“Don Delves is one of the industry's most knowledgeable compensation consultants His book makes an important contribution to the stock option dialogue.”—Larry Hirsch, Chairman & CEO of Centex Corporation “This is an excellent book for anyone interested in the important discussion of stock option expensing and, more significantly, the optimal use of stock options in compensation plans It is written from the point of view of an experienced and knowledgeable compensation consultant who has advised board compensation committees and talked with many people outside the field considering the economic and incentive effects of the overuse of stock options in the 90s.”—John M Biggs, former Chairman & CEO of TIAACREF “This book is very thoughtful and insightful There are no right answers– only degrees of balance The author has achieved that well.”—John Rau, President and CEO of Miami Corporation; former CEO of Chicago Title & Trust Company “If you are on the Compensation or Finance Committee of a Board, this is a must read With the portfolio of executive compensation Don Delves assisted us with, BorgWarner has risen to the top without megagrants of stock options.”—John F Fiedler, former Chairman and CEO of BorgWarner “Don Delves has given us a clear, lively exposition of multiple issues and variables to be considered in formulating incentives to improve corporate and executive performance Along with his unequivocal advocacy of expensing stock options, he calls for a more balanced approach to compensation, one that blends a variety of elements to engender more attention on the long-term health of the enterprise His interviews with thought leaders such as Paul Volcker and Myron Scholes and the incisive questions he poses help frame a robust debate on the proper use of options.”—Ronald L Turner, Chairman, President, and CEO of Ceridian Corporation This page intentionally left blank STOCK OPTIONS AND THE NEW RULES OF CORPORATE ACCOUNTABILITY Measuring, Managing, and Rewarding Executive Performance DONALD P DELVES McGraw-Hill New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto Copyright © 2004 by The McGraw-Hill Companies, Inc All rights reserved Manufactured in the United States of America Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher 0-07-143632-4 The material in this eBook also appears in the print version of this title: 0-07-141754-0 All trademarks are trademarks of their respective owners Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark Where such designations appear in this book, they have been printed with initial caps McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs For more information, please contact George Hoare, Special Sales, at george_hoare@mcgraw-hill.com or (212) 9044069 TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc (“McGraw-Hill”) and its licensors reserve all rights in and to the work Use of this work is subject to these terms Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited Your right to use the work may be terminated if you fail to comply with these terms THE WORK IS PROVIDED “AS IS” McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE McGraw-Hill and its licensors not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom McGraw-Hill has no responsibility for the content of any information accessed through the work Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise DOI: 10.1036/0071436324 Dedicated to my mentors, Bob and Judith Wright, and the Wright Institute for Lifelong Learning This page intentionally left blank For more information about this title, click here CONTENTS FOREWORD: A Conversation with Paul Volcker xi ACKNOWLEDGMENTS xvii INTRODUCTION xix PART ONE THE STOCK OPTION PROBLEM Chapter One Dimensions of the Problem The Problem with Options The Current Situation Executive Wealth and the Positive Power of Greed Stock Options and Corporate Culture 10 Shareholder Activism 11 The Specter of Government Regulations 13 A Sea Change for Options and Executive Compensation 15 Board Responsibility 15 What Do You Think? 18 Chapter Two The Sources of the Problem 19 Brief History of Compensation 19 Cultural Phenomena 21 Modern History of Compensation 27 Lessons of the LBO 29 When Executives Become Owners 33 The Role of Boards in Compensation 35 Stock Options for Start-Ups and the Technology Revolution 38 A Skewed Incentive System 40 vii Copyright 2004 by The McGraw-Hill Companies, Inc Click Here for Terms of Use viii Chapter Three The Accounting Story 43 Behind the Scenes of the Accounting Debate 45 FASB’s Renewed Campaign 48 Measuring the Value of Options 51 Determining Fair Value 54 A New Chapter in the Story 58 PART TWO ELEMENTS OF THE SOLUTION 63 Chapter Four An Accounting Solution Everyone Can Live With 65 Accounting Rule Implications 67 Special Treatment for Start-Ups? 69 What Do You Think? 75 Bridging the Gulf 76 Chapter Five Valuing Options 81 Black-Scholes and Beyond 83 The Four Guiding Principles 88 The Purposes of Stock 91 What Do You Think? 92 The Transition to Expensing Options 93 Chapter Six Providing the Right Questions—and the Right Tools— for Boards 101 Board Members’ Concerns 102 The Tyranny of Competitive Data 104 Taking a Deeper Look 110 What Do You Think? 114 CONTENTS CONTENTS Chapter Seven Making Options Performance Based 117 Weighing Performance-Based Options 118 The Purpose of Options 119 Adding Performance Measures 120 Dealing with Underwater Options 122 Other Option Tricks 125 What Do You Think? 127 Bringing Balance to Executive Compensation 127 Chapter Eight Designing a Balanced Portfolio of Incentives 131 The Risk Decision 131 The Psychology of Risk 132 From Bureaucrats to Innovative Thinkers 133 Taking a Healthy Risk 134 The Balanced Portfolio Approach 136 The Benefit of Stock Ownership 142 A Revolutionary Stock Concept 143 What Do You Think? 144 Building a Balanced Incentive Program 145 Chapter Nine Building Healthy Employee-Employer Contracts for Public and Private Companies 149 An Unhealthy Contract 151 Lessons of the New Economy 154 Making Healthier Contracts 155 The Role of Compensation 156 The Role of Long-Term Incentives 161 The Private Company 162 What Do You Think? 164 Valuing People and the Purpose of the Corporation 164 ix ... the proper use of options. ”—Ronald L Turner, Chairman, President, and CEO of Ceridian Corporation This page intentionally left blank STOCK OPTIONS AND THE NEW RULES OF CORPORATE ACCOUNTABILITY. .. PART ONE THE STOCK OPTION PROBLEM Chapter One Dimensions of the Problem The Problem with Options The Current Situation Executive Wealth and the Positive Power of Greed Stock Options and Corporate. .. Behind the Scenes of the Accounting Debate 45 FASB’s Renewed Campaign 48 Measuring the Value of Options 51 Determining Fair Value 54 A New Chapter in the Story 58 PART TWO ELEMENTS OF THE SOLUTION