The Options Game
The rules of compensation are changing as
more employees share in the risk of stock options.

By LEIGH ANNE LARANCE

At Divx Inc.'s Richmond offices on June 16, there was a sign at the front entrance announcing a mandatory morning meeting. Employees of the Circuit City subsidiary — formed to launch a new digital video rental system — crowded into the cafeteria to await the arrival of Circuit City CEO Rick Sharp.

Ed Sterrett, Divx's project manager for telecommunications infrastructure, had arrived that morning at 6 o'clock to catch up on some work. A colleague pulled him aside to fill him in on the pending news: The company he'd joined more than two years earlier would be shutting down. "It took me completely by surprise," he says.

Even more surprised were the late arrivals. They figured the meeting might be about a new benefit. Employees had been demanding a 401(k) for some time. One human resources worker, who must have been out of the loop, was passing out summary information on the retirement plan even as Sharp was about to pull the plug.

The cafeteria was packed, and the mood was tense. "There were some angry people there," Sterrett says. Soon, 250 of them would be flooding the Richmond job market. Yet many had a pressing question: What about the options they'd been granted as part of their compensation?

"To me, it's silly that people would think that when a company shuts down that there would be any value to their options," Sterrett says. An option is a right to buy shares at a fixed price in a set period of time. Their value is in the spread between the fixed price and the market price when the option is ultimately exercised.

For Divx, there would never be any shares, so the employees' options were suddenly worthless. But it took several weeks for some employees to accept that simple fact, Sterrett says. "They just did not think it was fair that they lost their stock options. They thought that the product would be resurrected, that it would be sold, and that if Circuit City made any money off the Divx concept, that those who held options should have a share in the profits. It seemed to be a big deal to some people.

"It's true we're a bunch of techies, nerds," he says. "But at the same time I know a lot of people play the stock market. They should have known the risk."

For Sterrett, the stock options were simply cream. He didn't know about them going in, so they weren't a make-or-break condition of his employment. "The agreement wasn't very clear," he recalls. "They called them units, they didn't call them shares." The rumor was that they would be worth $100 per unit, and that figure was a widely accepted fiction. Sterrett wouldn't say how many units he held, but he says most people he knew had between 5,000 and 10,000.

"After a while, when Divx really started to move and a lot of us were working 60 and 70 hours per week, the thought of these units was what kept us there, instead of trying to go out and find a sane job somewhere else," he says. "It was always our expectation ... that we'd all be rich off these stock options."

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Options used to be just for executives. Now many businesses are adopting a new philosophy: Everyone from the CEO to the late-shift security guard plays a role in a company's success, so everyone should share in skyrocketing market values. And if the company does not do well, workers ought to feel that, too.

One report commissioned by William M. Mercer Inc., the New York-based compensation consultant, found that options are a growing part of many pay packages. Of 350 large companies studied, 39 percent had option plans covering at least half of all employees in their most recent fiscal year, and 17 percent had made grants under those plans. In 1993, only 17 percent of those companies had option plans, and less than 6 percent had made grants.

The experience of Divx employees offers a view into the risky side of options. When they are granted in lieu of other compensation, they carry an even more venomous sting. Such tales are often overshadowed by rosy reports of young millionaires from Northern Virginia firms like America Online.

In many cases, however, pushing risks and rewards lower down in an organization can pay off. Falls Church-based Capital One Financial Corp. credits some of its success to employee ownership. In late April the company gave 50 stock options to the more than 6,000 workers who had joined the company since May 1998. It marked the third time the credit card company had awarded options to mid- and entry-level employees. For each person who received options under the first grant in March 1995, the awards have an in-the-money value of more than $30,000. No wonder Capital One was named by Fortune magazine as one of the country's 100 Best Places to Work.

"It used to be only high-tech firms," says Kelly Crean, a Richmond-based senior compensation consultant with William M. Mercer. As Capital One found, though, options are a powerful tool for recruiting and retaining workers in a tight labor market. And they're spreading. "Now ... you can go into any industry and find someone who's considering broad-based options," Crean says.

Norfolk Southern decided to introduce options at the same time it brought 11,000 former Conrail employees on board. The first options were issued to 5,500 employees on June 1, says Royce Stanford, the company's compensation director. Of its nonunion employees, about 400 already had been part of a management incentive plan that included such a program. "Our chairman, David Goode, thought the timing was appropriate to grant options on a broad basis to our nonagreement work force," Stanford says.

All nonunion employees — roughly 18 percent of the work force — were eligible for between 300 and 1,000 options, depending on their rung in the corporate hierarchy. The options allow the employees to buy the stock at $33.25, the average of the high and low prices on the day the company granted the options. They vest after one year and expire after 10 years. The company estimates that the program — called the Thoroughbred Stock Option Plan to fit with Norfolk Southern's logo — will cost about $39.7 million.

In a letter to employees, Goode wrote: "While stock options come with no guarantees, they do offer significant potential. My hope is these grants will create an incentive for you to think like owners who are always on the lookout for new and better ways to serve our customers and increase value for our stockholders."

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Stock-option plans aren't for big, public companies alone. They offer an edge to smaller firms that need to offset lower-than-average salaries for high-tech talent.

Employee ownership was always part of the plan for Brett Malone and Scott Woyak, who co-founded Blacksburg-based Phoenix Integration Inc. four years ago. "From day one we knew we wanted to do this," Malone says. It was just getting to the right point."

The company, which designs engineering software for companies like Lockheed-Martin and Ford, was planning to roll out the program in late September. "We can't compete with Silicon Valley rates, and people know that," Malone says. The people he hires "would rather be a part of a really good thing. ... To have some ownership in that really gives them a sense of pride."

It is more difficult to set up and administer stock-option programs in private firms because they often have a shorter history and there's no market for their shares. But it can be done.

Options are a good solution for young companies, says Andrea Muscatello of Roanoke-based McLeod and Co., an accounting and consulting firm. She helped put a value on Phoenix Integration for its option plan. Such valuations — both for options and for employee stock ownership plans — are a growing part of her company's business.

When executives decide they're willing to give up some ownership of the company, they've made a big philosophical decision. There are other details to work out, however, such as putting a dollar figure on the company to provide a point of reference for IRS reporting and to allow employees to exercise options. Executives also must decide which type of options to use: There are incentive options and nonstatutory or nonqualified options. "The majority are nonqualified, although incentive stock options are gaining more popularity," Muscatello says. In essence, incentive stock options are more favorable to the employee from a tax standpoint, while nonqualified options are more favorable to the company.

In either case options provide "a way to offset wage stagnation," Crean says. With pay increases of 3 percent to 4 percent per year, workers find themselves stuck in the career equivalent of a savings account. They can perform well, and the company can perform well, without much change in their personal bottom line.

Stock-option plans aren't the only way to tie pay to performance, however. There are still long-term incentive plans, bonus plans that give rewards for reaching different performance benchmarks, retirement plans that incorporate stock as part of a company match and traditional employee stock ownership plans — which often are a better fit for more established companies.

The twist with options is that the compensation is at risk. And except for administration fees, they don't cost anything if the value of the company doesn't increase. But there is another point to bear in mind: While it doesn't cost anything to grant options, they do dilute per share values.

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Do employees realize what they're getting into when they take options in lieu of cash compensation? Or are they simply trying to keep up with the Joneses — or the Gateses?

"Everyone reads the newspapers and they know what's happening," says Jeff Mitchell, an attorney with LeClair Ryan. His law firm helps companies set up option plans. "It's not just Microsoft."

Job candidates used to ask about pension plans. Then they wanted to know about 401(k)s. Now the question is, What about your options package? "They're just told it's something to ask for," says Bob Ranson of Boston-based Arnold Communications, an advertising and public relations firm. Ranson says that in two years of interviewing job candidates, in only one instance did a candidate not bring up the subject of options.

Ranson, senior vice president in the firm's McLean office, sometimes quizzes applicants about what they really want: Do they know that if the price goes down the options are worthless? "You're hearing about the people who win the lottery," he says. "They don't stop to think that a whole lot of people got options that aren't worth anything today."

The fact that technology firms are offering these perks puts pressure on more conservative professional services firms. Would you rather work as an accountant for a major CPA firm or join the corporate accounting team of a company that offers options? "I have friends who have been made offers to become in-house counsel," admits LeClair Ryan's Mitchell, "and one of the substantial pieces of the compensation is options."

"No question, it's enticing," says Ranson. Public relations professionals also are being recruited by tech firms. "Who in our business isn't potentially thinking about those things?"

He likes to think, though, that people who have more experience in the market have a more realistic view of the risks inherent in such compensation and see the value of going with an established firm over a start-up.

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A William & Mary business school student approached Professor Bud Robeson seeking some advice. Robeson says the student was considering a job with a Silicon Valley start-up and was at the negotiating stage. He could choose between a low-risk compensation package with a signing bonus or a high-risk package with options. Because it was a new company, the options were particularly hard to value. The student ended up taking a lower salary, no signing bonus, and the iffy options.

If he's lucky, his company will do better than Divx. But even employees there didn't fare poorly after the June announcement. Recruiters were on the phone trying to lure away the company's high-tech work force as soon as the news hit the street. "Most got jobs pretty quickly — and good jobs," Sterrett says. They didn't have to take a step down. Quite a few went to Circuit City and others signed up with Capital One. Sterrett started a new job on Sept. 13.

Would he work for another start-up? Or, given the same choice as Robeson's student, would he take the options as a part of his compensation package?

"Probably not," Sterrett says. He has two teen-agers and needs to think about stability and college tuition. Maybe if he were younger. He has already rolled the dice once.

"I knew all along that the options were a risk. The reason I stayed was I thought Divx was a good concept. In a sane world, it should have worked," Sterrett says. "I really thought Divx was a company that was going to last."

The thing he would stress to others is that options are risky. "You can do your little part to make those options worth something, ... but ultimately, you're a small part in the company," he says. "If you can afford to take a gamble, great. I guess it depends on what you want."