Compensation Trends in a Down Market

The Nasdaq is down almost 60 percent from its high of last year, and high-tech employers are announcing major layoffs on a daily basis. With the outsized stock option gains from the dot-com era looking like something from the distant past and unemployment levels increasing, how are employers and employees reacting?

The most obvious change is the increased importance of cash compensation. High-tech companies are more commonly looking for seasoned executives with real operating experience. In the current market, however, it is no longer possible to attract a George Shaheen to an e-commerce start-up, solely on the basis of a large stock option award that may ultimately prove to be worthless. As a result, the salaries paid by high-tech companies for experienced executives and employees have continued to increase. At the same time, there has also been an increase in cash signing bonuses for key personnel as well as annual cash bonus plans based upon financial performance.

Another important change is an increased focus on severance benefits. During the bull market of the last few years, most employees and executives focused on how much of their stock would accelerate upon a sale or a merger and paid little or no attention to severance arrangements. As a result, numerous high-tech personnel have been laid off recently with very limited severance benefits. In the current environment, job candidates are more likely to negotiate more extensive severance arrangements, particularly if they are coming from established companies.

The bear market for technology stocks has also resulted in changes to more prosaic compensation elements. Nowadays, executives and employees increasingly seek to have some or all of any relocation expenses covered. In addition, employers are looking at improved benefit plans, such as expanded health insurance and 401(k) plans with an employer match, as cost-effective ways to attract and retain employees. This focus is likely to increase if favorable benefits legislation is enacted as anticipated in late 2001.

Stock options remain king despite these changes, and greater emphasis will be placed on finding creative ways to make existing options more attractive to employees. Large stock market declines have resulted in unprecedented numbers of underwater stock options. It is not uncommon for even mature high-tech companies to have options with an exercise price 10 to 20 times the current fair market value. These companies face losing their best employees unless preemptive action is taken immediately. Addressing underwater stock options in a manner that retains key employees and is consistent with providing stockholder value will be one of the most important compensation issues for publicly held companies this year.

Techniques to address underwater stock options have already begun to emerge in response to recent guidance by the Financial Accounting Standard Board. New accounting rules allow for options to be exchanged for new equity interests under certain circumstances without triggering continuing compensation charges to earnings. One of the more popular techniques is to replace underwater stock options with a smaller number of restricted shares, perhaps on a 3 for 1 or 2 for 1 basis. This form of option exchange, if structured properly, can result in a win-win-win situation-employees receive immediate value, the company has a valuable retention tool and shareholders enjoy reduced dilution. Another common technique involves canceling underwater stock options and issuing new options more than six months later at the then fair market value.

Regulators and investors will closely monitor attempts to make underwater stock options attractive, and companies must proceed with caution before instituting option exchange programs. The Securities Exchange Commission (SEC) recently announced that broad-based option exchanges programs will normally be considered tender offers. This means that the publicly held companies implementing an option exchange program must undertake a process involving extensive disclosure to option holders and filings with the SEC. In addition, investors have already begun to question whether more aggressive programs, such as the exchange of one stock option for one share of vested stock, provide sufficient value to the company.

Several trends are emerging with respect to new stock award grants. The recent stock market downturn has pointed out the flaw with large one-time stock option grants that can end up entirely underwater. Companies are already moving toward periodic grants for their executives and outside directors in order to mitigate the effects of market volatility. This approach also reduces the likelihood that employees who join the company at different times will have significantly different option values. Companies will be more reticent about how and when to provide loans to executives to exercise stock options and to pay for restricted stock. In response to recent accounting changes that require companies to expense the cost of stock awards to certain non-employees, companies are reducing or altering their stock awards to outside consultants. Employers are increasingly requiring the forfeiture of stock option gains if the employee violates his or her covenant not to compete or other post-employment obligations.

Employers should expect their employees to be more savvy about their stock awards and their related tax implications. In the recent downturn, many employees ended up with large unanticipated tax liabilities as a result of option exercises, particularly with respect to incentive stock options (ISOs). Many option holders faced tax bills this past year that were several times larger than the value of their current stock value. To avoid this situation, some executives at publicly held companies terminated their employment before year-end to be able to sell their ISO stock immediately under insider trading restrictions and avoid the alternative minimum tax. Employers are well advised to better educate their employees on these issues and more carefully administer their incentive stock programs.

Employers will face challenges from disgruntled employees over their stock option programs. We are already beginning to see the first wave of stock option litigation over defeated expectations. Industry leaders such as Oracle, Broadcom, InfoSpace and Qualcomm have already been involved in multi-million dollar lawsuits. Some claims have resulted from over-promising option values to entice employees from old economy companies and modifying vesting schedules as part of change in control transactions. However, most claims appear to result from failure to attend to sound labor and employment practices, particularly during the hiring process and when instituting layoffs. Unclear offer letters, poor option agreement documentation and failure to obtain binding releases are a recipe for litigation. Now is a good time to revisit standard option grant documents for compliance with legal requirements and to confirm existing stock option inventories.