Google's Stock Option Plan: Good For Shareholders, Too

If anyone has figured out the drawbacks of Google's new transferable option plan, please weigh in, because at first glance it looks like a win all around.  (Which begs the question: Why haven't other companies done this?  Why does Google seem to be the only Valley company dead-set on innovating?)

There are two main constituencies who stand to gain or lose from the option program change: 1) shareholders (which include some employees) and 2) employees.  At first glance, the transferable program appears to benefit both of them.

For employees, the program should:

• Function more like a restricted stock grant, in that employees will be able to realize option value even if the stock drops.  This will make it easier for employees to assess the value of their options and be less worried about drops in the stock price.  In exchange for this advantage, the employees will receive fewer options, which will cap their upside if the stock does very well.  Most employees, however, would probably be glad to make this trade-off.

For shareholders, the program should:

• Result in less option-related dilution.  The company will grant fewer options to each employee (because each option is worth more), so the program should result in less dilution.
• Retain the risk-sharing aspect of options.  One reason option grants can be good for shareholders is that, if they aren't egregrious AND they aren't repriced, they can reduce compensation expense when the stock does not do well.  (Employees take options in lieu of some cash compensation.  If the options expire worthless, the employees don't get paid.)
• Less risk that options will be repriced.  Option repricing is one of the most egregious and remarkable gifts in the history of capitalism.  When a company reprices options, it removes the "alignment of interests" between employees and shareholders by removing any downside risk to employees if the stock drops.    In the new program, employees will feel pain as the stock drops.  Because there will be less reason to reprice, however (the options will retain some value), shareholders can worry less that management will plead "retention" and reprice.

Potential drawbacks:

• Less "aligning of incentives."  One could argue that, because employees will be able to generate some value from the options even if the stock drops, their interests are not as aligned with those of shareholders as they are in a traditional option program.  This drawback, if any, is minimal.  Employees will still feel the pain of a stock drop. 

Bottom line: Looks like another smart Google move.

UPDATE

Analyst Scott Cleland weighs in with a list of negatives.  I don't agree with any of them.

• Cleland says the new plan will enable employees to "rush for the exits", creating a short-term culture in which employees don't care about the company's long-term value.  He says a restricted stock plan would be much better, because it is long-term focused.  What he may be missing is that the new options vest on the same schedule as the old ones and on the same type of schedule that "restricted stock" would vest.  Employees will not be able to sell the new options sooner than the old options.  They will just be able to collect some of the "time value" of the options that they would otherwise give up if they did not hold the options to term.  This feature might encourage employees to sell earlier, but it should not trigger a rush for the exits any more than a cash salary would trigger one. 

• Cleland says the new program tells us that Google is having trouble hiring enough smart people because the stock price is so high (implication: they know it's overvalued).  This may be true, but it doesn't undermine the idea of transferable options.

• Cleland suggests that the program will lead to even more dilution for shareholders.  This is only true if Google grants more options than they would have under the old program.  They will probably do exactly the reverse: grant fewer options (because each option will be worth more).  What Cleland may be missing is that by "transfering" their options to an investment bank, the employees will NOT be exercising the options.  They will merely be selling them to another party (which may or may not exercise them at some future date).  What matters is the number of options granted, not whether/when they are transferred.

• Cleland says Google is arrogantly "innovating without permission" and should have checked with the SEC.  According to Google, they DID check with the SEC.  And, again, it's hard to see why the SEC would have a huge beef with an idea that's better for both shareholders and employees.

More alleged negatives?  (I'm sure there are some--I just haven't heard any good ones yet).

See also: Gooptions: A Bearish Signal For Google Stock?

GOOG 1-yr chart

Comments

[David Harper:]

I agree these are mostly good but think you've overstated the benefits. In numerical terms, yes fewer options will be granted, but investors (I'd argue) should not be counting the number of options granted. Better along the lines of ISS and their shareholder transfer value; if you look at economic dilution, these are going to be more costly because they have longer natural lives (the first life to exercise/sale plus the second life where the bank is still riding the "dilutive tail" of the option). So, fewer options but higher per-option value/cost/dilution.

Also, I don't buy the reduced risk because in terms of shareholder costs, you've got (I think) either accounting or economic (dilution) costs. Re accounting, I don't know the FAS 123 treatment, but these won't be cheaper "at grant." I don't see how this helps the problem of expensing at grant (and if i were pricing these under black-scholes or binimial), they'd get a slighter higer cost. So, similar to above, accounting cost is still fixed at grant (a huge problem!) and mostly a wash (fewer options, higher per-option) on the comp expense.

On alignment, I agree with you this could be a problem but you could argue the other side too: employees tend to exercise soon after vestin if they are in the money becuase...who wants to gamble?...but these smooth out the risk. The volatility of these ought to be less than the volatility of the intrinsic value, so I would think employees may be encouraged to hold them a little while longer.

On balance, good for employees and therefore, indirectly, for shareholders. But because this is a market *after* vesting, don't see it solving the difficult "at grant" problems.

2006 Dec 13 03:43 PM