ACCOUNTABILITY Stock Options and the New Rules of Corporate
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00_200295_FM_Delves 8/20/03 11:07 AM Page i “Don Delves is one of the industry's most knowledgeable compen- sation consultants. His book makes an important contribution to the stock option dialogue.”—Larry Hirsch, Chairman & CEO of Centex Corporation “This is an excellent book for anyone interested in the important discussion of stock option expensing and, more significantly, the optimal use of stock options in compensation plans. It is written from the point of view of an experienced and knowledgeable com- pensation consultant who has advised board compensation com- mittees and talked with many people outside the field considering the economic and incentive effects of the overuse of stock options in the 90s.”—John M. Biggs, former Chairman & CEO of TIAA- CREF “This book is very thoughtful and insightful. There are no right answers– only degrees of balance. The author has achieved that well.”—John Rau, President and CEO of Miami Corporation; for- mer CEO of Chicago Title & Trust Company “If you are on the Compensation or Finance Committee of a Board, this is a must read. With the portfolio of executive compensation Don Delves assisted us with, BorgWarner has risen to the top with- out megagrants of stock options.”—John F. Fiedler, former Chair- man and CEO of BorgWarner “Don Delves has given us a clear, lively exposition of multiple issues and variables to be considered in formulating incentives to improve corporate and executive performance. Along with his unequivocal advocacy of expensing stock options, he calls for a more balanced approach to compensation, one that blends a variety of elements to engender more attention on the long-term health of the enterprise. His interviews with thought leaders such as Paul Volcker and Myron Scholes and the incisive questions he poses help frame a robust debate on the proper use of options.”—Ronald L. Turner, Chairman, President, and CEO of Ceridian Corporation This page intentionally left blank. 00_200295_FM_Delves 8/20/03 11:07 AM Page iii STOCK OPTIONS AND THE NEW RULES OF CORPORATE ACCOUNTABILITY Measuring, Managing, and Rewarding Executive Performance DONALD P. DELVES McGraw-Hill New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto ebook_copyright 4x7.qxd 10/20/03 11:30 AM Page 1 Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Manufactured in the United States of America. 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CONTENTS FOREWORD: A Conversation with Paul Volcker xi ACKNOWLEDGMENTS xvii INTRODUCTION xix PART ONE THE STOCK OPTION PROBLEM 1 Chapter One Dimensions of the Problem 3 The Problem with Options 6 The Current Situation 8 Executive Wealth and the Positive Power of Greed 9 Stock Options and Corporate Culture 10 Shareholder Activism 11 The Specter of Government Regulations 13 A Sea Change for Options and Executive Compensation 15 Board Responsibility 15 What Do You Think? 18 Chapter Two The Sources of the Problem 19 Brief History of Compensation 19 2004 by The Cultural Phenomena 21 Modern History of Compensation 27 Lessons of the LBO 29 When Executives Become Owners 33 The Role of Boards in Compensation 35 Stock Options for Start-Ups and the Technology Revolution 38 A Skewed Incentive System 40 vii Copyright 2004 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use. 00_200295_FM_Delves 8/20/03 11:07 AM Page viii viii CONTENTS Chapter Three The Accounting Story 43 Behind the Scenes of the Accounting Debate 45 FASB’s Renewed Campaign 48 Measuring the Value of Options 51 Determining Fair Value 54 A New Chapter in the Story 58 PART TWO ELEMENTS OF THE SOLUTION 63 Chapter Four An Accounting Solution Everyone Can Live With 65 Accounting Rule Implications 67 Special Treatment for Start-Ups? 69 What Do You Think? 75 Bridging the Gulf 76 Chapter Five Valuing Options 81 Black-Scholes and Beyond 83 The Four Guiding Principles 88 The Purposes of Stock 91 What Do You Think? 92 The Transition to Expensing Options 93 Chapter Six Providing the Right Questions—and the Right Tools— for Boards 101 Board Members’ Concerns 102 The Tyranny of Competitive Data 104 Taking a Deeper Look 110 What Do You Think? 114 00_200295_FM_Delves 8/20/03 11:07 AM Page ix CONTENTS ix Chapter Seven Making Options Performance Based 117 Weighing Performance-Based Options 118 The Purpose of Options 119 Adding Performance Measures 120 Dealing with Underwater Options 122 Other Option Tricks 125 What Do You Think? 127 Bringing Balance to Executive Compensation 127 Chapter Eight Designing a Balanced Portfolio of Incentives 131 The Risk Decision 131 The Psychology of Risk 132 From Bureaucrats to Innovative Thinkers 133 Taking a Healthy Risk 134 The Balanced Portfolio Approach 136 The Benefit of Stock Ownership 142 A Revolutionary Stock Concept 143 What Do You Think? 144 Building a Balanced Incentive Program 145 Chapter Nine Building Healthy Employee-Employer Contracts for Public and Private Companies 149 An Unhealthy Contract 151 Lessons of the New Economy 154 Making Healthier Contracts 155 The Role of Compensation 156 The Role of Long-Term Incentives 161 The Private Company 162 What Do You Think? 164 Valuing People and the Purpose of the Corporation 164 00_200295_FM_Delves 8/20/03 11:07 AM Page x x CONTENTS PART THREE THE PATH TO ACCOUNTABILITY 169 Chapter Ten Restoring Corporate Integrity 171 Restoring Corporate Integrity: 9 Steps to a Healthier Organization 173 What Do You Think? 180 The Role of the CEO 180 Chapter Eleven Vision for the Future 185 The Power of the Corporate Executive 186 A Vision for the Future 187 Endnotes 193 Index 195 00_200295_FM_Delves 8/20/03 11:07 AM Page xi FOREWORD: A CONVERSATION BETWEEN DON DELVES AND PAUL VOLCKER, FORMER FEDERAL RESERVE CHAIRMAN When I set out to write this book, my topic was stock options. Specifically, my intent was to explore the much debated issue of expensing stock options. While that remains an essential theme of this book, it is impossible to address stock options without looking at the broader picture. Put another way, stock options are the trees; executive compensation and effective corporate governance are the forest. After completing this project, I am left with several compelling questions. What can we do differently? How can executive com- pensation become more balanced and healthier? What changes in corporate governance are necessary to ensure that independent- minded boards are better equipped to design and implement exec- utive compensation packages that are based on performance? How can ownership in a corporation be used as a reward after perfor- mance is demonstrated instead of as a perk that comes with the job? This then leads to the ultimate question: what is the purpose of the corporation and how is its success measured? Is the end goal of the corporation to serve its shareholders? If so, then the stock price would be the ultimate benchmark of its success.