to reward performance is actually punishing the executives for the performance of the market as a whole, something they have no control over. And it's not just executives being punished. Many companies reward employees with stock options, and these people have even less control over the market price of the shares.
What can a company do? It could issue more options at a new, lower exercise price, but you can bet the rest of the company's shareholders (who are maybe not swimming as deeply as the executives) are not going to get the same deal. Plus, option grants are charged against earnings and dilute the existing stock pool. Re-pricing can be difficult because that requires shareholder approval. But something has to be done before executives and other key talent tire of treading water and swim off to another firm offering a fresh set of dry stock options. How much incentive to stay can there be in this situation, especially when there are newer managers and executives at the firm with much lower exercise prices?
Instead of simply re-pricing options on a one-to-one basis, many companies have instituted value-to-value exchanges, where option holders can cancel their underwater options and be issued fewer options that are priced at the current market price. This averts the dilution problem and does not count as an additional compensation charge. Intel recently underwent such an exchange, although it excluded its named executives and directors from the program.
Does your company have underwater options? If so, are there any plans on how to handle them?