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Wednesday, July 9, 2003 - Page updated at 12:00 AM

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No more betting on stock options from Microsoft

Seattle Times technology reporter

Focus on options and stocks


How options work: Options are the right to buy a stock at a fixed price (called the "strike price") in the future. If you had an option to buy a stock with a strike price of $20 and the stock rose to $30 when you exercised the option, you would make $10. If the stock fell below $20, the option would have no value and would be "underwater."

Then and now:

What's below is a listing of the differences between Microsoft's stock-option plan and the stock-award plan announced yesterday. Chief Executive Steve Ballmer said employees will fare 15 to 20 percent better under the new plan if they receive stock awards close to the current stock price. At higher stock prices they'll do "maybe 10 to 15 percent less well off."

Then: Stock-option plan

Enable employees to buy stock at a price fixed when the option is granted.

Granted to all employees at hiring.

Granted annually depending on performance.

Vests — giving holders full rights to them — over four years.

Expires generally in seven to 10 years.

Future value depends on stock gain.

Now: Stock awards

Outright grant of stock shares to employees.

Granted to all employees at hiring,

Granted annually depending on performance.

Vests over five years, giving holders full rights to them.

No expiration date.

Guaranteed value, but fewer shares to be issued.

Just a few years ago, Microsoft stock options were coveted tickets to a world of prosperity and luxury, the keys to mansions, stadium suites and fancy cars that changed the look and feel of Seattle and its suburbs in the 1990s.

Yesterday, when Microsoft announced it will no longer grant options to compensate employees, the company confirmed what people in the region have sensed for some time: that gold rush is over and life is getting back to normal.

"You don't know for sure how much stock is going to be awarded or anything else, but the wild rides are probably over," said Marty Brown, director of the state Office of Financial Management.

The move is one of several sweeping changes Microsoft is making in response to concerns among investors and employees.

Instead of options, which allow holders to buy stock in the future at a fixed price, Microsoft will give employees stock outright starting in September, but they will receive perhaps fewer than half as many shares.

Microsoft will also start listing the expense of options and stock awards on its financial statements, thrusting it into the debate over corporate-accounting practices.

The top 600 or so executives will receive bonus stock awards based on three-year reviews of customer growth and satisfaction, but neither Chairman Bill Gates nor Chief Executive Steve Ballmer will receive awards.

And for employees left holding seemingly worthless options because the stock price has not risen enough over recent years, Microsoft found an investment bank willing to buy their paper shares for a few dollars apiece.

More predictable

Ballmer said the plan was designed to give employees more stable and predictable compensation, align their interests with shareholders' and make them "feel even more excited about their deal, their financial deal, at Microsoft."

In the 1990s, options were valuable when the stock price soared and holders could pocket the difference between the fixed price and the shares' rising value.

They funneled tens of billions of dollars to Microsoft secretaries, engineers, executives and everyone in between after the company went public in 1986. Seattle economist Dick Conway estimates that local employees made $8 billion on options in 1999 alone.

The options also inspired a generation of entrepreneurs who used them to lure employees and build companies when they had more ideas than cash.

But Microsoft options issued in the past three to five years have little or no value because the stock has declined. More than half of the outstanding stock options are now worthless, or underwater, because the stock has fallen below the price at which they were fixed.

That's created "angst" among employees, according to Ballmer, who spent more than a year trying to figure out a better way to compensate the company's 54,000 employees.

"Angst is bad," he said in an interview. "Even if people all stay here and work, I need them focused 100 percent on the right issues and not worrying about, you know, how they're going to send their children to college or how they're going to do whatever it is they're going to do."

Pluses, minuses

Under the program being scrapped, employees had received options for 1,000 or more shares when they were hired at Microsoft, and more after their annual performance reviews.

The options can't be converted to stock until they vest over four years, giving holders full rights to them. They also expire after seven to 10 years.

Under the new program, the stock grants will vest over five years and have no expiration date.

The company has not disclosed exactly how many shares employees will receive, but Chief Financial Officer John Connors said some may receive fewer than half as many.

Louie Gracey, a manager who was in an internal focus group that helped to fine-tune the program, said employees will receive about 35 percent as many shares.

Gracey, who has 20,000 options underwater after seven years at the company, said the awards program "seemed pretty reasonable."

Gracey and some analysts following the company took the change as an acknowledgement by Microsoft executives that the stock is unlikely to soar again the way it had in the 1990s.

"It feels to me like the leadership of our company is saying we've become more of a mature company — that we'll have more gradual, steady growth — versus more of a startup, rapid-growth company," said Gracey, a senior director in Microsoft's global platforms group.

He expects employees will be motivated by the change, since they can plan and count on the stock awards instead of speculate about the potential value of their options.

Paper profits

Meanwhile, pressure is growing for corporate America to include the expense of options in their financial statements. Many already do, but technology companies that rely heavily on options to compensate employees have resisted because the accounting change would wipe out billions of reported profit on paper.

For last year alone, the change will lower Microsoft's reported profit by $2.7 billion, to $5.3 billion.

There could be "some initial sell-off (of stock holdings) on the news," said Jonathan Rudy, an analyst with Standard & Poor's in New York. "There's nothing changing economically speaking, but in the actual reported number (Wall Street) looks at and everybody will be following — that number will be lower going forward," he said.

Other analysts focused on the subtler message sent by the switch from options to stock grants.

"Growth is an issue for this company, and I think I heard the company acknowledge that," said Victor Raisys at Soundview Technology Group in San Francisco. "Certainly, if they thought the stock was going to move significantly from here, they would have left the stock options in place because that would have been better for employees."

Dividend rumor

Connors, the CFO, will disclose the fiscal effect of the changes on July 17, when the company issues its fiscal 2003 financial report. Details on the sale of underwater stocks will come later in the year, because the company is still seeking Securities and Exchange Commission approval of that program. (Connors and Ballmer also refused to discuss speculation last week that the company is also planning to pay a large dividend to shareholders.)

Other technology companies that make heavy use of options are lobbying against proposed accounting rules that would require that options be accounted for as an expense.

Tech companies are unlikely to follow Microsoft's lead because the company is in a unique position, said Rick White, a former Washington state congressman now heading the Palo Alto, Calif.-based TechNet lobbying group.

"Microsoft's a lot different company from what it was 10 or 15 years ago," he said. "It's matured a bit, it's more secure in its market position, it's more like Coca-Cola than the Microsoft of 10 or 15 years ago."

White said Microsoft "was the first company that really perfected the use of stock options and they were really fundamental to them motivating employees."

Intel, a Microsoft ally and leading opponent of expensing options, will not follow suit, a spokesman said.

Banking on Morgan

For employees holding recent options that can't be cashed in, Microsoft is setting up a program that would allow them to sell their options to an investment bank for a few dollars apiece. Employees can hold on to the options in hopes the stock rises enough to make them valuable, or it can let the bank — J.P. Morgan Chase — take that gamble.

In an e-mail explanation to employees, Ballmer said the program will be available for options priced at $33 or higher. The company expects those with prices close to $33 could be sold to J.P. Morgan for around $2, those with prices at $42 could be sold for about 60 cents and those with a price of $45 could be sold for about 25 cents. The stock fell 22 cents in after-hours trading yesterday, after finishing the regular session up 28 cents on Nasdaq at $27.70, before the changes were announced..

For the state of Washington, the change to stock awards should make it easier for government officials to predict personal income. Microsoft briefed state officials on the changes Monday.

"The impression that I had after the briefing yesterday was that it's good for the employees, and if it is good for the employees, it's good for the company and the whole economy," Chang Mook Sohn, the state's chief economist, said yesterday.

Microsoft was the single largest contributor to economic growth in Washington in the 1990s, according to a report the company commissioned from economist Conway. Its outsized effect was largely the result of the wealth created by options.

In 2001, Microsoft employees in the state made $2.4 billion in wages and $3.5 billion in stock-option income, and from 1999 to 2001 the company was responsible for 28.3 percent of King County's employment growth.

While that era's growth is unlikely to be repeated, the region will still benefit from the wealth and stability created by the stock-award program, Connors said.

"The phenomenal effect of the '90s is still being felt in the Puget Sound area today and will be for generations," he said. "I think for Puget Sound-based employees, the stock-award program will give them a more stable and predictable form of compensation, and it will also give us a very competitive package relative to anything in this area, but, more importantly, relative to anything in the industry. So I think for the Puget Sound economy, (it's a) very good thing long term."

Brier Dudley: 206-515-5687 or bdudley@seattletimes.com

Copyright © 2003 The Seattle Times Company

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