Journal of Applied Corporate Finance

S U M M E R 2 0 0 1 V O L U M E 14 . 2

Option-Based Compensation: Panacea or Pandora’s Box

by Stuart L. Gillan,
TIAA-CREF Institute
OPTION-BASED
COMPENSATION:
PANACEA OR
PANDORA’S BOX?
uring the past decade, investors have
D become increasingly concerned about
the proliferation and size of stock option
plans. Shareholder concerns center on
four main issues. First, the cost of option-based
compensation may exceed the associated benefits,
resulting in excessive transfers of wealth from share-
holders to optionholders. Second, the current ac-
counting for and disclosure of option-based com-
pensation may not be adequate for valuation pur-
poses. Third, although many companies submit
option plans to a shareholder vote, it appears that
some companies may use exchange and market rules
to avoid the shareholder approval process. Given the
potential for stock option plans to transfer large
amounts of wealth from shareholders to optionholders,
the ability of shareholders to vote on option plans is
seen as a critical corporate governance issue.
Fourth and finally, with recent stock-price de-
clines, many employees now hold out-of-the-money
or underwater options. In order to retain and moti-
vate employees, some corporations have responded
by repricing or replacing underwater options with
new grants. This replenishment has raised share-
holder concern that the practice effectively rewards
employees for failed performance, and that repricing
undermines the rationale for using options as incen-
tive compensation in the first place.
Along with increased shareholder concern has
been an increase in the perceived importance of
human capital—employees—in determining corpo-
*An earlier version was presented at the TIAA-CREF Institute Corporate
Governance Forum 2001: Executive Compensation, Stock Options, and the Role
of the Board of Directors. I would like to thank John Ameriks, Ken Bertsch, Jennifer
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BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE
by Stuart L. Gillan, TIAA-CREF Institute*
rate profitability and shareholder returns at many
companies. Proponents of option-based compensa-
tion argue that it aligns employee and shareholder
interests. Moreover, it has been suggested that options
are critical not only in motivating and retaining
employees, but also in fueling economic growth. It is
difficult, however, to measure the benefits of compen-
sating employees with stock options.
Similarly, assessing the cost of stock options can
be complex. Although an economic transfer from
shareholders to employees takes place at the time an
option is granted, the option exercise occurs some
time in the future. This raises the issue of how to
measure the potential wealth transfer from share-
holders to optionholders resulting from option grants.
One approach is to develop an estimate of the
expected value transfer at the time of the grant—
using dilution measures or option pricing tools.
Alternatively, given sufficient disclosure in corporate
financial statements, one could focus on actual
option exercises and measure the realized value
transfers.
Although recognizing that there are potential
benefits of option-based compensation, the primary
focus of the paper is on (1) measuring the “cost” of
option-based compensation, (2) management actions
to deal with underwater options, and (3) share-
holder concerns about the use of stock options.
Shareholder concerns suggest that the use of option-
based compensation will continue to be a hot-button
corporate governance issue.
Bethel, Jay Hartzell, Jacob Rugh, Lelia Stroud, and Mark Warshawsky for helpful
comments and discussions. The opinions expressed in this article are those of the
author and not necessarily those of TIAA-CREF or its employees.
DILUTION
One of investors’ primary concerns about stock
option plans is the extent to which shareholder value
may be diluted—that is, transferred to optionholders.
This section examines several dilution measures that can
be used to benchmark the potential value transfers.
While commonly used, dilution measures implicitly
assume that each option granted will be exercised when
it is deep in-the-money. That is, the dilution measures
assume that the exercise price will be paid in exchange
for a share of stock with a much higher market value. The
actual value transfer from shareholders to optionholders
will depend on the difference between the option
exercise price and the market price of the share at
exercise. This section illustrates how dilution measures
provide an upper bound on the potential cost. Alternate
approaches to dilution are discussed later in the paper.
The term dilution is used in a number of different
ways in different contexts. Basic Dilution provides an
overall measure of dilution from stock options by
dividing options granted during a year by the number
of shares outstanding at year-end. Full Dilution esti-
mates the portion of the current shareholders’ value
transferred to employees if employees exercise their
options. Full Dilution recognizes that on exercise there
are additional shares outstanding. Potential Dilution,
often referred to as the option overhang, which can be
measured either in Basic or Full terms, incorporates the
number of options the company has available for
grant into the numerator of the dilution calculation.
EXAMPLE 1: MEASURES OF DILUTION
Suppose a company has 100 shares outstanding
and a current price of $30. Some time ago the
company granted employees 16 options, and the
company has an additional 16 shares available to
grant as options.
BASIC DILUTION
= (options granted / current shares outstanding)
= (16/100)
= 16%.
POTENTIAL BASIC DILUTION
= ([options granted + options available for grant]/
current shares outstanding)
= (32/100)
= 32%.
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JOURNAL OF APPLIED CORPORATE FINANCE
Once the options are exercised the company will
have 116 shares outstanding. Each share has an
equal claim on the company’s assets.
THE FULL DILUTION IS:
= (options granted/ [current shares outstanding +
options granted + options outstanding])
= (16/(100+16+0))
= 13.8%
The original shareholders owned 100% of com-
pany prior to exercise, but only 86.2% after exer-
cise (100 shares out of 116).
POTENTIAL FULL DILUTION
= ([options granted + options available for grant] /
[current shares outstanding + options granted +
options available for grant])
= (32/132)
= 24.2%.
Note that Potential Dilution can be measured
using Basic and Full approaches by adding shares
available for grant to the options granted in each
calculation.
Suppose that the company issues an addi-
tional 10 options. The company has 100 shares
outstanding, 16 options from the original grant,
and 10 newly granted options. The potential
wealth transfer resulting from the new grant is
borne by current shareholders and current
optionholders.
Following the Potential Dilution example,
current shareholders own 100 shares, so 100 /
[100 + 16 + 10 ] represents the proportion of the
potential transfer from shareholders to new grant
recipients. Similarly, with 16 current
optionholders, 16 / [100 + 16 + 10] represents
the magnitude of the potential transfer from cur-
rent optionholders to new grant recipients.
To provide a perspective on how the examples
work in practice, Table 1 reports on option granting
activity at Microsoft during 1999. The Full Dilution
resulting from the new options granted is 1.32%. Put
another way, the 1.32% Full Dilution represents the
portion of the company that new optionholders may
TABLE 1 DILUTION AT MICROSOFT
The table reports measures of Basic and Full Dilution for Microsoft during Fiscal 1999. Shares outstanding is reported as of fiscal
year-end. Option activity is as reported in Microsoft’s 1999 10-K. Note that options outstanding of 766 million include the current
year grant of 78 million options.
Options (millions) Basic Dilution Full Dilution

Granted 78 (78/5,141) = 1.52% 78/(5,141 + 766) = 1.32%

Outstanding 766 (766/5,141) = 14.90% 766/(5,141 + 766) = 13.14%
Available 980 (980/5,141) = 19.06% 980/(5,141 + 766 + 980) = 14.23%
Potential Dilution 1,746 (1,746/5,141) = 33.96% 1,746/(5,141 + 766 + 980) = 25.35%
Shares Outstanding 5,141

TABLE 2 BASIC DILUTION IN A LARGE SAMPLE

The table reports summary statistics on Basic Dilution for a broad set of U.S. companies tracked by the IRRC. The sample comprises
the S&P 1,500 and approximately 500 other companies with broad institutional ownership. Basic Dilution is measured in percentage
terms as 100 × (Options/Shares outstanding as at year-end.) Statistics for potential dilution are reported only for companies where
shares available for grant at year-end can be determined. Options Available for Potential
Grants Grants Grants Outstanding Grant at Dilution
1997 1998 1999 1999 year-end 1999 1999
Average 2.70 2.98 2.85 9.00 4.79 13.93
Median 1.67 1.78 1.94 7.65 3.42 11.83
95th Percentile 8.87 10.03 8.61 21.06 9.62 31.41
Number of Companies 1,517 1,589 1,655 1,680 1,340 1,340
Source: Author’s calculations based on IRRC data.

ultimately receive. However, as noted in the hypo-
thetical example, the dilution falls on shareholders
and optionholders.1 The optionholders prior to the
new grant face a potential value transfer in the
proportion of: [688/(766 + 5,141)] = 11.7%. Share-
holders prior to the new grant face a potential value
transfer in the proportion of: [5,141/(766 + 5,141)] =
87%. For this reason, current shareholders have not
really given away a full 1.32% of their wealth in the
company. Rather current shareholders face a poten-
tial wealth transfer of around 1.17% of the value of
the company—their 87% “share” of the 1.32% Full
Dilution.
Dilution in a Broad Sample of Companies
To examine the issue of dilution further, the
following table reports measures of dilution and
potential dilution using Basic Dilution (options as a
percentage of shares outstanding) for a large sample
of U.S. companies. The sample is based on a set of
companies tracked by the Investor Responsibility
Research Center (IRRC) that includes the S&P 1,500
and approximately 500 other companies with broad
institutional ownership. Complete 1999 data for this
analysis was disclosed by 1,680 companies. Table 2
reports summary statistics on Basic Dilution for the
1,680 companies, including option grants in each year
1997-1999, options outstanding at the end of 1999,
options available for grant, and potential dilution.
The “Run-rate” (sometimes referred to as the
option “burn-rate”) is annual option grants as a
percentage of shares outstanding. A constant or
declining run-rate may indicate a stable compensation
policy, whereas an increasing run-rate is likely to
indicate increasingly aggressive granting of options.
As shown in Table 2, in 1999 companies on
average granted options equal to 2.85% of shares
outstanding, an increase from 2.7% in 1997. Median
grants exhibit an increasing trend from 1.67% in 1997
to 1.94% by 1999. Median grant levels are somewhat
lower than the average, suggesting that companies
with a higher level of option use raise the average.
Some companies were particularly aggressive in
their option granting practices, with those at the 95th
percentile making annual grants in the 8.6-10%

1. Jennifer Carpenter and David Yermack (2001) “Dilution from stock-based

compensation,” working paper, New York University.

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VOLUME 14 NUMBER 2 SUMMER 2001
range. At the end of 1999, the average level of
options outstanding as a proportion of shares out-
standing was 9% (median 7.65%.) At the upper end
of the distribution, the company at the 95th percen-
tile had options outstanding equal to over 21% of
current shares outstanding.2
The last two columns of Table 2 report on shares
available for option grants and potential dilution (the
total of shares available for grant and options
outstanding) for the three-quarters of the sample for
which the required information is available. Each
measure is reported as a percentage of year-end
shares outstanding. Comparing shares available for
grant to past grants indicates that companies had
between one and two years’ worth of option grants
on hand. This could provide an indication as to
whether or not the company is running out of shares
for option grants, and at what point the company
may need to adopt additional option plans.
Table 3 provides perspective on how grant
practices vary across industries by reporting industry-
level Basic Dilution. Industry groups are based on 2-
digit SIC codes. Table 3 reports option activity for three
industries with a low use of option grants, and three
industries with a high use of option grants. There is
considerable variation in grant practices across indus-
tries, with Electric, gas and sanitary services at the low
end of the scale and Engineering and management at
the high end. The median level of dilution from prior
grants (options outstanding) ranges from 2.35% to
13.78%. Median grants during 1999 ranged from 0.88%
to 5.03%, and dilution from options outstanding at the
95th percentile ranges from 9.8% to 26.91%.
There is also substantial variation in grant practices
among companies in the same industry. For example,
the median company in the Food stores industry had
dilution from 1999 grants of 1.28% and options outstand-
ing of 4.25%. In contrast, the company at the 95th
percentile in Food stores had 1999 grant dilution at
4.42% and options outstanding equal to 15.63%.
Estimated Value Transfers of Option Grants
Whereas dilution measures provide a basis for
benchmarking option use, the issue quickly turns to one
of the “cost” to shareholders. Although the dilution
measures discussed above provide estimates of the
2. By way of comparison, John Core and Wayne Guay (2001) “Stock option
plans for non-executive employees,” forthcoming Journal of Financial Economics,
report average options outstanding during the 1994-1997 period of 6.6% (median
5.2%) for a large sample of firms.
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JOURNAL OF APPLIED CORPORATE FINANCE
upper bound of potential wealth transfers from share-
holders to optionholders (as a proportion of the equity
that optionholders may ultimately receive), option
pricing tools are typically used to estimate the dollar
value of grants, which may then be benchmarked
against market values. Typically, the deeper in-the-
money the options are, the closer they are economically
to a share of stock. This implies that if the majority of
options are deep in-the-money, the potential value
transfer can be approximated by Full Dilution. To the
extent that options are not deep in-the-money, value
estimates as a proportion of current market value will be
lower than the Full Dilution.
To illustrate, during 1999 Microsoft reported grants
of 78 million options to employees. The estimated value
transfer at the time of grant (explained later in this
section) amounted to about $967 million, representing
approximately 0.2% of Microsoft’s 1999 year-end market
value. This is an estimate of the expected value transfer
at the time of grant, based on assumed inputs and the
Black-Scholes option pricing model. Consequently, the
estimates are subject to criticisms of the model and the
inputs used. For example, option pricing models are
designed to value exchange-traded options, not em-
ployee stock options. Employee stock options typically
have a much longer maturity than exchange-traded
options, vesting restrictions, non-transferability features,
and other characteristics that may imply different valu-
ations relative to exchange-traded options. Moreover,
there is evidence that employees tend to exercise
options early, sacrificing a significant portion of the
value. On the other hand, many employee stock options
in practice have value-enhancing features not captured
by standard option pricing models. For example, em-
ployee stock options are American options (which
permit exercise before the expiration date), whereas the
standard Black-Scholes model is designed to value
European options (which can be exercised only on the
expiration date). Some employee stock options also
have reload features or may ultimately be repriced,
which enhances their value relative to estimates using
standard option pricing models. Similarly, at least for
some employees, informational advantages may add
substantial value by permitting “fortuitous” timing of
option grants and exercises.3 Moreover, it has been
suggested that, although option pricing approaches
may provide an estimate of the potential cost to
3. David Yermack (1997) “Good timing: CEO stock option awards and
company news announcements,” Journal of Finance 52, 449-476.
 Whereas dilution measures provide a basis for benchmarking option use,
the issue quickly turns to one of the “cost” to shareholders.

TABLE 3 INDUSTRY-LEVEL BASIC DILUTION

The table reports summary statistics on Basic Dilution for selected industries. Industry groups are based on 2-Digit SIC codes. Basic
Dilution is measured in percentage terms as 100 × (Options / Shares outstanding as at year-end.) Panel A reports on three industries
with low levels of options outstanding relative to other industry groups. Panel B reports on three industries with high levels of
options outstanding relative to other industry groups.
Options Available for Potential
Grants Grants Grants Outstanding Grant Dilution
1997 1998 1999 1999 1999 1999

PANEL A: LOW OPTION-USE INDUSTRY GROUPS

DEPOSITORY INSTITUTIONS
Mean 1.51 1.56 1.57 5.77 4.24 10.24
Median 1.16 1.20 1.22 4.39 2.72 8.59
95th Percentile 3.74 5.63 4.74 13.01 14.98 23.90
Number of companies 85 92 91 94 72 72
ELECTRIC, GAS, AND SANITARY SERVICES
Mean 1.08 1.18 1.47 3.84 3.58 8.23
Median 0.51 0.57 0.88 2.35 3.12 6.45
95th Percentile 4.03 2.96 4.15 9.80 11.83 18.96
Number of companies 59 69 80 84 53 53
FOOD STORES
Mean 1.55 1.45 1.53 5.14 1.82 6.94
Median 0.85 1.02 1.28 4.25 1.74 6.19
95th Percentile 4.01 5.96 4.42 15.63 3.42 17.60
Number of companies 8 9 9 9 8 8
PANEL B: HIGH OPTION-USE INDUSTRY GROUPS
SECURITY, COMMODITY BROKERS, AND SERVICES
Mean 2.69 2.85 3.09 10.38 8.23 18.1
Median 2.2 2.14 2.43 9.35 4.93 14.26
95th Percentile 10.37 6.97 9.1 19.7 40.87 49.86
Number of companies 19 21 23 23 18 18
BUSINESS SERVICES
Mean 5.64 6.03 5.40 13.96 6.42 20.40
Median 3.98 4.53 4.28 12.51 4.62 19.14
95th Percentile 18.04 14.99 13.04 25.56 20.62 41.49
Number of companies 144 154 165 165 136 136
ENGINEERING AND MANAGEMENT SERVICES
Mean 4.29 4.61 5.61 14.03 5.45 19.83
Median 3.33 3.80 5.03 13.78 6.19 18.72
95th Percentile 9.82 15.04 13.24 26.91 13.24 38.88
Number of companies 20 20 19 19 15 15

shareholders, risk-averse employees typically assign
a much lower value to the option grant.4 There are also
other potential, if even more difficult to quantify,
costs. For example, options may provide senior
managers with incentives to increase risk or reduce
dividend payments, which may not be in the interest
of shareholders.
Despite such criticisms, the use of option pricing
tools provides a useful alternative approach in
benchmarking the level of expected value transfers
from shareholders to optionholders. To illustrate the
application of option pricing techniques, the remain-
der of this section follows the approach of Michael
Mauboussin to value option grants at Microsoft.5

4. Brian Hall and Kevin Murphy (2000) “Stock options for undiversified 5. Michael Mauboussin (1998) “A piece of the action: employee stock options
executives,” NBER working paper 8052. in the new economy,” Frontiers of Finance, Credit Suisse First Boston.

119
VOLUME 14 NUMBER 2 SUMMER 2001
 Using the Black-Scholes option pricing formula,
and the company’s assumptions for volatility, risk-
free rate, average exercise price ($54.62), and
weighted-average option life (6.2 years), the base
estimate of the value transfer from options grants on
78 million shares during 1999 is $1.78 billion. Note,
however, that as employees leave the company and
their options expire, options are cancelled. Cancel-
lations at Microsoft have averaged around 3.3% of
options outstanding per year. Using 3.3% as an
estimate of the rate of future cancellations, the value
transfer estimate declines to $1.71 billion.6
As noted in the earlier examples, if a company
has significant stock options outstanding, the value
transfer resulting from new grants is from sharehold-
ers and current option holders. With 5.14 billion
shares outstanding and 688 million options granted
in prior years, Microsoft notionally has 5.83 billion
shares with a potential claim on earnings.7 After the
new grant of 78 million options, Microsoft notionally
has 5.91 billion shares with a potential claim on
earnings. Thus, future cash flows will flow to current
shareholders in the proportion of (5.14/5.91= 87%)
and to current optionholders in the proportion of
(0.69/5.91=12%).8 By implication, when new op-
tions are granted, both current shareholders and
current option holders are diluted. The value transfer
from current shareholders is 87% of $1.71 billion, or
approximately $1.49 billion.
Finally, for tax purposes, Section 422 of the
United States Internal Revenue Code allows compa-
nies to expense the difference between the market
price and the exercise price when employees exer-
cise their options.9 Assuming that the tax benefit is
the tax rate of 35% multiplied by the estimated value
transfer, the estimated after-tax value transfer from
incumbent shareholders is $967 million, which is
approximately 0.2% of Microsoft’s year-end market
value. Recall from the earlier analysis that the Full
Dilution approach resulted in an estimated value
transfer of 1.17% of market value. The option pricing
approach captures the fact that new grants are not
deep in-the-money and provides a lower estimate of
the expected value transfer.
There is considerable debate about how to
measure the value transfers resulting from option
6. Ideally we would like to estimate cancellations as a proportion of annual
grants.
7. All numbers have been rounded for ease of exposition.
8. This provides an upper bound as not all options outstanding are “in-the-
money.”
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JOURNAL OF APPLIED CORPORATE FINANCE
grants. This debate spans a number of issues,
including the legitimacy of using standard option
pricing models and the appropriate time to estimate
or measure value transfers (whether at grant date,
vesting date, or exercise date). There is also vigorous
debate as to whether or not any estimates should be
treated as an expense in the income statement. The
next section focuses on an alternative to using option
pricing models at grant date by examining realized
value transfers on option exercise.
Realized Value Transfers
The value transfer approach based on an option
pricing model is, by its nature, a forward-looking
exercise. Moreover, the focus is on grant-date esti-
mates of the potential value transfer. An alternate
approach is to use information at the time of exercise
to measure realized value transfers. This section first
presents examples of measuring realized value trans-
fers, and then examines realized value transfers in a
large sample.
Illustrating Realized Value Transfers
EXAMPLE 2: VALUE TRANSFER
Suppose that a company has 100 shares outstand-
ing and assets of $3,000. Some time ago the com-
pany granted employees 16 options with an exer-
cise price of $10. On exercising their 16 options,
employees pay the company the $10 exercise price
per share for a total of $160. The $160 cash pay-
ment increases the company’s assets to $3,160,
and shares outstanding increases to 116 as employ-
ees receive 16 shares. Each share has an equal value
of ($3,160/116) = $27.24.
CASE 1: LARGE MARKET VALUE INCREASE SINCE
GRANT DATE
The employees’ net gain:
= (value of shares acquired – total exercise price
paid)
= ([16 shares @ $27.24] – $160) = $276.
9. Under IRS regulations, some options do not qualify for tax deductions. To
the extent that such options are granted by companies, calculations using the
reported tax benefit will understate the potential value transfer.
 There is considerable debate about how to measure the value transfers
resulting from option grants.
The value transfer from the original share-
holders:
Value before exercise – Value after exercise
=$3,000 – (100 shares @ $27.24)
= $3,000 – $2,724 = $276
= ($276/$3,160), or 8.7% of the market value of the
firm.
CASE 2: ENORMOUS MARKET VALUE INCREASE
SINCE GRANT DATE
If the value of the firm prior to exercise were to
increase to say, $1,000,000, then on exercise each
outstanding share would be worth ($1,000,160/
116) = $8,622.07.
The employees’ net gain:
=(value of shares acquired – total exercise price
paid)
= ([16 shares @ $8,622.07] – $160) = $137,793.
The value transfer from the original shareholders:
Value before exercise – Value after exercise
= $1,000,000 – (100 shares @ $8,621.69)
= $1,000,000-$862,169 = $137,793.
= ($137,793/$1,000,000), or 13.8% of the market
value of the firm.
As in the earlier dilution examples, any subse-
quent option issuance transfers value from cur-
rent shareholders and current optionholders to
new grant recipients.
The realized value transfer of $276 in Case 1 of
Example 2 equates to 8.7% of the market value of the
company on the exercise date (which includes the $160
employees pay to exercise their options). In Case 2, where
the market value of the company increased dramatically,
the wealth transfer was 13.8%. The potential value
transfer is capped at the level of Full Dilution, in this case
13.8% of the market value on the exercise date.
As noted earlier, for tax purposes companies are
permitted to expense the difference between the
market price at exercise and the option exercise
price. As a result, companies may report the associ-
ated tax savings in their financial statements. For
10. It has been suggested that the tax disclosures are “hard to come by” and
are not plainly visible in the income statement, see Jack Ciesielski (2000) “1999 S&P
500 stock compensation: The fluff grows,” The Analyst’s Accounting Observer.
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VOLUME 14 NUMBER 2
example, Microsoft reported in its 1999 10-K a tax
saving associated with option exercises of $3.1
billion. The tax saving is equal to the tax Microsoft did
not pay—that is, the tax rate multiplied by the difference
between the market price and the exercise price (0.35
× (Market price – exercise price) = $3.1 billion). This
implies that the pre-tax amount was ($3.1 billion/0.35)
= $8.86 billion, or $5.76 billion after tax. This $5.76 billion
after-tax figure amounts to a realized value transfer equal
to 1.25% of Microsoft’s year-end market value.
Realized Value Transfers in the S&P 500
Table 4 reports realized value transfers for S&P 500
firms during the period 1997-1999. Note that the tax
benefit from stock option exercise was readily available
for less than one-third of all S&P 500 firms each year.10
Panel A of Table 4 focuses on after-tax value transfers as
a percentage of year-end market value. Assuming a tax
rate of 35%, the median estimated after-tax value transfer
each year from option exercises ranges from 0.38% to
0.44% of market value, with an increasing trend during
the period. Average values are somewhat higher, in the
range of 0.58%-0.62% range. In Panel B the emphasis is
on measuring the aggregate value transfers at the sample
companies. These aggregates, which would contrib-
ute to any economy-wide measure of labor costs,
range from $11.9 to $28.4 billion while averaging
$19.7 billion a year during the three-year period.
These value transfers reflect exercises of past option
grants. It would seem reasonable to “allocate” a
portion of the realized value transfer to prior years
rather than view this as the “cost” of stock options in
a particular year. Nevertheless, measuring realized
value transfers over time is analogous to measuring
option run-rates; it provides an indication of annual
realized value transfers, and may suggest a trend.
To evaluate the potential value transfers in the time
between grant and exercises, one could take the follow-
ing approach: At grant dates, use an option pricing model
to estimate the value transfer and the sensitivity of options
granted (and outstanding) to the price of the underlying
stock. As the stock price changes, estimate the change
in the value of the options, and the resulting increase or
decrease in the expected value transfer. Upon exercise
there could then be a reconciliation between the current
estimate and the realized value transfer.
SUMMER 2001
 Stock-based compensation is viewed by many as being a critical component of
compensation programs with many potential benefits.

TABLE 4 REALIZED VALUE TRANSFERS AT S&P 500 COMPANIES

The table reports on estimated realized value transfers at approximately 162 S&P companies for which information on tax
benefits from option exercise was available. Panel A reports on the after-tax value transfer as a proportion of current stock
market value. Panel B reports on the aggregate dollar amount of the after-tax value transfers.

PANEL A: AFTER-TAX VALUE TRANSFERS AS A PERCENTAGE OF MARKET VALUE

1997 1998 1999 3-year Average
% % % %

Mean 0.58 0.62 0.54 0.58

Median 0.38 0.40 0.44 0.41
Number of companies for which 155 161 162
tax benefit information is available
PANEL B: AGGREGATE AFTER-TAX VALUE TRANSFERS $ BILLION
1997 1998 1999 3-year Average
Tax benefit 6.4 10.1 15.3 10.6
Implied cost 18.4 28.9 43.7 30.4
Implied after-tax cost 11.9 18.8 28.4 19.7
Number of companies for which 155 161 162
tax benefit information is available
Source: Author’s calculations based on data from FACTSET and The Analyst’s Accounting Observer.

Although we can estimate value transfers, such
estimates are imprecise by virtue of both the informa-
tion available and the limitations of the models used.
Many companies disclose information on option
grants only in 10-K reports, which typically are
available after fiscal year-ends and announcements of
fourth quarter earnings. Inevitably, the question then
arises as to whether option related disclosures are
timely and relevant for investment decision making.
GENERAL DISCLOSURE ISSUES
Under Generally Accepted Accounting Prin-
ciples (GAAP) and Securities and Exchange Com-
mission (SEC) requirements, two main types of
option-based compensation disclosure are required
in corporate financial statements.11 The first set of
disclosures requires an estimate of compensation
costs at grant date. The second set requires a three-
year summary of option granting activity.12
The primary accounting rule governing ac-
counting for stock options is SFAS 123. Under SFAS
123 companies must either take a charge to income
or, as almost all do, provide additional footnote
disclosures reporting net income and earnings per
share as if the costs had been charged to income.
(The as-if estimates are referred to as “pro-forma”
disclosures.) Companies are granted considerable
latitude in making assumptions about inputs into
option pricing models, including the expected life of
the option, stock price volatility, dividend yield, and
the risk-free rate. Although such assumptions must
be fully disclosed, different assumptions can lead to
quite different estimates of the cost of stock options.
Companies can then allocate estimated costs over the
expected life of option grants; that is, only a portion
of the current year’s option grant is treated as an
expense in the current fiscal year’s as-if estimates of
net income and earnings per share. The portions of
the estimated costs from prior grants allocated to the
current fiscal year are also included in the as-if
estimates of net income and earnings per share.
The value of prior-year grants is not updated to
reflect changes in the market price of the stock,
which suggests that, everything else being equal, the
footnote values may over- or under-estimate the

11. This discussion relates to company-wide option disclosures, and not 12. In addition, under SFAS 128, Earnings per Share, in-the-money options are
specifically those required for senior executives under the proxy rules. considered to be shares outstanding when calculating the number of shares to
determine diluted earnings per share. Options “at-the-money” or “out-of-the-
money” do not result in EPS dilution.

122
JOURNAL OF APPLIED CORPORATE FINANCE
 Companies with options deep underwater face pressure to reprice to address
employee incentive and retention concerns.
“costs” conditional on the change in the stock price
since the grant date. Recent research suggests,
however, that perhaps “everything else” is not equal
when it comes to the accounting estimates of option
grants. For example, a 1998 study by David Yermack
reports that companies choose methods that tend to
minimize the reported value of option grants.13
The three-year summary of option activity in-
cludes a statement of options: (1) outstanding at the
beginning of the year, (2) outstanding at the end
of the year, (3) exercisable at the end of the year,
(4) granted, (5) exercised, (6) forfeited, or (7) expired
during the year. Specifically, for each item compa-
nies are required to disclose the number of options,
a “meaningful” range of exercise prices, and a
weighted-average exercise price for each range.
Additional information is required for options out-
standing and options currently exercisable (items
(2) and (3) above.) This additional disclosure entails
a breakdown into finer price ranges, with the number
of options, weighted-average exercise price, and
weighted-average remaining contractual life reported
for each price range. Finally, the number of shares
represented by in-the-money options must be added
to the number of shares outstanding when reporting
fully diluted earnings per share.14
SEC rules also require disclosure of the material
features of a compensation plan in the proxy statement
when it is submitted to shareholders for approval.
However, the disclosures need only relate to the plan
being voted on, not all plans at the company. Thus,
shares available for grant under all company plans may
be difficult to ascertain. The SEC currently has a release
out for public comment on this issue. Proposed changes
include the disclosure of shares available for grant under
all stock option plans and an indication as to whether
or not each plan was approved by shareholders.15
In the section on Realized Value Transfers earlier
in the paper, disclosures of the tax benefit associated
with option exercises were used to estimate realized
value transfers. However, not all companies have this
information readily available. In the earlier analysis, tax
information was readily available for only one-third of
13. David Yermack (1998) “Companies’ modest claims about the value of CEO
stock option awards,” Review of Quantitative Finance and Accounting, 10, 207-226
14. Under the “Treasury Stock” method, the number of shares subject to option
included in fully-diluted shares outstanding can be reduced by the number of shares
that could be purchased with the exercise proceeds. See John Core, Wayne Guay
and S.P Kothari (2001) “The economic dilution of employee stock options: diluted
EPS for valuation and financial reporting,” working paper, Wharton School,
University of Pennsylvania.
123
VOLUME 14 NUMBER 2
the S&P 500 companies studied. Similarly, in a sample
of 15 of the largest companies in the NASDAQ 100 index,
Bear Stearns’ analysts found explicit disclosures on the
tax benefit from option exercise for only six of the 15.
For another five companies the analysts were able to
estimate a tax benefit from other disclosures. Two
companies had insufficient information available to
ascertain the tax benefit.16 It is apparent that companies
have some leeway in determining if, and how, they
disclose the tax benefit information. And, in July 2000,
the FASB’s Emerging Issues Task Force (EITF) reached
a consensus in support of improved disclosure of the tax
benefit in the statement of cash flows.
SHAREHOLDERS AND CORPORATE
GOVERNANCE CONCERNS: PANDORA’S BOX
As noted earlier, this paper focuses on the
“costs” of stock options. But this focus is not meant
to imply that options have no benefits. Rather it is an
acknowledgement that the benefits of option-based
compensation are difficult to measure. Stock-based
compensation is viewed by many as being a critical
component of compensation programs with many
potential benefits. Such benefits may include:
Incentive effects: Stock options may align em-
ployee interests with those of shareholders. If an
employee holds stock options, then the value of those
options increases as the stock price rises. Employees
with significant amounts of options have a strong
incentive to work to increase company value; that is,
employee and shareholder incentives are aligned.
Employee retention: Stock options may help
companies retain employees, particularly in a com-
petitive labor market. Fresh option grants over time
create incentives for employees to stay, especially
when options are in-the-money and close to vesting
or when employees must forfeit options when
leaving the company.
Financing: To the extent that options are substi-
tuted for other forms of compensation, they may
reduce other labor costs, conserve cash, and provide
a form of contingent financing for the company. 17
15. SEC Release No. 34-43892, Jan. 26, 2001, Disclosure of Equity Compensa-
tion Plan Information Reference: File No.: S7-04-01.
16. See Pat McConnell, Janet Pegg, and David Zion (2000) “Accounting issues:
Employee stock options,” Bear Stearns Equity research, Accounting and Taxation.
17. Edward Lazear (1999), “Output-based pay: incentives or sorting?” NBER
working paper 7419.
SUMMER 2001
FIGURE 1 20
AVERAGE VOTES CAST 18
AGAINST STOCK OPTION

Average % Vote “Against”

PLANS 1988-1999 16
14
12
10
8
6
4
2
0
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Year

Source: Based on IRRC reported voting results.

Ultimately option-based compensation stock options to directors, officers, or employees in

should be used only so long as it increases the amounts that are less than 5% of outstanding
market value of the firm. That is, the economic common shares as routine. Although the NASD
benefits of option-based compensation should does not currently have a parallel rule governing
exceed the economic costs. It is also important to broker voting, many NASD brokers, who are also
consider what types of companies are likely to members of the NYSE or Amex, vote uninstructed
benefit from option-based compensation, the shares of NASDAQ-listed firms for beneficial own-
types of employees that should receive option- ers. As a result, some companies will seek authori-
based compensation, and the extent to which zation for option plans by requesting a number of
companies should use option-based compensa- shares less than or equal to 5% of current shares
tion. These questions in turn raise issues as to the outstanding.
role of shareholders in approving option plans, There is compelling evidence that brokers vote
the basis for their decisions, and any sharehold- in favor of management proposals, and, further, that
ers’ concerns about the use of option-based the level of broker votes can be significant—often
compensation. 10-15% of shares outstanding.18 Thus, for some
companies, “shareholder approval” of an option
Shareholder Voting plan may hinge on votes cast by brokers in favor of
the management proposal. The use of broker votes
Depending on a stock option plan’s character- to pass stock option plans has been characterized by
istics, companies may need to seek shareholder some as “ballot stuffing,” and is of concern to
approval. In doing so, however, some companies shareholders given high potential dilution at some
appear to “game the system” by taking advantage companies.19 One indication of general shareholder
of exchange rules to garner votes. Specifically, if concern about stock option plans is illustrated in
beneficial owners fail to vote their shares or to Figure 1, which shows the rising average percentage
provide voting instructions on some management of votes cast against stock option plans during the
proposals, the NYSE and Amex permit member period 1988-1999.20
brokers to vote the shares. The NYSE and Amex In general, the higher the potential dilution
permit brokers to vote on management proposals resulting from options outstanding and options
seeking the authorization or issuance of stock or sought, the greater the opposition from shareholders.

18. Jennifer Bethel and Stuart Gillan (2001) “The impact of broker votes on 20. Based on S&P 1,500 companies as tracked by the IRRC – see Drew Hambly
shareholder voting and proposal passage,” working paper, TIAA-CREF Institute. (2000) “Management proposals on executive compensation plans,” Investor
19. Council of Institutional Investors http://www.cii.org/brokervoting.htm. Responsibility Research Center, Corporate Governance Service Background Re-
port A.

124
JOURNAL OF APPLIED CORPORATE FINANCE
 Ultimately option-based compensation should be used only so long as it increases
the market value of the firm.
This concern about dilution persists despite the
earlier analysis suggesting that economic approaches
to benchmarking option use result in lower esti-
mates of the cost of stock options relative to the
company’s market value (as compared with stan-
dard dilution measures). It is perhaps surprising
that corporations do not encourage an economic
option pricing approach to measuring dilution, as
opposed to the standard dilution approach (al-
though one would expect a high correlation be-
tween the two measures). It is not clear, however,
to what extent institutional voting thresholds would
change using an economic approach as opposed to
a dilution approach.
The trend toward more votes against options
plans, with some plans even failing on rare occa-
sions, indicates that shareholders are apprehensive
about levels of potential dilution at some companies.
Past repricing of options at a company are especially
likely to trigger “no” votes by many shareholders.
Concerns About Repricing
The rationale for voting against stock option
plans at companies that have repriced is twofold.
First, it is perceived as rewarding employees for
failed performance, thus undermining the rationale
for using options as incentive compensation. Sec-
ond, the repricing of employee stock options is often
criticized as providing employees a benefit that is not
available to shareholders who have suffered a de-
cline in the value of their investment.
The counter argument is that, in a tight labor
market, failure to reprice may result in poorly
motivated employees and undesirable employee
turnover (as employees effectively reprice their
underwater options by getting new options from
a new employer). Thus, a failure to reprice may
cost the company and shareholders more in the
long run.
To assess the degree to which companies have
underwater options, Figures 2 and 3 report the
cumulative distribution of option “in-the-moneyness.”
Figure 2 reports on the degree to which options
granted during 1999 were in-the-money at the end
of January 2001. In-the-moneyness is measured in
percentage terms as 100 × ([January 2001 closing
price – Weighted average price for 1999 grants]/
Weighted average price for 1999 grants).
Negative in-the-moneyness indicates that op-
tions were, on average, underwater. Specifically, a
125
VOLUME 14 NUMBER 2
negative 50% on the horizontal axis in Figure 2
indicates that the January 2001 market price was
50% below the weighted average exercise price of
options granted during 1999. Figure 3 is similar but
reports in-the-moneyness for options outstanding at
year-end. In-the-moneyness is measured as 100 ×
([January 2001 closing price – Weighted average
price of options outstanding at fiscal year-end 1999]
/Weighted average price of options outstanding at
fiscal year-end 1999]).
Two features of Figures 2 and 3 are worth
highlighting. First, in many cases options issued
during 1999 and outstanding as of year-end were
deep in-the-money, thus highlighting potentially
large wealth transfers from shareholders to
optionholders. However, as one would expect,
options were underwater by a large amount at many
other companies. Figure 2 shows that grants made
during 1999 were underwater for approximately 40%
of companies. Similarly, based on the weighted
average price of options outstanding, Figure 3
suggests that approximately 35% of companies had
1999 or prior option grants that were underwater.
Some 10% of companies had either 1999 grants or
options outstanding at year-end that were underwa-
ter by more than 50%.
Table 5 expands the analysis by reporting on
selected industry groups where there is substantial
variation in the degree of in-the-moneyness. Specifi-
cally, Table 5 reports a set of industry groups in
which some companies had outstanding options
deep in-the-money, whereas other companies had
options outstanding underwater by at least 30%.
Take, for example, the Business services group,
which includes a large number of hi-tech companies.
Business services had 59 companies with underwater
options, and 107 with options in-the-money. Com-
panies where options are underwater had options
outstanding with an exercise price that was on
average 46.4% above the stock market price at the
end of January 2001. Options were in-the-money for
the other 107 firms by an average of 220.5%. Similar
patterns can be seen for other industry groups.
Such markedly different levels of in-the-
moneyness suggest considerable variation in indi-
vidual company performance, or in sub-sector per-
formance. Companies with options deep underwa-
ter face pressure to reprice to address employee
incentive and retention concerns. Such pressures
may be heightened given that there are other firms
in similar industries performing well.
SUMMER 2001
FIGURE 2
CUMULATIVE 100

Proportion of Companies
DISTRIBUTION OF 90
OPTION 80
IN-THE-MONEYNESS:
GRANTS DURING 70
FISCAL 1999 60
50
40
30
20
10
0
-100% -50% 0% 50% 100% 150% 200% 250% 300% 350% 400% 450% 500%
In-the-moneyness (%)

FIGURE 3
CUMULATIVE 100
Proportion of Companies

DISTRIBUTION OF 90
OPTION 80
IN-THE-MONEYNESS:
OUTSTANDING 70
FISCAL 1999 60
50
40
30
20
10
0
-100% -50% 0% 50% 100% 150% 200% 250% 300% 350% 400% 450% 500%
In-the-moneyness (%)

Breathing Underwater require that if a company alters the terms of a stock

When employees hold underwater options,
companies typically worry about employee reten-
tion and morale. Some companies consider repricing
options, but doing so risks angering shareholders
who are apprehensive about dilution in general and
repricing in particular. Companies can undertake a
pure repricing by lowering the exercise price of prior
grants. This is usually implemented by canceling
underwater options and simultaneously granting
replacement options at the current market price. In
some cases, companies will make a grant equal in
present value (using an option pricing model) to the
initial award rather than replace underwater options
on a one-for one basis. Recent clarifications by FASB
option plan—in effect undertaking a repricing—the
plan must be treated as “variable” for accounting
purposes.21 The FASB pronouncement, which is
retroactive to December of 1998, requires that an
estimate of the cost of the options at grant date be
made, charged as an expense to earnings, and then
marked to market on a quarterly basis. Although
some companies such as Amazon.com have recently
repriced stock options, it is likely that repricing will
be used less frequently given the reluctance of many
companies to take a charge to earnings.22
A key element of the FASB ruling is that any
issuance within six months of a cancellation consti-
tutes a repricing for accounting purposes. This
clarification has led some companies, Sprint being

21. Broadly speaking, stock option plans are classified as variable compen-
sation if the full terms of the plan (e.g., number of underlying shares and / or
exercise price) are unknown at the time of grant, or a pre-specified performance
hurdle must be met. Such plans result in an expense recorded on the income
statement.
22. For an analysis of companies that have repriced in the past see Mary Ellen
Carter and Luann Lynch (2001) “The effect of accounting on economic behavior:
Evidence from stock option repricing,” working paper, Columbia University
Graduate School of Business

126
JOURNAL OF APPLIED CORPORATE FINANCE
 ….underwater options do have value and represent a potential value transfer from
share-holders to optionholders.

TABLE 5 UNDERWATER AND IN-THE-MONEY OPTIONS OUTSTANDING BY INDUSTRY GROUP

The table reports the extent to which options outstanding as of fiscal year-end 1999 are in- or out-of the-money. In- and out-of-
the-moneyness are calculated as 100 × ([January 2001 closing price – Weighted average price of options outstanding at fiscal year-
end 1999]/ Weighted average price of options outstanding at fiscal year-end 1999].) The table reports on two sets of companies
within each industry group: First, companies where outstanding options are underwater (Panel A), and second, companies in the
same industry where outstanding options were in-the-money (Panel B). Specifically, Panel A reports the average out-of-the-
moneyness for those industry groups where average out-of-the-moneyness was 30% or more. Panel B reports the average level
of in-the-moneyness for companies within the each industry where options were in-the-money.
Panel A Outstanding options Panel B Outstanding options
underwater (out-of-the-money) in-the-money
Average amount Average amount
underwater in-the-money
Industry Group Number of (% relative to Jan. Number of (% relative to Jan.
(2-digit SIC code Classifications) Companies 01 stock price) Companies 01 stock price)

Business services 59 -46.4% 107 220.5%

Communications 14 -58.2% 48 186.4%
Eating and drinking places 6 -41.6% 18 85.0%
Electrical and electronic equipment 28 -35.2% 92 303.7%
Engineering and management services 11 -50.7% 9 187.6%
Food and kindred products 9 -38.2% 31 53.2%
Furniture, home furnishings and equipment stores 2 -41.7% 7 91.5%
General merchandise stores 9 -43.8% 12 163.9%
Health services 5 -38.1% 14 140.1%
Heavy construction contractors 1 -70.0% 5 101.2%
Industrial machinery and equipment 35 -32.7% 63 159.7%
Instruments and related products 13 -35.2% 43 139.6%
Insurance agents, brokers, and service 2 -42.7% 8 177.0%
Insurance carriers 20 -36.4% 46 64.7%
Metal mining 5 -60.2% 1 123.7%
Miscellaneous retail 16 -54.5% 17 92.7%
Motion pictures 2 -91.7% 2 138.0%
Motor freight transportation and warehousing 1 -76.6% 11 110.6%
Nondepository credit institutions 6 -60.3% 13 108.2%
Primary metal industries 25 -46.8% 10 114.9%
Security, commodity brokers, and services 2 -62.8% 21 137.7%
Transportation equipment 21 -39.1% 23 66.2%
Wholesale trade—durable goods 20 -40.1% 20 58.7%

among the first, to adopt a “synthetic” repricing
strategy. Sprint announced that it would give em-
ployees a choice to hold onto their current grants or
hand them back to the company with the promise
that a replacement grant would be made in six-
months and one-day at the then market price—thus
circumventing the definition of a “repricing.”
Alternatively, companies with sufficient options
available for grant, such as Lucent and Microsoft,
have simply issued employees replacement options
while leaving prior underwater grants outstanding.
While this may help maintain employee morale, the
fact remains that underwater options do have value
and represent a potential value transfer from share-
holders to optionholders. In the event that there is
a dramatic increase in the stock price at such
companies, this doubling of grants could prove very
costly to shareholders.
In the face of insufficient shares available for
grant, some companies may take advantage of
exchange and market rules permitting the adoption
of plans without shareholder approval.23 In the

23. NYSE Listed Company Sections 312.01, 312.03 and 312.04 exemption of Marketplace Rules Section 4310. The rules suggest that non-approved plans of up
shareholder approval for “broad-based” stock option plans which and NASD to 20% of current shares outstanding may be possible.

127
VOLUME 14 NUMBER 2 SUMMER 2001
absence of any change to current rules, one would
expect the adoption of more plans without share-
holder approval, particularly at those companies
facing shareholder opposition to new option plans.
Moreover, given current disclosure requirements, it
is difficult to determine the extent to which compa-
nies are using non-shareholder-approved plans.
IRRC reported that, as of July 2000, 52 out of 1,157
(approximately 4.5%) S&P 1,500 companies re-
ported having plans in place that had not been
approved by shareholders.24 This 4.5% estimate is
likely to understate number of non-approved plans
because it includes only those companies where
plan disclosures were readily available. More re-
cently, the compensation consulting firm iQuantic
reported that during 1999 more than 70 out of 200
technology companies surveyed (35%) adopted op-
tion plans without shareholder approval.25
In contrast, many companies seek share-
holder approval for all stock option plans. Others
have adopted plan restrictions prohibiting future
repricing without shareholder approval. Indeed,
some companies have sought and received share-
holder approval to reprice stock options. Repricing,
however, remains a focal point of shareholder
concern, a concern exacerbated by what are per-
ceived to be high levels of potential dilution.
CONCLUSION
Determining the “cost” of option-based com-
pensation is a complex task, for shareholders and
employees alike. More importantly, to the extent that
there is a difference between the value placed on
options by employees and the economic cost of
options to shareholders, it raises questions about the
economic efficacy of this form of compensation. Put
another way, are employees being paid in a currency
24. Annick Siegl (2001) “Potential dilution 2000: Potential dilution from stock
plans at S&P 1,500 companies,” Investor Responsibility Research Center.
STUART L. GILLAN
is a Research Economist at TIAA-CREF Institute and former
Associate Chief Economist at the U.S. Securities and Exchange
Commission. He holds a Ph.D. in finance from the University of
Texas at Austin.
128
JOURNAL OF APPLIED CORPORATE FINANCE
(stock options) that is significantly less valuable to
them than to shareholders?
Another valuation issue is that standard at-the-
money options are “free” from an accounting per-
spective; that is, they generally do not result in a
compensation expense. This raises questions re-
garding the extent to which accounting consider-
ations may influence compensation policy. For
example, do the current accounting rules result in a
preference for standard options over potentially
superior alternatives (such as indexed- or perfor-
mance-based options) simply because they do not
result in an expense? Similarly, does the absence of
an expense lead to the overuse of standard options?
Despite the difficulties in valuing options, share-
holders monitor option use and have actively voted
against management-proposed stock option plans
they believe to be excessive. However, exchange
and market rules allow companies to adopt some
stock option plans without shareholder approval. In
the absence of any change to current rules, one
would expect more companies to avoid share-
holder approval, particularly when facing share-
holder opposition to new option plans. A central
governance question, then, is whether exchange
and market rules permitting companies to avoid
shareholder approval of stock option plans disen-
franchise shareholders.
Focusing solely on dilution, repricing, and the
cost of stock options begs the question on a number
of issues, notably: what types of companies may
benefit from option-based compensation, what types
of employees should receive option-based compen-
sation, and whether or not the benefits of option-
based compensation outweigh the costs. Neverthe-
less, shareholder concerns suggest that option-
based compensation will continue to be a focal point
for controversy. Pandora’s box is open.
25. Ted Buyniski and Daniel Silver (2000) “Trends in equity compensation: An
executive summary of iQuantic’s high-tech equity practices survey 1996–2000,”
iQuantic report.
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