Workers Facing Other Options
Microsoft Corp.’s decision to abandon controversial stock option-based pay packages in favor of plans based on restricted stock may persuade other companies to follow suit.
Whether such a shift would be a boon or a bane for workers depends on the circumstances, said Jack Marsteller, principal and compensation expert at benefit consulting firm Towers Perrin in Los Angeles.
In general, stock options are most valuable for workers at fast-growing companies.
Restricted stock, on the other hand, can benefit workers at mature, slower-growing companies -- such as Microsoft.
But other factors play into the equation, such as exchange rates, stock price appreciation and taxes.
Stock options are rights to buy shares at a set price in the future. They’re usually priced at fair market value at the time of the grant, and become valuable only if the company’s stock price rises.
For example, if a company’s shares sell for $10, an employee might be given 300 options to buy company shares any time during the next 10 years at $10 a share. If the company’s stock price rises to $30 a share during that time, the worker could exercise the options -- purchasing the stock at $10 a share and immediately selling it for $30 -- and pocket a pre-tax windfall of $6,000 (300 shares multiplied by the $20-per-share profit on the exercised options).
But if the stock price falls during the 10-year period, the options would expire worthless. And if the stock rose just 20% over that decade to $12, the profit from exercising the options would be just $600.
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Outright Gifts
Restricted stock, on the other hand, is an outright gift of company shares. If a company’s stock is selling for $10, for example, each restricted share granted to an employee is worth $10 on the date it vests -- or becomes the unfettered property of the recipient. Generally, grants of restricted shares vest over four years.
Restricted stock rises or falls in value right along with regular shares of a company’s stock. Unlike options, which can expire worthless, restricted stock generally will have some value unless a company’s stock price falls to zero.
A wrinkle in comparing the value to workers of restricted stock versus options is the exchange rate. A company that decides to replace stock options with restricted stock in its employee pay plans must decide how many shares of restricted stock should be substituted for a given number of options when figuring a worker’s compensation package.
However, there is no universal formula for determining the exchange rate. The Black-Scholes option-pricing model, often used by companies to put a dollar value on stock options granted to workers, can provide a clue, said Matt Ward, chief executive of WestWard Pay Strategies Inc. in San Francisco.
This model typically suggests that companies should give workers one restricted share for every two or three stock options given up.
However, because there’s less downside risk with restricted shares, some argue that workers should be granted fewer restricted shares than the Black-Scholes formula might indicate.
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The Exchange Rate
Companies probably will settle by giving one restricted share for every three to five stock options, said Diane Doubleday, executive compensation consultant with Mercer Human Resources Consulting in San Francisco. In some cases, the exchange ratio may be even less generous.
To illustrate how options can be more valuable than restricted stock for workers at fast-growing companies, assume that, in the example above, the company grants its workers one restricted share for every three options given up.
In other words, the employee who had 300 options would get 100 restricted shares instead.
If the company’s stock price still was $10 after 10 years, the restricted shares would be worth $1,000 ($10 x 100 shares), while the options would have expired worthless ($0 profit x 300 options).
However, if the stock rose to $30, the restricted stock would be worth $3,000. That’s all profit, since the employee paid nothing for the stock, but it’s only half what the employee would have made on the 300 options given the same price increase.
One troubling aspect of restricted stock grants is that they can cause employees to lose control over their tax obligations.
With stock options, taxes usually are due only after the options are exercised and sold. (In some cases, however, the tax can be due at the time of exercise, even if the employee doesn’t sell the shares.)
With restricted shares, tax is due when the shares vest. And the company, not the employee, determines when that will happen. Microsoft, for one, is weighing plans that would cause shares to vest at an irregular schedule based on company performance measures, which could make tax planning even more difficult for workers, Doubleday said.
And because restricted stock grants are a form of compensation, their value is taxed at ordinary income tax rates, which can be as much as 35 cents on the dollar.
But if the worker eventually sells the shares for less than they were worth when they vested, the difference can be claimed as a capital loss and used to offset any taxable capital gains -- and possibly up to $3,000 in ordinary income -- the worker may have.
On the other hand, the tax implications can be even worse for stock option recipients who hold on to the shares they receive after exercising their options instead of selling them immediately and taking the profit.
That’s because paper profit on exercised stock options can be subject to the alternative minimum tax. This tax is due, even if the value of the underlying stock crashes in the interim.
That’s left hundreds of one-time dot-com millionaires with massive tax bills on stock that is almost worthless.
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Times staff writer Kathy M. Kristof, author of “Investing 101” and “Taming the Tuition Tiger,” welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes .com. For past Personal Finance columns visit The Times’ Web site at www.latimes.com/perfin.
