The Wall Street Journal Interactive Edition -- December 4, 1997

Microsoft Has Double Loyalty: Shareholders and Employees

Remember "stakeholders," the rallying cry for anticapitalist types who wanted corporations to serve their employees, communities and country as well as their miserly owners? It was seemingly abandoned in the 1990s, when America accepted the Darwinian notion that companies function best when they work for one constituency -- their shareholders. In fact, many companies embraced a second constituency: skilled employees. By awarding them huge bundles of stock options, such companies have been transferring ever-appreciating portions of their profits to workers. Of course, they are motivated not by warm-hearted charity but by cold-hearted reality. Capital is in surplus; skilled geeks are at a premium. No surprise that labor is grabbing a bigger share of the capitalists' pie. The problem is that most companies are accomplishing this reallocation in semidarkness. Because of their refusal to clearly recognize the cost of options, no one is quite sure how much pie will be eaten by whom. But the scale of the reallocation is staggering. Microsoft is the case to look at, for two reasons. With 21,000 option-holding employees, it has the richest (and perhaps the most deserving) "second constituency" of anyone. Moreover, Microsoft has voluntarily calculated and disclosed the cost of options in a far more meaningful way than accounting standards require. In effect, it has warned its investors and employees that as partners they are also rivals who compete for the same spoils. Consider: In its latest fiscal year, ended June 30, Microsoft earned $3.45 billion. But during that year, Microsoft issued 47 million shares to employees with options to purchase at far-below-market prices. That brought in $744 million. But to keep its number of shares from becoming excessive, the company repurchased 37 million shares on the open market, which cost it a staggering $3.1 billion. At the end of the day, two-thirds of its reported earnings had vanished, and its total float was higher than before. Microsoft partially offset this cash drain by issuing preferred stock, but any way you slice it, a huge portion of its earnings was consumed in the selling-cheap-buying-dear stock-option treadmill. And as of Sept. 30, Microsoft's employees still held options to purchase 258 million shares, at an average price of about $42 -- more than $100 under Wednesday's close. According to option-holder Gregory Maffei, who also happens to be chief financial officer, the $26 billion that Microsoft would have to spend to retire those shares "is probably the most important liability we have." It isn't a liability in the strict sense, because Microsoft doesn't have to repurchase stock now or ever. But it is illustrative of the value (unrecognized in Microsoft's reported net income) that is going to employees. "We as a company have been wrestling with stock options for a while," Mr. Maffei adds. "They are an important part of how we hire, motivate and retain employees. But we recognize that they have a cost -- a drag on future accretion of value." Beginning this year, all companies must disclose the cost of options in a footnote. That has brought welcome and thus far widely ignored information to light. However, companies have a lot of latitude in how they come up with a number. For this and other reasons, the new disclosures, though a big improvement, are at times suspect. Microsoft's innovation begins with the realization that long-term options can be purchased (at negotiated prices) from private dealers. Thus, in theory, Microsoft could pay a premium to dealers in return for options to buy the same number of shares as the company granted to its employees, and at precisely the same terms. Had it done so, then, as employees exercised options from Microsoft, the company would do likewise with its options from dealers, acquiring just enough shares to transfer to workers. There would be no increase in shares, and no need to repurchase stock. Microsoft would lose only the "premium," the amount dealers charged it for the options. This premium is the true cost of options. Indeed, it is exactly what Microsoft would have charged its employees had it granted them options in arm's-length transactions, rather than as part of their pay. In the last quarter, Microsoft granted its employees 28 million options. That, in fact, is far more than private dealers could have provided. But Microsoft was able to estimate, and pretty closely, the premium it would have paid if the market were big enough. And that premium, it recently disclosed, would have reduced reported earnings over the previous four quarters (through Sept. 30) to $2.05 a share from $2.65. This voluntarily disclosed, 60-cent haircut is roughly twice as big as the one that emerges in the mandatory footnote. "While no one number is perfect, we believe our methodology is more correct," Mr. Maffei says. You can bet that other option issuers in and out of tech-land are watching. Richard Nanula, chief financial officer of Walt Disney, reportedly is pondering a similar standard. (Response from Mr. Nanula: "No Comment.") The only people not paying attention are on Wall Street. Analysts are blithely ignoring the new disclosure. But at some point, Microsoft's phenomenal growth will slow. Employees used to outsized gains on options will clamor for more, perhaps in the form of cash; shareholders will lobby against them. And investors and employees will realize that Microsoft serves two constituencies -- just as Microsoft has been telling them. Return to top of page Copyright © 1997 Dow Jones & Company, Inc. All Rights Reserved.