Apple Clears Jobs; Questions Remain

The company exonerated Steve Jobs, but its SEC filing didn't answer everything about options backdating

by Arik Hesseldahl

Investors hoping Apple Computer would end the year on a high note were not disappointed on Dec. 29, the last trading day of 2006.

That's when Apple (AAPL) filed statements with the U.S. Securities and Exchange Commission that took pains to exonerate Chief Executive Steve Jobs from wrongdoing in the company's handling of stock options from 1997 to 2002. A special committee appointed by Apple's board "found no misconduct by current management," the company said in a lengthy explanatory note attached to its yearend financial filing. That reiterated remarks made by Apple in October, and it was exactly what many investors and analysts wanted to hear. Apple's shares gained nearly 5%, to $84.84.

As upbeat as the tone was toward management, the documents nevertheless underscores concerns over the way Apple handled options, which were used by many companies in recent years to compensate employees, and have become the target of widespread investigation. The practice of backdating, or changing a grant date to artificially boost the value of the option, can skew results by understating compensation costs and overstating profit.

Apple said its own probe turned up "a number of grants for which grant dates were intentionally selected in order to obtain favorable exercise prices," and that Jobs was "aware or recommended the selection of some of the favorable grant dates." Jobs "did not receive or financially benefit from these grants or appreciate the accounting implications."

Disappointing Behavior

But if Steve Jobs didn't fully understand the accounting implications of backdating stock options, then who did? As it did in October, Apple pointed the finger at two former officers it hasn't identified. Former general counsel Nancy Heinen left Apple in May and former chief financial officer and director Fred Anderson resigned his board seat in October. Heinen's attorney didn't return calls seeking comment.

Anderson's lawyer, Jerome Roth, released a statement on Dec. 29 saying Anderson was "disappointed to learn that during part of his tenure as chief financial officer at Apple, the company apparently was not strictly complying with its processes for granting stock options." Roth said that Anderson "did not play any day-to-day role in the granting, reporting, and accounting of stock options and he was not involved in any knowing manipulation of the process."

One of the most controversial grants came in October, 2001, when Jobs received 7.5 million options. The terms of the grant weren't finalized until December of that year. In today's filings, Apple said the grant was approved at a special board meeting on Oct. 19, 2001—a date when in fact no board meeting took place. It also said it unearthed no evidence that current managers were aware of the irregularity surrounding the approval of the options.

Searching the Options

Roth stressed that Anderson was not a member of the board of directors at the time. "As such, Fred had no knowledge of any impropriety relating to this option grant to Mr. Jobs," Roth said. The grant was part of a larger block of 27.5 million options, which Jobs canceled in 2003 because they were under water. Instead he took a grant of restricted stock.

To be sure, the members of Apple's special committee are not the kind who would sign off on an independent review that is anything but rock-solid. Jerome York implemented massive restructuring as IBM's (IBM) chief financial officer in the early 1990s and earlier this year was front man for Kirk Kerkorian's bid to take over General Motors (GM). Former Vice President Al Gore, sometimes mentioned as a possible Presidential candidate, would also be unlikely to succumb to pressures that might cause political trouble down the road. "I'm sure Apple did a super-thorough investigation," says Rich Marmaro, a defense attorney at Skadden, Arps, Slate, Meagher & Flom who is involved in a number of cases concerning backdating. "Given that Al Gore is on the special committee, I'm sure it was even more super-thorough."

Also, backdating expert Erik Lie, the University of Iowa professor whose research helped spark the recent scrutiny of options, says he's unconvinced the suspicious 2001 grant to Jobs is nefarious. Even though the facts of the grant fit the classic scenario for backdating, Lie points out that Apple could have picked a more lucrative day to set the price than Oct. 19.

Lie says his research suggests backdated grants tend to be granted at the low end of V-shaped curves—that is, after periods in which the underlying shares have declined in price, and before big run-ups. But on Oct. 19, Apple's shares had been on the rise for two weeks. While Apple shares did rise 20% from Oct. 19 through the end of that year, the pattern isn't all that striking compared to other grants, says Lie.

Maybe not, but at that time there were nevertheless several stock-moving events around which the company could have timed the granting of options. The date of the fictitious board meeting was two days after Apple reported earnings for its fiscal 2001 fourth quarter. Those earnings beat expectations, but Apple gave a downbeat forecast for the quarter ahead, citing uncertainty in the global economy and the sales environment, prompted in part by the aftermath of the September 11 terrorist attacks.

Apple's stock closed at $16.99 on Oct. 17, before earnings were announced. That happened to be the same day Apple invited journalists to an Oct. 23 event at which Jobs would unveil the iPod.

In all, Apple said it would take an $84 million after-tax charge for recognizing expenses related to options grants. Apple said an outside committee of lawyers had examined evidence surrounding more than 42,000 options grants made on 259 distinct dates between October, 1996 and January, 2003, and also examined options grants made from 1994 to 1997. The team "spent over 26,500 person-hours searching more than 1 million physical and electronic documents and interviewing more than 40 current and former directors, officers, employees, and advisors," the company said.

Whatever questions the filing left unanswered, it left many analysts assured for now of one key matter: the fate of Steve Jobs. "The No. 1 question was whether or not Jobs would keep his job," says Jonathan Hoopes of Thinkequity Partners in New York. "Any overhang on the stock around the question is now almost entirely gone."

The Main Point

In a research note issued after the filing was made public, David Bailey of Goldman Sachs concurred. "While all of the potential implications of Apple's options backdating cannot be neatly resolved with a single filing, Apple's long-awaited 10K puts to rest the relatively minor impact of its backdating issues," he wrote. "This should allow the stock to be driven more by fundamentals in the near term where we see several positive catalysts which should take the stock higher."

Shannon Cross of Cross-Soleil Research in New York put it more succinctly. "It appears from the filings today, that Steve Jobs is safe both from an employment standpoint as well as with respect to the SEC."

Getting the options morass behind it will refocus attention on Apple's coming year, which is expected to kick off on Jan. 9, 2007, when Steve Jobs is scheduled to deliver the keynote address at the Macworld Expo in San Francisco. At that event, Jobs is widely expected to unveil a wireless phone derived in part from the iPod music player, which the company has popularized over the last five years. Jobs will also likely disclose some details about a product in development known at Apple as "iTV."

Apple's Options Woes Deepen

News reports of falsified documents sent investors scurrying. The stock price has recovered, but Apple's legal troubles are far from over

by Arik Hesseldahl

For Apple (AAPL), it was beginning to look a lot like, well, Christmas. Analysts pointed to brisk sales of iPods and iTunes during the holidays, the most recent earnings report indicated robust demand for Macs, and the blogosphere was abuzz with rumors of hot new gadgets to be unveiled by Apple Chief Executive Steve Jobs in January.

But then came reminders that the company remains mired in an options mess. Early in the normally quiet week before the New Year, a California legal trade publication reported that Apple may have falsified documents relating to stock-option grants made to executives between 1996 and 2002, and that CEO Steve Jobs has retained his own lawyer in relation to the probe.

Jobs Retains Counsel

The Recorder, a legal journal based in San Francisco, said federal investigators are focusing on a set of documents concerning Apple's handling of stock-option grants. An Apple spokesman declined to comment on the report, but a source familiar with the matter confirmed to BusinessWeek.com that Jobs has retained an outside attorney. The person didn't identify the counsel.

The report—and a later article in the Financial Times—served as reminders that Apple has yet to move beyond concerns over its handling of stock-option grants to executives. It also raises questions about the extent to which Steve Jobs' reputation may be harmed by the matter.

Apple has already owned up to "irregularities" and said an internal investigation found several instances where Apple options grants appeared to have grant dates that predated approval. It also has said Jobs was aware of the practice but that he didn't benefit personally from it—and that the company hadn't found misconduct by its current management team (see BusinessWeek.com, 6/29/06, "Apple's 'Irregular' Options," and 10/5/06, "Apple Comes Clean on Options").

Apple is among dozens of companies, many of them in the tech industry, now being called on the carpet for how they doled out options. More disclosures are likely to emerge by Dec. 29, when Apple is due to file its quarterly and fiscal yearend reports with the Securities & Exchange Commission.

Investigation Targets

Meanwhile, according to the Recorder, federal officials are weighing the revelation of falsified documents as they consider pursuing a criminal investigation against the company or current and former executives. The report said that investigators appear to be focusing primarily on the actions of two executives, former General Counsel Nancy Heinen, and former Chief Financial Officer and Director Fred Anderson. A Financial Times report, published early on Dec. 28, cited unidentified sources as saying Jobs was handed 7.5 million options in 2001 without the required authorization of the company's board.

The approval date of this block of options coincides with a crucial point in Apple's corporate history: The grant came only a day after the company had reported quarterly earnings, at a time when the stock was trading near its lowest point during the calendar year, and only a few days before Oct. 23, the day that Apple introduced the iPod music player. Even so, by 2003 these options were worthless and Jobs voluntarily canceled 27.5 million options because they were underwater. In exchange he received restricted stock.

Anderson had been CFO since March, 1996, and retired on June 1, 2004. A week later he was named a director of the company but resigned his board seat on Oct. 4 in the aftermath of Apple's investigation. Since leaving Apple's board, Anderson also has retained a lawyer, Jerome Roth, of Munger, Tolles & Olson in San Francisco. Roth didn't return a call seeking comment.

Heinen had joined Apple following its 1996 acquisition of Next, the deal that also brought Jobs back to Apple after an absence of more than a decade. Heinen left the company suddenly on May 1, 2006, and within three months had retained two criminal defense lawyers, Cristina Arguedas and Miles Ehrlich. Neither lawyer returned calls seeking comment.

Jobs Defended

Many tech companies relied heavily on stock options in the late 1990s and early part of this decade as a means to compensate and retain employees. In Apple's case, options grants were made at times when the stock price was at a historical low and in close relation to major announcements. In one instance, Anderson was among the executives who received stock-option grants with approval dates of July 11, the day that Apple's stock hit a 10-year low. Within a month, the announcement of a $500 million strategic investment from Microsoft (MSFT) sent the stock soaring and created a huge paper profit for the executives who received the grants.

Analyst reports from Piper Jaffray's (PJC) Gene Munster and UBS' (UBS) Ben Reitzes urged calm. "If individuals at Apple did falsify certain options documents, that is clearly a negative for the company," Munster wrote. "We believe there is less than a five percent chance that Steve Jobs would have been personally involved."

That sentiment was echoed by Reitzes. "Investors seem to be reacting to the mention of Steve Jobs," he wrote. "We believe it could make sense to obtain counsel given his immense personal fortune and influence. We believe Apple seems to be on track toward putting options issues behind it and expect delayed filings within two days. We should also receive more information regarding the probe and the potential impact on management."

Concern about the implications of the reports weighed on Apple shares on Dec. 28. In afternoon trading, the stock declined $1.2, or 1.5%, to $80.32.

A New Legal Eagle

The potential financial impact of any restatements related to the options matter on Apple is expected to be minimal. The number of options involved is not sufficient to materially impact Apple, which said in a preliminary report in October that it had clocked $19.3 billion in revenue, with $1.9 billion in profit, and reported a cash position of more than $10 billion in its fiscal fourth quarter (see BusinessWeek.com, 10/19/06, "Apple's Big Mac").

Apple has also called in a new legal ringer. On Nov. 13, Apple announced that it had hired Donald Rosenberg as senior vice-president, general counsel, and secretary, replacing Heinen. Rosenberg joined Apple after a stint as general counsel at IBM (IBM). Highly regarded after some 30 years on IBM's legal team, Rosenberg has a reputation as a tough negotiator. His primary job at IBM before becoming general counsel was interacting with regulatory agencies like the Justice Dept. and the SEC. As part of his compensation package, he received a grant of 200,000 shares of restricted stock, according to SEC filings. The restricted stock will vest in blocks of 50,000 shares each until 2010.

But the cloud of worry about a criminal probe into the matter can't be discounted, says Jill Fisch, a professor of corporate and securities law at the Fordham University Law School in New York, and a former Justice Dept. trial attorney. "Once you start seeing falsified documents, that shows knowledge of wrongdoing as opposed to an accounting screw-up or a coincidence," Fisch says.

"The Tone at the Top"

The documents in question, Fisch said, are likely to be internal Apple documents relating to compensation records. But if Apple employees were found to have falsified them, the offense could be just as serious as filing false reports with the SEC. And in deciding whether to proceed with a criminal case, the particular facts surrounding any supposedly falsified documents will weigh heavily. "The government will consider the extent to which people knew they were doing something wrong, the size of the economic gains," she says. "The government will be much more concerned about the tone at the top and whether or not it thinks there was a climate of corruption as opposed to scattered instances of accounting mistakes."

Apple has tried to portray the options matter as one in which it has taken all the correct steps by voluntarily taking the matter to the SEC, cooperating fully with regulators, and disclosing its findings in a timely manner. But cooperation may not be enough to stave off a criminal prosecution, Fisch says. "The fact that Apple cooperated fully wouldn't save any one executive from prosecution."

Tough Questions for Apple

Even if the options mess doesn't play out as a worst-case scenario, the iPod maker has some important questions to answer about policy and procedure

by Arik Hesseldahl

It's been a decade almost to the day since Apple Computer (AAPL) announced it would acquire NeXT Computer. The deal brought Steve Jobs back within Apple's Cupertino (Calif.) walls, setting in motion an epic turnaround that's sure to rank among the greatest second acts of American corporate history. Righting the foundering ship wasn't easy at first, though the effort has picked up speed in recent years as the iPod music player has gone from curiosity to cultural icon, helping boost sales of other Apple products and luring investors to Apple stock.

But there's little time for celebration this anniversary. Apple executives instead are coming to grips with a scandal concerning the granting of stock options, and they're preparing to release long-delayed regulatory filings that investors and analysts hope will shed light on what happened, who's responsible for misdating of certain grants, and the likely impact on Apple's bottom line.

On Dec. 29, after the close of the market, Apple is expected to file its quarterly and annual reports with the Securities & Exchange Commission. Apple has already acknowledged some 15 instances where options appear to have grant dates that predate approval. That suggests the possibility of backdating, or changing a grant date to artificially boost the value of the option, a practice that can understate compensation costs and overstate profit.

The extent of the damage the practice may have caused Apple took center stage in recent days amid news reports that Jobs received 7.5 million options without the board's approval and that minutes of board meetings were falsified to suggest directors had indeed approved the grant (see BusinessWeek.com, 12/28/06, "Apple's Options Woes Deepen"). Apple's shares dipped and recovered amid conflicting views on how profound an effect the options issue will have on Jobs and the company he runs.

But as Apple executives prepare to deliver the documents, there's a long and growing list of unanswered questions. Here are a few:

1. What did Steve Jobs know about the backdating of options, and when did he become aware of the practice?

Apple in October said that in some cases, "Jobs was aware that favorable grant dates had been selected." It also said "he did not receive or otherwise benefit from these grants and was unaware of the accounting implications." Jobs has retained a lawyer in relation to the options issue. Getting the full story on what he knew, and what he did once he became aware of the practice, will be crucial.

In 1997, near the time when Jobs assumed full CEO responsibilities, an internal Apple memo leaked to CNet, the technology news service, suggested stock options, rather than cash, would be the basis of bonuses at Apple in the future. Knowing this, Apple should disclose exactly which people were in the chain of command, both in the executive suite and on the board of directors, for approving options grants to employees at all times from this point forward.

2. If Jobs or any other senior managers knew executives were not following procedures, policies, and laws during the period in question, what action was taken to correct the actions and discipline or dismiss those responsible?

Apple, again in October, said it uncovered "serious concerns regarding the actions of two former officers in connection with the accounting, recording, and reporting of stock-option grants." It didn't identify the individuals and said it hadn't found any misconduct by its current management team.

Longtime Apple general counsel Nancy Heinen, who is according to some reports a potential target of a criminal investigation, left suddenly on May 1, 2006. Her attorneys haven't returned calls seeking comment. The board resignation of former Chief Financial Officer Fred Anderson was announced on Oct. 4, the same day Apple announced the findings of its options investigation. His counsel also hasn't returned calls seeking comment.

3. Which employees were granted options in the 15 instances where backdating is said to have occurred? What, if any, financial benefit did they incur? What was the final disposition of those options?

It stands to reason that if no one benefited financially from the backdating, intentional or not, of these options, then the probability of criminal prosecution against the company drops. "If there was no financial benefit, it's a much less appealing case to prosecutors," says William Sullivan, a securities lawyer with Paul, Hastings, Janofsky & Walker in San Diego. According to the Recorder, a legal journal based in San Francisco, federal investigators are considering whether to pursue a criminal investigation into the matter.

4. What are the periods for which financial results will have to be restated, and by what amounts? Additionally, what are the tax implications?

Generally, given the number of options involved, the restatements and tax implications aren't likely to be meaningful for a company with nearly $20 billion in revenue last year, and a cash reserve of $10 billion. Repayment of any back taxes, plus any fines on top of that, will likely amount to pocket change, but the amounts should be spelled out regardless of size, if only to erase any shadows of doubt among shareholders.

5. What new procedures, policies, and review requirements are now in place to ensure something like this doesn't happen again?

In the wake of the options mess, Apple appears to be showing a preference for granting blocks of restricted stock that vest over time to senior employees. Documenting the controls, policies, and procedures around these grants will be important as well.

6. Should the fallout of the options matter result in the departure of Jobs—however unlikely that scenario may be—what plans are in place for the board to name a successor? Who might that person be?

The uncomfortable set of questions couldn't help but be raised in 2005 when Apple disclosed that Jobs had undergone surgery for pancreatic cancer. Jobs recovered, but now as Apple grapples with the options issue, and even if the odds are long that he's in serious trouble, the questions can't help but resurface.

Still Time for '06 Tax Savings

Here are some yearend strategies investors can use to help trim their bill from Uncle Sam

by Marc Hogan

With December almost half over, it's probably too late to make good on those old New Year's resolutions you haven't quite gotten around to. Those trips to the gym may just have to wait until next year, just like your unwritten novel. But here's some good news: Investors may find there's still plenty of time to help trim their 2006 tax bill.

A few smart moves now can save money when the tax collector calls in April (see BusinessWeek.com, 12/9/06, "Yearend Tax Tips"). "The biggest mistake that clients make with yearend planning is not doing any," says Allentown (Pa.) financial planner Kevin Brosious. "Often they wait too long and try to cram everything in the final weeks of December, and there just isn't enough time."

Still, investors shouldn't fret so much about avoiding the tax man that they end up making costly miscues. "I see this more often than people not making proper tax moves at yearend," cautions Andrew Tignanelli, president of Lutherville (Md.) financial planning firm the Financial Consulate.

This Five for the Money looks at some sensible late-year strategies for easing the Apr. 15 burden. It may be the season for caroling, but it's not too early for investors to start humming the Beatles' Taxman.

1. Sock Away for Retirement

Contributing to a 401(k) or individual retirement account isn't just a wise decision for your golden years. A savvy retirement savings program can also help reduce investors' tax bills in the current year. If you have the cash, putting as much as you can into your retirement plan will lower your taxable income.

The 401(k) contribution limit for 2006 is $15,000, and workers 50 and older can stow away another $5,000. For IRAs, the maximum is $4,000, or $5,000 for the over-50 crowd. The deadline for 401(k) contributions is Dec. 31, but investors can keep funding their IRAs until April.

Naperville (Ill.) financial planner Robert Gerstemeier says he suggests his clients defer as much as they can into their 401(k)s before the yearend deadline. "Some people may take a cash-flow hit in the short term, but in a few months when they complete their 2006 taxes they will be glad they did this," Gerstemeier explains.

Small-business owners who haven't yet set up a workplace retirement plan may wish to do so (see BusinessWeek.com, 11/27/06, "Saving on 2006 Taxes"). Steven Podnos, principal at Merritt Island (Fla.) financial-planning firm Principal Wealth Care, says solo 401(k)s for sole proprietors and their spouses have helped his clients shelter big chunks of their income.

2. Give to a Good Cause

Investors caught up in the spirit of holiday giving might want to direct some of their largesse to charity. Of course, philanthropy doesn't have to be purely altruistic. Donations of several kinds can ease the tax bite come April.

Investors can donate highly appreciated stocks to a church or favorite charity. "This results in the [charity] receiving the full value of the shares, as they don't pay taxes on any gains," says Timothy Brown, a financial adviser with Woodbury (Minn.)-based Brown Wealth Management. Plus, the investor can deduct the gift while getting around the capital gains tax.

A donor-advised fund can be another tax-smart way to give. These vehicles allow people to parcel out a gift of cash or an appreciated investment, like stocks or mutual funds, to their favorite charities over time—and take an immediate tax deduction. "People enjoy the systematized approach to charity," notes Luke Hail, a financial planner with Cincinnati wealth-management firm Foster & Motley. "Usually they actually end up making higher contributions to charity than if they would have made ad hoc contributions throughout the year."

IRA rollovers are a new type of donation allowed in 2006. Investors who are due to take a required minimum distribution from their IRA can reap tax benefits by transferring the money to charity. "If you do this directly, you avoid the income tax owed on the distribution," says Tom Orecchio, principal at Old Tappan (N.J.) wealth-management firm Greenbaum & Orecchio.

3. Sell Your Losers

A yearend portfolio tune-up can also help stymie the tax man. As stocks finish a strong year, investors can soften the tax hit from any capital gains they might have booked by taking losses to offset them.

Investors with more losses than gains use up to $3,000 in losses on stocks sold by Dec. 31 to offset ordinary income. It's important to remember that the losses must be in taxable accounts for investors to enjoy the tax benefits.

Exchange-traded funds, or ETFs, can be a simple way of harvesting tax losses. An investor might want to sell Intel (INTC), which is down 15% year-to-date, and buy the Technology Select Sector SPDR (XLK), a basket of similar companies, suggests Russell Wild, an Allentown (Pa.) financial adviser and author of Exchange-Traded Funds for Dummies.

"If you wish, after 30 days you can sell your ETF and repurchase your beloved Intel," Wild says. "Voilà, you've just earned yourself a sweet tax deduction."

Mutual fund shareholders, too, should beware of capital gains payouts (see BusinessWeek, 12/4/06, "Taking Stock of Taxes"). Find out when a fund is making its distribution, and don't buy the fund before that date. "Many international and growth funds have had sizable distributions this fall," says James Daniel, founder of Alpharetta, (Ga.)-based financial-planning group the Advisory Firm. "The tax bill is going to be large."

4. Use Your Time Wisely

The holiday season is a hectic part of the year already. For taxpayers hoping to reduce their bills to Uncle Sam, it only gets busier. Pushing up deductible expenses into the current year could be a good way to lessen the tax pain.

In some cases, paying expenses early may allow taxpayers to itemize their deductions, rather than just take the standard one, financial advisers say. This strategy can also benefit investors who expect to be in a lower tax bracket in 2007. Jim King, a financial advisor at Itasca (Ill.) wealth-management firm Balasa Dinverno & Foltz, recommends accelerating mortgage payments, tax payments, and medical costs if you are sure they can be deducted.

5. Watch out for the AMT

Different guidelines apply if an investor is subject to the alternative minimum tax, or AMT (see BusinessWeek.com, 1/12/06, "Coping with the Alternative Minimum Tax"). Investors getting slapped with the AMT might want to postpone making their state income tax and property tax payments until next year, suggests Burt Hutchinson, president of Lewes (Del.) financial-planning firm BLH Financial Services. Those payments aren't deductible if the taxpayer owes the AMT.

Trouble is, figuring out whether you'll qualify for the AMT might not be easy. Risk factors include gross income over $100,000 combined with the exercise of stock options, large capital gains, high property tax or mortgage interest deductions, and many dependents. "If AMT hit last year or may hit this year, time with the tax preparer before Dec. 31 could be a good investment," says Scott Anderson, a Newport Beach (Calif.) financial planner.

But there's no need to wait until the last minute to consider tax issues. Investors may want to map out some tax savings strategies early next year to avoid the yearend crunch—consider it your next New Year's resolution. The savings might even pay for that gym membership.

Google Gives Employees Another Option

In a bid to breathe new life into scandal-tainted stock options, Google (GOOG) plans to give employees a novel method of cashing in their options starting next April. The search giant will let employees sell their vested stock options, which give the holder the right to reap the difference between the initial price and the current price, to selected financial institutions in an auction marketplace it's setting up with Morgan Stanley (MS).

The program is a unique stab at unlocking for employees the underlying value of these securities that have been a favored method of luring and keeping employees, particularly among technology companies. In the past year or so, as rules requiring the expensing of stock options kicked in, employers have been cutting back on the number of options they grant, or doling out new incentives such as restricted stock, in a bid to avoid a hit to reported profits.

That has some observers worrying about the possible demise of a classic performance incentive tool. While options continue to be granted by many companies, some 30% have cut back their options grants, and 25% of employees who once received options and other equity awards now do not, according to the National Center for Employee Ownership, a nonprofit research group in Oakland, Calif. And for those getting grants, the value of their options is about a third lower than it used to be.

How It Works

Under Google's Transferable Stock Option program, employees could sell their stock options on the semi-private marketplace much the way public options are sold today. That would let employees potentially reap more than if they merely exercised and then sold the securities. Say an employee holds an option with a strike price of $400, meaning it can be purchased for $400 and then resold at a higher price. If Google's stock is trading at $500, an investor might pay $150 for that option, betting that the stock will rise well past $500 during the life of the option. The employee selling the option could net an immediate $150. An employee exercising and then selling the same option would net only $100, the difference between the strike price and the current price.

The impetus for the new approach is Google's volatile stock, which can change substantially in the space of a month or even days. Google's stock has been on a long if volatile rise since the company's initial public offering in 2004 at $85 a share. Just since Sept. 1, the shares have risen 27%, to $481.78 on Dec. 12, after rising above $500 in November.

As a result, many recent and incoming employees may feel the options don't have much value, given how high Google's stock already is. Moreover, an employee who joins one week ultimately may end up having very different compensation than another hired a few weeks later. That difference can raise pay equity issues and potentially reduce the incentive for employees to stick around. "This goes a long way toward solving recruiting and retention issues," says Dave Rolefson, Google's equity and executive compensation manager.

"Very Innovative"

If Google's plan works—an open question at this point—other companies once again might find options an attractive offering for hiring and keeping talent. "I think it's a very good idea," says James Glassman, resident fellow at the American Enterprise Institute, who was briefed on the plan. "It achieves Google's goal of making the value of options more apparent to people who get them."

There could also be some unpredictable consequences to the plan. Investors buying these options no doubt will want to hedge their bets, possibly through a short sale—a bet that Google's stock will fall. That's not usually something companies like to see. But Google believes the overall impact of the program on the company will be positive. Former Securities & Exchange Commission Chairman Arthur Levitt, now a senior advisor to the Carlyle Group, says he's not sure what all the implications will be. "But on balance, it's a very innovative program," he says.

The plan is only for employees, not executives, who Google says are already adequately compensated. So on its face the plan doesn't address some of the recent problems surrounding stock options, including manipulation of the date on which the securities are granted, so-called backdating, that have landed companies other than Google in legal hot water. But it does offer a different—and possibly more accurate—way to value stock options, an area of great debate even now, nearly a year after options were required to be logged as expenses on a company's books.

No Benefit to the Bottom Line

Google's program isn't aimed at minimizing the impact to its bottom line, however. Indeed, the company expects to incur a larger expense on its books as the plan rolls out. That's because the fair market value of the options will be greater under the new plan than the current one. The reason: The options, which are estimated to have a four-year average life before employees exercise them, will convert to two-year options when they're sold to investors. So their expected life will be essentially extended by two years—making them more valuable because investors will have two more years for Google's stock potentially to rise, and thus more of an impact on Google's bottom line.

If Google's stock doesn't rise, or even falls, the options may well still have value, because investors may assume that over a two-year period the stock has a good chance to rise again. So employees may be able to sell even underwater options—those whose strike price is higher than the current stock price—and reap gains. "Underwater options lose their value as retention tools," notes Levitt. Even under Google's new plan, however, if its stock price drops well below options' strike prices, investors may not want to pay for them, and the options will still be worthless.

Google said it's not implementing the new plan because it's having problems attracting and retaining employees—at least not yet. "We're not having any problem recruiting people to work at Google," says Rolefson. "Attrition rates are very low." The idea, in an increasingly competitive business, is to keep it that way.