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July 12, 2000
Stock Option and Incentives Jump: Should Investors be Nervous?

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Tight Labor Market and Executive Attraction and Retention Efforts Spur Growth of Restricted Stock Grants - Should Investors Beware?

The median amount of stock granted last year under all long-term plans continued to increase to about 1.6 percent of total outstanding shares, compared with 1.3 percent in 1997, according to a study from Towers Perrin. The survey also shows a rise to 30 percent from 19 percent in the proportion of companies granting restricted stock for hiring and retention needs. All levels of management employees are affected by these developments.

As a % of sales and net income

Annual bonuses now represent about one-quarter of 1 percent of sales at the median regardless of company size, a change from earlier surveys when larger companies paid a smaller percentage of revenues for bonuses. At the median, companies paid approximately 4.8 percent of net income for bonuses.

"Annual bonus plans are virtually universal and cover a greater number of employees than long-term incentive (LTI) plans," said Ted Jarvis, a consultant in the Towers Perrin Los Angeles office. "On the LTI side, stock option plans are by far the most prevalent vehicle and cover a larger number of participants than long-term cash, restricted stock, or performance share plans. The median practice among survey respondents is to give annual bonuses to about 5 percent of their employees and stock options to about 3 percent."

One Percent of Shares Rule Obsolete

Current granting practices confirm the obsolescence of the "one percent rule" traditionally endorsed by many investors that calls for the number of annual option and share grants not to exceed 1 percent of total outstanding shares. The median annual stock grant is now 1.6 percent of outstanding equity, with the 25th to 75th quartile ranging from 1.1 percent to 2.5 percent of total outstanding equity. This continues the upward trend noted in previous Towers Perrin surveys, when only the largest companies stayed within the 1 percent benchmark.

This year, even the largest corporations exceeded the traditional threshold, even though the inverse relationship between company size and proportion of total equity used was in keeping with past patterns, with smaller companies (revenues under $3 billion) using about 1.8times as much as their larger counterparts.

Big range from company to company

Practices vary considerably among participants with respect to the use of stock options, according to Jarvis, with the top quartile of the companies in the sample granting options to 11.6 percent of their employees. By comparison, companies in the same quartile offer long-term cash plans to 2 percent of employees, performance shares to 0.4 percent and restricted stock to 2.6 percent.

And while 75 percent of the companies have stock option plans, only half as many, 37.5 percent, have long-term cash plans. Performance share plans are reportedly used by 21.4 percent of respondents.

"We were not surprised to see that companies are paying out more cash for annual incentives than for long-term incentives and that stock remains by far the most widely used type of LTI plan for managers," noted Jarvis.

Investors beware

"We believe employers should examine the continued growth in the amount of stock granted to management employees," Jarvis added. "The higher utilization is creating a growing chasm between how much stock companies need to pay management employees at competitive levels and how much stock institutional investors are willing to authorize for stock-based plans.

"Given the tight market for talent and the sensitivity of company share prices to investor demands," continued Jarvis, "companies must give special care to structuring their management reward programs."

Cash provided under long-term incentive (LTI) plans utilizes an annual median cost of one-tenth of one percent of sales and under 1.7 percent of profits, according to the study.

Data for this CompScan survey was compiled from more than 50 companies in a range of sizes and industries. Financial companies surveyed had a median asset size of about $28 billion, while the median sales of the non-financial companies in the survey total about $5 billion.

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