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.