Stock option overhang levels increased significantly in 2000, even though a majority of employers lowered their overhang in an attempt to find an optimal level that benefits both shareholders and employees.
Because the overhang "increasers" raised their overhang levels more than the "decreasers" reduced theirs, average overhang rose from 13.0 percent in 1999 to 14.6 percent in 2000. These are among the major findings in a new study of 980 publicly-traded companies released by Watson Wyatt Worldwide.
Stock option overhang is defined as the number of stock options granted plus those remaining to be granted as a percent of a company's total shares outstanding. Watson Wyatt says its research has consistently shown that there is an overhang "sweet spot" or optimal level where the incentive and dilution effects are balanced for maximum benefits to employees and shareholders. This sweet spot varies substantially by industry.
The sharp increase in average overhang reverses a five-year trend during which overhang growth slowed. The rise in overhang level is explained partly by the fact that employees exercised fewer options in 2000 when the stock market dropped. At the same time, many employers continued to grant new options to workers at a fairly constant rate. Despite the rising average overhang, more than 50 percent of companies reduced their overhang during 2000, an indication that many employers are concerned about excessive overhang.
"The trick for employers is to find the overhang sweet spot where they can achieve superior returns to shareholders," said Ira Kay, Ph.D., national director of compensation consulting at Watson Wyatt. "For most companies and industries, this optimal level is below their actual overhang levels."
Achieving optimal overhang is important in both bull and bear stock markets, according to the study. For example, technology firms with near optimal overhang levels (26 percent) in 2000 delivered a negative 2 percent return to shareholders, while firms with high overhang levels (above 29 percent) lost nearly 40 percent of their value in 2000.
"This phenomenon is not just limited to technology firms or firms in declining industries. The same pattern holds true for companies in the health care industry that enjoyed a banner year in 2000," says Dr. Kay.
"We believe stock option overhang will continue to rise for the next year or two and then level off. But there are pressures in the marketplace that impact overhang, both positively and negatively, that will force companies to closely examine their stock option programs to make sure they continue to be an effective compensation program," said Dr. Kay.
To view the study, called "Managing Stock Option Overhang in Today's Economy," click here.
