Unless I miss my guess, ESOPs are going to make a comeback soon. Just as toadstools sprout from the mud after a steady rain, ESOPs surge after economic slowdowns. What are ESOPs? That depends on whom you ask. There are actually two distinct types, a fact that leads to considerable confusion. This confusion is enhanced by the fact that both types are very complicated. And now we know, if we know nothing else, that complicated financial instruments can lead to big problems. Fortunately, with ESOPs, these two types are radically different, one in my view to be avoided at all cost, and the other extremely beneficial (although not overly common).
The toadstool that I referred two is one of the two types of ESOPs -- namely, the Employee Stock Option Plan. These are the programs whereby employees are granted the option to purchase shares in their company at a discounted price ("strike price") and can redeem them later for a payout if the value increases. As a rule, employees pay nothing for these shares when they are granted, then after some period of time when the value of the shares have increased, the employee sells them and realizes the gain associated with the difference between the strike price and the market value at the time of the sale. The intent is to align employee interests with those of the shareholders by providing employees with motivation the behave in ways that will boost the company's stock price.
The reasons that I consider this type of ESOP to be a toadstool are almost too numerous to list, but I will attempt to do so, beginning with the one that relates to their popularity in financial downturns. ESOPs are viewed by companies as a way to compensate employees without spending real cash. And real cash is something companies don't have much of right now. This is why I am anticipatinga surge in ESOPs. I suspect employees may start to hear their leaders say "we can't pay you back the money you lost in recent salary cuts, so we are going to issue options." If this happens, a lot of people are going to experience the downside of options. So what are those downsides?
- First of all, let's face it, the value of a share of stock has about as much connection to the value of a business as a bet at the crap table has with a passbook savings account. So the inference that employees who own stock will be better employees is about as sensible as saying that gambling helps you save money. Sensible action on the part of employees rarely has any connection whatsoever to share price. So rather than encouraging right action, stock options create an intense fixation on something completely outside employees' control.
- In addition, by their nature, stock options create the illusion of extreme value. Sensible people who would never expect their salaries to double over-night, naturally assume their shares will. Ask anyone who owns a pile of stock options valued at $1 per share what those shares will be worth in three years and you will be shocked at what you hear. For every person who says 50 cents, there will be 100 who will say $20. And where do they get this idea? Often not from themselves. They get it from management.
- Stock options are the perfect vehicle for managers to create (consciously or unconsciously) the illusion of future wealth for their employees. This illusion can be used to great advantage to secure increased loyalty and extra effort. If employees can be convinced that their options will make them wealthy, they will attempt to move mountains.
- To encourage this perception, companies grant huge sums of stock. They do this in order to make the grants appear more valuable than they actually are. Case in point -- rather than giving an employee 1 share of stock valued at $5,000, they will grant 50,000 shares wort 10 cents. By doing this, they are manipulating human nature. They know that a person can more easily be imagine a 10 cent investment becoming worth $10 than they can imagining a single $5,000 share suddenly being worth a half million dollars. But the ratios are the same.
- What happens when reality settles in (as it always does) and stock options fail to live up to employees' expectations? Disappointment, resentment and betrayal are sure to follow.
- The reality of options is that real wealth, as in so many other things, if it is to be had at all, falls into the hands of a select few (usually high level executives and investors) not the larger employee group.
All of this, coupled with the fact that administering a company-wide ESOP program is breathtakingly expensive and complicated makes it, in my view, one of the most flawed forms of compensation ever conceived. In fact, of all the companies and people I have known involved in ESOPs (and there have been hundreds), the only person I know who consistently sings their praises has spent his entire career at Exxon. Over the last 30 years his stock has steadily increased in value and has made him a wealthy man. But for every person like that, there are thousands who worked for companies like Enron and AIG who have a very different story to tell.
THE BOTTOM LINE
If you find yourself talking to a company about a new job, and management starts discussing stock in lieu of cash, beware. Your pocket is about to be picked.
In the next entry of this three part series, I will provide additional details on more pitfalls and problems with Employee Stock Option Plans.