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April 14, 2004
Stock Option Dilution Rose But Granting Slowed in 2003, Anticipating Mandatory Expensing
    by William Baue

Right after the Financial Accounting Standards Board called for mandatory option expensing, the Investor Responsibility Research Center released its yearly dilution study.

What is the effect of stock option granting on shareowner value? The best way to answer this question is to report stock options as an expense, according to the proposal released in an Exposure Draft late last month by the Financial Accounting Standards Board (FASB). The FASB, which sets financial reporting standards that are officially recognized as authoritative by the Securities and Exchange Commission (SEC) and the American Institute of Certified Public Accountants (AICPA), is accepting public comment letters on the proposal to make option expensing mandatory until June 30, 2004.

Many technology companies staunchly oppose option expensing, and organized a "fly-in" to Washington, DC to lobby legislators to block the FASB proposal. Bills in both houses of Congress (S. 1890 and H.R. 3574) seek to circumvent such broad-based reform by expensing options for only the CEO and the four highest-paid officers. Options for other employees would be exempt, and small businesses would not have to expense options.

Calculating dilution is the next-best way to assess the effect of stock options on shareowner value. The Investor Responsibility Research Center (IRRC), an independent, provider of research on impartial corporate governance and social responsibility issues, recently released its yearly study on dilution. Entitled Stock Plan Dilution 2004: Overhang from Stock Plans at S&P Super 1,500 Companies, the report may represent the best resource for investors to assess the impact of stock options on shareowner value while waiting for the conclusion of the option expensing battle.

"Dilution measures the potential impact of the number of options being granted on future shareholder value, by expressing that number as a percentage of currently outstanding shares," said Carol Bowie, IRRC's director of governance research. "Some critics of expensing argue that this is a sufficient measure of the impact of option grants on shareholder value, but most investors don't agree."

"Expensing deducts the presumed (for example, grant-date estimated) value of each option from the company's income, thus lowering profits," Ms. Bowie told "One goal of advocates of expensing is to impose more discipline on the practice of granting options--having them hit the bottom line is expected to achieve that."

Interestingly, dilution continues to rise despite the fact that stock option granting rates have slowed down, according the report, which examined 487 S&P 500 companies, 391 S&P MidCap companies, and 588 S&P SmallCap companies. The average 2003 dilution level stands at 17 percent, up from 15.7 percent for 2002, with information technology companies continuing to have the highest average dilution, at 25.7 percent.

The average option run-rate (calculated by dividing the total number of options granted by the total outstanding common shares) fell for the first time since the IRRC dilution reports began in 1997, decreasing from 2.9 percent in 2002 to 2.5 percent in 2003.

"Of course, anticipation of an expensing requirement has motivated many companies to begin changing their practices," said Ms. Bowie. "Other factors include the collapse of the bull market (options are not expected to return the kind of gains that were common during the 1990's, thus they are less attractive to executives), and shareholder opposition."

Shareowner opposition to stock-based incentive plans has decreased "very slightly" for the second consecutive year, according to the report, down to 21.9 percent for 2003 from 22.2 percent for 2002. This is likely indicative that stock option plans are changing to become more agreeable to institutional investors, according to Ms. Bowie

"Most companies try to design their plans to fit the voting guidelines of major investors and proxy advisors--for example, they avoid the kinds of features, like evergreen funding and repricing provisions, that generate opposition," she said. Evergreen funding refers to automatic share replenishment, and repricing allows companies to revise the price of "underwater" options, or those granted at a price has since fallen below the current market price.

Shareowner action has also affected the options landscape. High profile resolutions calling on companies to expense stock options have received majority shareowner support at IT companies such as Apple Computer (ticker: AAPL), Citrix Systems (CTXS), and Veritas Software (VRTS), as well as HP (HPQ) this year.

"Shareholder actions related to executive pay have been one of the factors influencing boards to be more thoughtful about executive pay practices, including stock option grants," said Ms. Bowie. "I don't think anyone would say it is the only factor, or necessarily the major one, but when companies like Microsoft [MSFT] say they will no longer use options, I think it's safe to say that shareholder criticism has had an influence."


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