Concluding Comments:  I believe that companies should have do disclose the methodology they use when measuring corporate performance, as it pertains to employee compensation and stock option grants.  At the end of the day, a corporation’s compensation structure and risk / reward structure will dramatically impact an employee’s behavior. 

 At the end of the day, how and why are stock options granted?

Is it based on sales growth or net income growth?  How does the company account for one-time charges?  Do they account for such charges when determining bonuses / option grants?  Does the company grant bonuses / stock grants based on cash flow from operations or total cash flow (including investment and finance-related income)?  Does the company measure free cash flow as a determinant in compensation / rewards of stock options?  Finally, how does a company evaluate balance sheet changes, as it pertains to stock option plans?

Stock Option Plans – My take on them

I am writing this article to discuss the issue of stock options and their relevance / importance in business today.  In particular, I believe current media / political attention on stock options has been skewed towards whether or not they should be expensed in companies’ financial statements they file with the SEC. 

The questions that most investors / politicians are trying to tackle are:

1. What is the dilution impact on the income statement if all stock options were exercised, as of today?  
2. Do current financial statements make it easy for investors to understand the impact of stock options to their investments?
3. How do stock options impact corporate growth?
4. Will expensing stock options stifle innovation and economic growth?

I believe that attention to the above questions is warranted because the dilution impact is substantial to some publicly traded companies.  However, I believe there is a much more important question that politicians / business managers need to tackle.

At the end of the day, how and why are stock options granted?

Is it based on sales growth or net income growth?  How does the company account for one-time charges?  Do they account for this when determining bonuses / option grants?  Does the company evaluate based on cash flow from operations or total cash flow (including investment and finance-related income).  Does the company measure free cash flow as a determinant in compensation / rewards of stock options?  Finally, how does a company evaluate balance sheet changes, as it pertains to stock option plans?

I’ll use this example.

Company A was experiencing above average growth in their industry due to legislation that encouraged deregulation and more competition in the industry.  As a result of the legislation and nice profit margins experienced in the industry (service providers and equipment makers) massive amounts of capital were invested into the industry.  The large sums were a function of (1) a capital intensive industry, (2) industry growth at 20% - 25% per year for the last 5 - 10 years.  In some areas industry growth was over 100% a year and (3) projected growth of 20% per annum for at least the next five years.

• Sales grew because the new services in the industry increased productivity of workers, streamlined business communications, improved financial results and helped consumers communicate in ways never before experienced.

As the industry began deregulating Company A decided they would reward their employees, in cash bonuses, promotions and stock option grants, based on a Return on Sales formula.  In saying this, the human resource department and CEO designed a compensation / incentive system that was easy to track.

Ex.        Sales                      $10 billion

            Expenses                        $7 billion

            Gross Income                  $3 billion

           Return on Sales = 3/10 = 30%

Since deregulation had occurred top line growth at Company A had been 50% per year for the last three years, well above the industry average of 35%.  Deregulation appeared to be working.  Consumer prices were falling due to more competition and businesses were getting new services that helped increase corporate productivity / communication. 

Company A’s CEO and senior executives, along with employees, have done an excellent job based on the formula adapted by the company and get nice cash compensation and stock option grants.  Additionally, the stock market, observing the growth in top line results vs. the competition deems the company to be a “core holding” for investors wishing to invest in the sector. 

At the end of the fourth year growth begins to stumble in the industry.  Over a few quarters it becomes clear to investors that initial returns on their new investments, in particular the service companies, is quite poor.  The increased level of competition has driven down margins in the industry to the point where debt levels are becoming a big issue in the industry.  Very little, if any, additional capital appears to be is being invested into new ventures or equipment providers within the industry.

This has put the industry into quite a predicament.

1)  Service providers have a capital shortage.  During the industries’ growth period they had investors throwing money at them left and right.  They even had equipment providers giving them vendor financing to help drive equipment makers’ top line growth.  How will they fund their existing business plans because they are not fully funded?    Most determine that they must reduce their capital spending plans.

2)  The capital spending issues negatively impact equipment providers, causing them to experience a 25% reduction in revenues.  Much of the equipment sales are part of previous vendor finance agreements they had with the service companies. While the equipment providers have managed to shift some of the risk to finance companies their net exposure is five times what it was four years ago.  Additionally, concern grows about the possibility of bankruptcies.

3)  Free cash flow has been week for equipment providers the past year.  A great deal of cash went to financing stock repurchases and on frivolous projects that aren’t generating returns because customers find little value in the services.  Their headcount is three times what it was just three years ago due to acquisitions made in recent years.

4)  The incumbent service providers need to deliver new services to their clients.  However, at the same time they are seeing that many companies might not survive.  They can buy the equipment much cheaper (perhaps 10 – 20 cents per dollar) if the new companies end up in bankruptcy.  As a result of weakened competition the incumbents begin cutting back their capital expenditures. 

Now the results are in…….

1)  It appears as though the assumptions the companies modeled in making their acquisition aren’t going to occur.  They take a write down.  Thankfully they purchased most of the companies with stock, which held a high price during the boom years.

2)  Service companies go bankrupt.  No company wants to buy a company with a capital shortage and a high level of relative indebtedness.  Incumbent companies wait for bankruptcy to be declared before they buy assets of the companies.

3)  Equipment providers find that their growth evaporates and that, within 2 years, sales fall 50%.  Much of the growth rates were financed by the capital markets. 

4)  Everyone (service providers and equipment providers) have too many employees but they don’t reduce headcounts fast enough.  At the end of the day executives throughout the industry lose their jobs.  Many employees received generous compensation due to top line growth and EPS growth.  However, equipment providers find that much of their growth came at the expense of the company’s balance sheet. 

5)  Company A has a high cash burn (negative cash flow due to too many employees not generating sales.)  Additionally, the company has a high level of relative indebtedness because it borrowed heavily during the boom years to finance some projects. 

Conclusion: 

Had the company rewarded employees and executives based on free cash flow they wouldn’t be in the situation they are.

They would have avoided:

1)   Expensive acquisitions

2)   Leveraging their balance sheet

3)   Costly projects that generated minimal cash benefit to the company.

As the months pass senior executives retire.  Many are millionaires from the stock they sold in the boom years, the cash bonuses they received and they have stock options that are worthless.  But, at the end of the day, many of the executives don’t need the options because they did so well during the boom years.  As they increasingly got 3-5x the number of shares (via options) many of them sold a large portion of their holdings. 

The company is in shambles. 

1)  The company, in years five and six, had to lay off over ½ its workforce.

2)  Many of those laid off also lost a lot of $$$ in their 401k plans.

3)  The company’s balance sheet is in ruins.  The company has tons of debt and has taken on “convertible notes” that will convert to stock in the event of paying down debt.

4)  Products had to be discontinued because sales can’t offset the continued R&D / update of all the product lines.

5)  The number of shares outstanding is up 50% vs. six years ago while revenue is about the same.  Profits and cash flow are starting to turn but the growth days are gone.

I hope everyone finds the facts/insights presented in this article valuable.  If you find them interesting please send me a comment @ dan@betterbizbooks.com and forward the article onto as many friends as you want to.  If you want to receive further articles such as this click on the subscribe button on the right to sign up for my Free Monthly Newsletter.

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