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Technology Stocks : Wind River going up, up, up! -- Ignore unavailable to you. Want to Upgrade?

To: Michael Greene who wrote (3431)	7/20/1998 5:18:00 AM
From: Snowshoe	Read Replies (1) \| Respond to of 10309

Employee stock options at Microsoft Michael, The following essay about employee stock options at Microsoft should give us some insight into the potential situation at Wind River Systems. I believe the problems cited here legitimize your request for a response from WIND's CFO. I'm cutting and pasting the whole article, since the server seems rather slow... valueforum.com VALUATION AND IMPLICATION - EMPLOYEE STOCK OPTIONS AT MICROSOFT by Graham Bodel & Andy Gee An article in the July 7th, 1997 edition of Fortune, titled "The next best thing to free money" and a spate of other similar commentaries has once again brought the issue of valuing employee stock options to a head. The company at the centre of this debate is Microsoft where the total stock options outstanding have an intrinsic value of $23 billion. Interestingly, the total profits for Microsoft in the past 10 years are approximately $8 billion or almost one third the amount of the deferred compensation represented by the value of employee stock options owed. This article addresses both the valuation issue and some of the wider implications for management decision-making. Many people, most of whom should know better, appear to believe that stock options are free. Whether the expense comes in the form of dilution upon exercise or, in Microsoft's case, the cash used to buy stock on the open market to deliver upon exercise to avoid dilution, there is an economic expense. In 1993, after years of wrestling with the problem of how to account for the (unpredictable) expense of stock options, the US Financial Accounting Standards Board recommended that non-tradeable employee stock options should be valued using the Black-Scholes option pricing model and expensed in companies' accounts. A storm of protest followed and the Board backed down and restricted the required disclosure to a footnote to the accounts. In part the valuation debate has focused on whether or not the full option price should be expensed because part of its value derives from the award of equity (an equivalent stock bonus) and part from the increase in stock value (equity appreciation). William H. Scott of Science Applications International Corporation has proposed a method for valuing the part of the option that represents the true cost to the company (the equivalent stock bonus). The rest of the value and risk is attributable to equity appreciation and is owned by the option holder. The equivalent stock bonus is the expected number of free shares of stock at the original price. The adjusted Black-Scholes is clearly appropriate for valuing a company's existing options. But that does not address the problems for management associated with stock options. Five years ago when Microsoft senior management issued options to their employees did they have any idea what the stock price would climb to? No way. If they did know, would they have given the same number of options away. No way. The reason is because at that time five years ago, management had an idea what the employee should be paid. The amount of options granted was based on what their value was to the company. It was paid in options for a number of reasons, not the least of which were that it locks employees in and did not involve an immediate cash expense. The problem is that today, the value of the options granted 5 years ago far exceeds their previously anticipated future value. There is a massive transfer of value from shareholders to employees happening here. Can this be expected to continue into the future? The answer is no because shareholders won't stand for it. Compensation through options has appeared to have led to overcompensation up until now. This has very serious implications for management decision-making. If management is overcompensating at the expense of shareholders, perhaps a new compensation method needs to be explored. For start up companies, sometimes issuing employee options is the only alternative as revenues haven't started flowing in. Microsoft started out this way and employee stock options served a noble purpose. But Microsoft, now nearly twenty years old, is a mature company and options may have run their course. From this situation come some serious and perhaps unprecedented implications. At one extreme, Microsoft could be seen as financing its future competitors. Ambitious young software engineers at Microsoft who have just been handed several million dollars could easily start up their own company without financial assistance. The software industry does not require nearly the same capital base and start-up costs as many industries. Not to suggest this is an easy or inexpensive process, but Microsoft certainly is making it easier. At the outset, Microsoft was wise to offer generous compensation to woo industry stars away from potential competitors or new entrants. If Microsoft has been overcompensating these type of people then surely they are at risk to these stars (fresh with venture capital provided by Microsoft share options) leaving to start up their own shop. On the other hand, if employees aren't leaving to start ambitious new competitors with their new found wealth, then perhaps Microsoft hasn't been hiring ambitious people. The problem is that Microsoft can't let go of their option plan even though it has become clear over the last decade that stock options is not the optimal method of linking performance with compensation. Let's assume for a moment that Microsoft altered their compensation scheme to properly reflect the performance of employees. The end of this incredible "virtuous cycle", as CFO Greg Maffei would say, would signal the perfect time for those with vested options to make their move away from Microsoft, the well now dry. Let's alternatively assume that Microsoft could change its compensation scheme without the risk of losing their good people. There still exists the 23 billion dollar intrinsic overhang of existing employee options. Management now has to make some decisions with respect to capital structure if it still wants to avoid dilution of its common stock. Up until now, they have been able to muster up the cash while remaining debt-free. However, they have been selling put warrants to third parties to generate cash to finance buybacks. They also in December issued 980 million dollars of convertible preferred shares specially tailored for the same purpose. Is it unrealistic to assume that if this is to continue, Microsoft will have to take on some debt? All of this intrinsic overhang is compensation. If this had to be charged as an expense pro rata over the next five or ten years can you imagine what would happen to earnings? To satisfy the FASB's desire to maintain temporal matching perhaps it would be better to charge the expense over the last 5 years. The question is how much would this adversely affect Microsoft's past earnings? The answer is that it would eliminate every penny of Microsoft's cumulative earnings since its IPO.....almost three times over! Upon examination it appears that it may be difficult for Microsoft to continue to buy back shares on the open market to avoid dilution. Let's assume they let dilution take its course and stopped the buy-backs. In 1996 the dilutive effect of a 10% increase in the share price would just about wipe out all profits. Of course the intrinsic value does not tell the whole story. The options will be exercised into shares representing one fifth of the market value of the company, an ownership block larger than Bill Gates, who does not receive any options. Perhaps this new block of employee owners would try to encourage the perpetuation of the virtuous cycle. Why would they vote against an employee compensation plan that in the past was turning many of them and their colleagues into millionaires? They can't because the cash has to come from somewhere to avoid dilution. The implications for valuation are clear. Future cash expenses such as employee remuneration must be forecasted in a realistic way. If Microsoft has been overcompensating in the past, and it appears that they have been, shareholders will be wary of the method that has led to this - stock options. The implications for management decision making aren't as clear. Stock options are fantastic for cash-strapped companies in their embryonic stages, but Microsoft is past that. More than providing a link between performance and compensation, stock options are transferring value in undesirable ways and possibly leading to changes in capital structure. In the extreme, the stock options may even adversely alter Microsoft's competitive environment. Copyright c 1997, CPS. All rights reserved.