The Real IMPACT Of Stock Dilution by Aaron Brown and Brian Cumberland While the business press looks at the issue Typically, dilution is calculated by adding up all the of stock options from the executive pay and stock outstanding under employee stock plans and expensing angle, large investors are more con- any stock available for future awards under such cerned with options’ “overhang” impact—how plans. This is then divided by the company’s com- big mega-option plans could dilute their share mon shares outstanding. This overhang calculation holdings. The authors suggest that boards look is commonly used by investors, Wall Street analysts, beyond basic overhang measures to judge the company management, and corporate boards to help options’ true “IMPACT.” understand the impact of employee stock programs on shareholders. During the 1980s and 1990s, stock options were virtually an “inalienable right” for many workers Institutional investors today look far more throughout the U.S. This mind-set started with the closely at measures of whether a stock pro- investment community and spread to Corporate gram is excessive, liberal, costly or excessively America. Executives needed some tie to shareholders dilutive. and the best alternative from an accounting perspec- tive was stock options. Advisory groups are providing advice to insti- While shareholders rode the bandwagon of align- tutions on how to vote for company-sponsored ing management with themselves, the proportionate proposals to increase stock available for employee interest of their shares was being diluted, sometimes compensation programs. For example, Institutional as much as five percent or more annually. Not only Shareholder Services (ISS) weighs both shareholder did companies have to beat historical growth, but value transfer and voting power dilution, and overall they also had to beat the annual dilution from their dilution must be in line with industry norms with stock programs. Companies have traditionally been restricted stock counting more than options. Glass, motivated to use stock options since they bring no Lewis, & Co. and Investor Responsibility Research charge to earnings and, in most instances, are tax Center (IRRC) publish reports on corporate gover- deductible upon exercise. nance including opinions on whether a company’s This may all be about to change. stock program is excessive, liberal, costly, or exces- The organization responsible for setting account- sively dilutive. ing standards in the United States, the Financial How are institutions reacting to this dilution is- Accounting Standard Board (FASB) has proposed a sue? new standard governing the accounting for stock op- CalPERS, the large pension for teachers and tions. If the proposed standard is finalized by FASB, other civic workers in California, has flexed its vot- starting January 1, 2005, it would generally require ing muscle by voting down excessive increases in all options to be expensed at grant-date fair value, stock plans. CalPERS generally relies on ISS and and reflected on companies’ income statements. This is meant to more accurately reflect the impact Aaron Brown is a former Executive Compensation Practice of options on a company’s financial status. Leader and Brian Cumberland is Principal in Charge of One of the most widely used ways to determine KPMG’s Compensation and Benefits Practice in the U.S. stock plan dilution is the “overhang” calculation. Southwest Region. [www.kpmg.com] 18 NOVEMBER/DECEMBER 2004 THE CORPORATE BOARD THE REAL IMPACT OF STOCK DILUTION Overhang measures lack sophistication for Stock Dilution Surprisesmm m properly presenting the effect of stock options. Overhang Not The Same As IMPACT What is the actual impact of those plans on shareholders? Company Company A B However, it has become evident that overhang Common shares outstanding 100 100 lacks the sophistication for properly presenting stock option impact when a company has a volatile stock Options at $5 10 5 price. For example, suppose a company grants all its Options at $10 10 5 options with an exercise price of $80 and the stock is now trading at $10. None of the calculated option Total options outstanding 20 10 overhang would actually result in dilution until the Overhang 20% 10% company’s stock price recovered to above $80 per share, an increase of 800 percent in stock price. Current stock price $6 $20 An alternative way to view dilution from employee Current MCAP $600 $2,000 long-term incentive programs is to calculate the actual impact of those plans on shareholders. We call this Current IMPACT $10 $125 calculation “IMPACT Analysis.” The IMPACT to shareholders represents the actual Current IMPACT/MCAP ratio 1.7% 6.3% value of long-term incentive awards outstanding divided by market capitalization (MCAP) of the * IMPACT = (current stock price – option price) x number of options outstanding company (number of common shares outstanding times the current stock price). The value of long-term incentive awards outstanding is the sum of: IRRC for voting advice, but they also have their Options: What is known in the industry as “in own stipulations, such as limiting total awards for the money” value or “spread” (today’s stock price the “Top 5” executives to five percent of any broad- less option exercise price times the number of op- based stock plans. tions outstanding). TIAA-CREF looks carefully at any plans with Restricted stock: Each restricted share of stock over 15 percent dilution (overhang) or a two percent outstanding times today’s stock price. overall annual dilution run rate. Long-term cash programs: Stock Appreciate SWIB (State of Wisconsin Investment Board) Rights (SARs), phantom stock units, and cash plans supports plans with less than 10 percent overhang are valued using today’s stock price and performance and one percent annual run rate. They will also sup- to date. port up to 20 percent overhang for high performing The chart (above left) illustrates the differences companies. between overhang and IMPACT. The basic over- Putnam Investments will support an annual run hang calculation here suggests that shareholders rate of less than 1.67 percent and overhang of less of Company A will experience significantly more than 10 percent. dilution than Company B. Company A’s overhang Fidelity will vote against overhang over 10 is 20 percent, while Company B’s is 10 percent. In percent unless discussions with the company justify reality it is the other way around given the current the overhang. stock price. The IMPACT Analysis shows the true Vanguard Group looks critically at companies dilution is larger on Company B’s shareholders. Of with more than a 15 percent overhang or two percent Company B’s market capitalization, 6.3 percent is annual run rate. going to its employees, while only 1.7 percent of THE CORPORATE BOARD NOVEMBER/DECEMBER 2004 19 Aaron Brown and Brian Cumberland Effect Of Restricted Stockmm mmmt Same Overhang, Different IMPACT Dilution Company Company Company A B C Common shares outstanding 100 100 100 Options at $5 10 5 0 Restricted shares 0 5 10 Total awards outstanding 10 10 10 Overhang 10% 10% 10% Current stock price $6 $6 $6 Current MCAP $600 $600 $600 Current IMPACT $10 $35 $60 Current IMPACT/MCAP ratio 1.7% 5.8% 10.0% * IMPACT = (stock price – option price) x number of options outstanding Company A’s market capitalization is going to its IMPACT also provides a means to better understand employees. the potential dilution long-term incentive programs Overhang focuses only on the number of shares can have on shareholders in the future. Multiples given to employees, without considering whether of today’s stock price (.25x, .5x, .75x, 2x, 5x, 10x, employees must purchase those shares, or if the shares etc.) can be used to calculate future IMPACT to are an outright award. IMPACT Analysis recognizes shareholders given certain assumptions on future that options have a different effect on shareholders stock price performance. than do shares of restricted stock. On a share basis, the dilution value of options is generally less than the dilution value of restricted stock. If all long-term incentives have a similar charge For comparison purposes, we analyzed the S&P 500 to earnings for their targeted value, compa- using both typical overhang and IMPACT on dilution nies can use the most appropriate incentives to shareholders. The difference between overhang without fear of being penalized. and the IMPACT calculation across industries and even between companies within the same industry Overhang, FASB’s expense model, and IMPACT can be staggering. should all be used in conjunction to gain a better Different industries show major differences in picture of how a company’s long-term incentive IMPACT calculations. For example, the high- program is affecting shareholders. FASB is on the technology industry has generally high overhang right track with its goal of expensing all types of values—but lower IMPACT ratios—than the oil long-term incentives including options. If all long- and gas industry. term incentives have a similar charge to earnings 20 NOVEMBER/DECEMBER 2004 THE CORPORATE BOARD THE REAL IMPACT OF STOCK DILUTION Different Industries, Different Dilutionsmmmmmmmmmmmn Overhang And IMPACT In The High-Technology And Oil & Gas Industries 30% 25% Overhang 20% 15% Overhang % Dilution 10% 5% IMPACT IMPACT 0% High-Technology Oil & Gas Industry Industry 10% 9% Information Technology Industry 8% Oil & Gas Industry 7% 6% 5% 4% 3% 2% 1% IMPACT IMPACT Market Cap Ration 0% 0.5x .075x 1x 1.5x 2x 3x 4x 5x Stock Price as a Multiple of 12/31/2002 Price THE CORPORATE BOARD NOVEMBER/DECEMBER 2004 21 Aaron Brown and Brian Cumberland for a targeted incentive value, then companies can should be aware that long-term incentives outstand- use the appropriate incentive without fear of being ing will have a fully dilutive effect because of either penalized for not using options.