When Microsoft executives sat down last year for a brainstorming session with J.P. Morgan Chase & Co., they spelled out a common problem plaguing former highflying technology companies.
The dilemma focused on stock options, which Microsoft Corp. has long used as a major part of its employee compensation. The problem was, Microsoft values these options in its financial statements at a price equal to the full value of the stock, assuming the employee eventually will exercise the option. But since the company’s stock price had been in a slump, the employees didn’t consider the options nearly as valuable as the company was purporting them to be in the footnotes of its public filings.
Microsoft Chief Executive Steve Ballmer, meeting with senior J.P. Morgan executives over dinner in New York, complained about the gap between what the company was reporting and the actual value the options presented to employees.
“Well, we have some ideas about that,” said J.P. Morgan’s Peter Engel, the banker in charge of the Microsoft business.
Tuesday, some of those ideas finally began to take shape. Microsoft, in a shift that could be copied throughout the technology business, said it plans to stop issuing stock options to its employees, and instead will provide them with restricted stock.
The deal could portend a seismic shift for Microsoft’s Silicon Valley rivals, and it could well have effects on Wall Street. Though details of the plan still aren’t clear – and must be approved by the Securities and Exchange Commission – J.P. Morgan effectively plans to buy the options from Microsoft employees who opt for restricted stock instead.
Employee stock options are granted as a form of compensation and allow employees the right to exchange the options for shares of company stock. Options all have strike prices – the prices at which the options can be exercised and turned into stock. For many Microsoft employees, the strike prices on their options are far above where Microsoft shares are trading.
Microsoft had 1.6 billion options as of June 30, 2002, the end of that fiscal year, on a split-adjusted basis. The average strike price on the options was $26.88, and the strike prices ranged from 40 cents to $59.56. Microsoft shares traded at $27.70 at 4 p.m. Tuesday on the Nasdaq Stock Market.
The price offered to employees presumably will be lower than the current value, giving J.P. Morgan a chance to make a profit on the deal. Moreover, J.P. Morgan will be the only bank involved in the program, which could potentially make the deal quite lucrative for the bank. Rather than holding the options, and thus betting Microsoft’s stock will rise, people familiar with the bank’s strategy say J.P. Morgan probably will match each option it buys from the company’s employees with a separate trade in the stock market that both hedges the bet and gives itself a margin of profit.
Microsoft employees who feel bullish about the company’s prospects don’t have to turn in the options. But for others who would be happy to get some cash now for options that are worthless and may remain so, it may be a good deal.
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For Wall Street’s so-called rocket scientists who do complicated financial transactions such as this one, the strategy behind J.P. Morgan’s deal with Microsoft isn’t particularly unique or sophisticated. They add that the bank has several ways to deal with the millions of Microsoft options that could come its way.
The bank, for instance, could hedge the options by shorting, or betting against, Microsoft stock. Microsoft has the largest market capitalization of any stock in the market, and its shares are among the most liquid, meaning it would be easy to hedge the risk of holding those options.
J.P. Morgan also could sell the options to investors, much as they would do with a syndicated loan, thereby spreading the risk. During a conference call with investors, Mr. Ballmer said employees could sell their options to “a third party or set of third parties,” adding that the company was still working out the details with J.P. Morgan and the SEC.
Mr. Ballmer also said that giving employees shares rather than options would better align their interests with those of shareholders. “Whether it’s dividend policy or how much risk to take, it’s always good to have the employees thinking as much like the shareholders as possible,” he said.
Most Microsoft employees have stock options, and the company didn’t say any employees, with the exception of Mr. Ballmer and Microsoft Chairman Bill Gates, who don’t have options, would be excluded from cashing in their options. Messrs. Ballmer and Gates never have been granted stock options, the company said.
The mention of dividends was intriguing to some analysts. Microsoft made a splash earlier this year when it said it would begin paying a dividend. Few technology companies pay dividends, though recent tax legislation has begun to change that.
Employees who own stock options don’t gain from dividends, and in fact can be hurt by them, because the dividend payout makes it less likely that the company’s share price will hit the strike price of the employee’s option. With restricted stock, which Microsoft will begin giving out next year, employees will benefit from the dividend.
The size of Microsoft’s effort makes it unique, but financial firms often stay busy doing just this exercise with employee stock options. UBS AG in Switzerland has offered companies so-called traded-option plans, or TOPs, which let employees get cash for their options without costing the company that issued the options anything.
Options experts were nevertheless surprised by one element of the Microsoft arrangement. Typically, employee stock options aren’t transferable, meaning they can’t be sold as can standard stock options. Employees can cash out of them only by exercising the options and selling the stock.
From J.P. Morgan’s perspective, if the options aren’t transferable, the bank might be unable to use some hedging techniques, because it wouldn’t be able to respond to a margin call by producing the options. That would make the transaction especially risky for J.P. Morgan.
“It’s inferred that these options are transferable and they are good and they are able to go into the hands of the investment banks so when they need them they will have them,” said Jonathan Kahn, of Castlebridge Risk Solutions, who helps develop hedging strategies for clients.