Here's Your Stock. Here's the Catch...

A different way to accomplish that goal is with full-value grants, which can come in the form of restricted stock, performance units, or performance shares. As Adam explains, all do basically the same thing: Annually or periodically, an individual is given shares of stock in the company. “The shares are actually issued to you; you own them, and they are taxed as ordinary income,” he says. But you don’t really own them until they vest, usually after a period of three to five years.

For companies trying to hang onto valuable executives in a tough climate, the condition placed on restricted or performance shares may simply be that the individual stay with the company for a period of time—that is, until the shares vest. More often, the conditions take the form of targets that must be hit. The targets might relate to any number of performance factors, including return on equity, revenue goals, or stock performance relative to a company’s major competitors.   

Why the Shift?

Because stock options reward people (or don’t) based solely on what happens to the company’s share price, they have certain flaws as incentives. One problem is that options provide executives “with only upside rewards and no downside penalties,” says Kevin Nussbaum, president of CBIZ Human Capital Services in St. Louis. True, the option is worth nothing if the company’s stock doesn’t rise. But unlike the holder of restricted-stocks, the option holder doesn’t lose any tangible value that he once possessed. “With options,” Nussbaum says, “the executive has no skin in the game.”

Turner says that a big risk of overreliance on options as a part of compensation is that “you may pay a lot of the company’s economic value” to employees for reasons that have to do with market factors rather than with performance. “In a bull market, options can make money fall from the sky,” Turner says. “In the late ’90s, with the [Standard & Poor’s] growing at 20 percent a year, [option-laden] executives got rich in companies growing at 15 percent.” On the flip side, he says, in bear markets “[executives] can do all the right things for two years and still not see their stock price move.”

The heavy influence of market factors means that “how well did you do vs. your competition?” often is a better basis for rewards, Turner says: “Do we consider 15 percent a good growth rate if our competitors are growing at 30 percent?” Options don’t allow a company to set such conditions; restricted stock grants do.

For those reasons and others (including shareholder pressure and the bear market that began in 2000), experts say that options were losing some cache even before Financial Accounting Standard 123R reduced their accounting advantages. However, the new expense-reporting requirement had a dramatic effect. Turner points to an annual study of 350 large public companies conducted by Mercer and published by The Wall Street Journal. In 2000, the study found that 98 percent of the companies used stock options as part of executive compensation. By 2006, the number dropped to about 83 percent.