Option Overhang Continues To Increase

Even with escalating levels of stock option overhang –the sum of shares reserved for outstanding grants plus shares available for future grants as a percentage of common shares outstanding – 54% of the 1,219 publicly traded companies surveyed report lowering overhang levels, resulting in anoverall decline in the annual overhang growth rate from 11.8% between 1997 and 1999 to 8.4% from 1999 to 2001.

Technology companies report the highest levels of overhang, increasing to 24.9% in 2001 from 21.3% in 2000.   Watson Wyatt attributes this increase to the large number of unexercised options and the trend for technology to compensate its employees more with stock options than other industries.  

Companies have been looking to reduce their overhang levels in an effort to find the “sweet spot” – theoptimal level at which companiesfinancially outperform their peers.   This “sweet spot” occurs at the point where the incentive and dilution effects are balanced for optimal benefitsto employees and shareholders.

Watson Wyatt says companies moving beyond optimal overhang levels provide lower returns to shareholders.    Technology companies near optimal levels, overhang at 15%, returned -12% in 2001, as compared to technology companies with higher and lower overhang levels losing more than 20% of their value.  

“Shareholders, through their buying and selling patterns, are looking forcompanies to cut back on their overhang levels.   As a result, companies have become increasingly concerned about managing their stockoption programs closer to the optimal overhang level.  Companies with highoverhang tended to lower their overhang levels in 2001, while those withlowoverhang levels significantly increased their levels”, according to Ira Kay, Ph.D., national directorofcompensation consulting at Watson Wyatt.  

Kay projects that as companies begin re-evaluating their stock option programs, due to the current push for new accounting standards, many companies will shift from stock options to other compensation programs, particularly programs that encourage the direct ownership of stock.

A full copy ofCorporate Governance in Crisis:  ExecutivePay/StockOption Overhang 2003 is available for purchase at Watson Wyatt’s Web site www.watsonwyatt.com/research/reports.asp .