| The direct cost to shareholders of stock option | | | | and Oracle, 16%.10 These cost effects extend |
| compensation is the dilution of their ownership | | | | for many years, depending on the life of the |
| interest. A common managerial response to the | | | | options. At many companies, options have a life |
| dilution is to buy back outstanding shares. The | | | | of five years. Increasingly, companies extend their |
| trouble with that solution is that it devours | | | | lives to as long as 10 and 15 years. |
| corporate funds that might be more profitably | | | | Accountability |
| deployed. Shocking indirect costs are accounting | | | | Legal rules are ill equipped to police executive |
| rules that fail to require employee stock options | | | | compensation. The general stance of U.S. courts is |
| to be recorded as an expense on the income | | | | to evaluate compensation issues, if at all, under a |
| statement. This translates into earnings per share | | | | waste standard. This standard rarely upsets |
| figures that overstate actual earnings for | | | | corporate decisions. Waste requires pretty much |
| companies with executive stock options | | | | the irrational trashing of corporate assets in ways |
| outstanding. Even the diluted earnings per share | | | | akin to dumping truckloads of cash into the |
| figure does not reflect these costs. | | | | Hudson River. In the case of executive |
| Accordingly, you must adjust earnings figures for | | | | compensation, U.S. courts are quite deferential to |
| the cost of options. Doing this is not easy, | | | | management indeed. |
| however, for not all information is necessarily | | | | As for securities disclosure laws, the SEC requires |
| found in the financial statements. You need to | | | | substantial and focused disclosure of top |
| examine the footnotes for something called | | | | executive compensation in comparative |
| overhang, which is the percentage of the | | | | performance charts. Nevertheless, corporations |
| company that outstanding stock options would | | | | continue to structure executive compensation |
| represent if they were exercised. The average | | | | packages so that they don't show up in the |
| percentage has mushroomed from under 10% a | | | | bottom-line numbers. For example, after |
| few years ago to nearly 15% now. | | | | accounting standard setters ruled that a reduction |
| Still, the actual cost of options is not presented | | | | in the exercise price of a previously issued option |
| directly, though there is some footnote disclosure | | | | had to be recorded as an expense on the income |
| about this. The real cost equals the price at the | | | | statement, many companies chose instead to |
| time of exercise minus the amount the executive | | | | extend the life of the option. |
| pays (the exercise price). This is the truest | | | | Without effective legal or accounting regulations, |
| measure of cost because the company could | | | | the chief job of policing executive compensation |
| have generated that much by selling the optioned | | | | lies with the corporate board. Board members |
| shares to others at the prevalent price instead of | | | | must insist that executive compensation peg |
| at the option price. The cost of executive stock | | | | individual contributions to corporate performance. |
| options is substantial, averaging about 5% of | | | | Measuring executive performance by business |
| annual earnings among S&P 500 companies and in | | | | profitability is the most definitive yardstick with |
| some cases amounting to half of reported | | | | regard to shareholder as well as labor interests. |
| earnings, including at Yahoo!, Polaroid, and Palm.9 In | | | | When measuring performance, companies should |
| less dramatic but still striking examples, if stock | | | | reduce earnings by the capital employed in the |
| options were recorded as a cost, the 1999 | | | | relevant business or by the earnings the firm |
| earnings of some major companies would be | | | | retains. |
| slashed: Cisco, 24%; Microsoft, 12%; IBM, 8%; | | | | |