On July 8, 2003, Microsoft announced a new employee compensation plan that replaces stock options with restricted stock. Since then, numerous other companies have followed suit, and the regulators are on the path toward significant changes regarding accounting for stock options. Although these new plans reduce problems associated with employee options, they fail to address the fundamental issues of stock price-based compensation plans. In an era when incentive compensation is subject to increased shareholder scrutiny, Microsoft failed to take advantage of a significant opportunity to redefine its incentive compensation program to focus on the fundamental factors that determine sustainable shareholder value.

Until recently, stock options had been widely perceived as a cost-efficient way of linking management compensation to increasing shareholder value. In determining the number of options issued, along with strike prices and exercise dates, the company (on behalf of shareholders) establishes the precise relationship between shareholder returns and employee rewards. If the shareholders get paid (through higher stock prices), the employees get paid (through their options). If the shareholders don’t get paid, the employees don’t get paid either.

The single most critical component determining a company’s stock price is its operating performance, but that is just one of many factors, and most of these other factors are beyond management’s direct control.

The biggest external factor affecting a company’s share price is whether the overall market is going up or down. These trends reflect changes to the market’s implicit discount rate, or cost of capital. When the cost of capital falls, the market advances, and vice versa. Empirical evidence from the past fifty years shows that the market’s implicit discount is a greater source of variation for the S&P 500 than the underlying operating performance of the firms comprising that index (as measured by Cash Return on Investment). Other external factors, such as changing market expectations and the market’s ongoing sector rotation, have a significant and often unpredictable influence on the market performance of specific stocks.

An old Wall Street adage warns against confusing a bull market with brains, but this is precisely what results when incentive compensation payouts are determined by stock price. In a rising market, the broad upward price trend masks sub-par performance for a significant number of companies and managers are paid, often handsomely, for performance in excess of what they really delivered. And in a bear market, when strong operating performance is outweighed by a general downtrend in prices, firms often find themselves changing the rules in order to retain and motivate management talent whose contributions aren't appropriately reflected in depressed stock prices.

Unless the broad market stays relatively flat, boards incur a significant risk of overpaying or underpaying their managers based on factors that have little or no relationship to the results those managers have delivered. Despite the care that individual firms devote to specific compensation decisions, random market movements create payouts that are unfair, whether to stockholders, managers, or both.

Some firms have attempted to offset these random market moves by repricing existing options or otherwise adjusting the rules, but this band-aid approach has contributed to a growing skepticism surrounding management compensation in general. Critics suggest that “overpaid executives” are “having it both ways” by cashing in during good times, then “changing the rules” once the old system no longer works to their advantage.

Within this context, Microsoft’s move from options to restricted stock is just one more example of a firm tweaking the rules rather than dealing with fundamental issues. When one considers that a restricted stock grant can be viewed as an option to purchase stock at an exercise price of zero, Microsoft’s move is considerably less significant than it first appears. All it does is shift the risk/return tradeoff in response to a down market.

Microsoft’s staff is reportedly (and understandably) happy with the move. Those who prefer a more adventurous risk/return tradeoff can still buy listed options through their brokers, while the more risk-averse are finding that their “performance” bonus is now substantially guaranteed. The options only had exercise value when the market price was above the strike price, but the restricted stock grants maintain considerable value as long as the stock price doesn’t collapse completely. Restricted stock isn’t “pay-for-performance.” It’s “payfor-pulse.”

The problems with restricted stock and options stem from the same root causes. From the employee’s perspective, both represent a less-than-perfect currency which only partially correlates with the results employees are asked to deliver. Making employee compensation contingent on stock price saddles employees with market risks unrelated to their performance. The inherent randomness of the market diminishes the intrinsic value of both options and stock. As top performing management talent becomes increasingly scarce, paying that talent with a currency devalued by market risk represents an inefficient and increasingly expensive use of corporate resources.

Microsoft’s mistake is its failure to discriminate between a desirable source of risk (company performance) and an undesirable source of risk (overall market volatility). When the overall risk/return tradeoff proved unfavorable for their staff (due to a sustained bear market) they didn’t refocus compensation on company performance. They simply backed off from risk entirely.

Ultimately, simple reliance on either options or restricted stock represents abdication of one of the board’s fundamental responsibilities – setting objectives for management performance, and measuring results against those objectives. A compensation framework that depends primarily on stock price effectively says to employees, “we’re not exactly sure what we want you to accomplish, but we’ll be pay you so long as the stock price goes up.” Instead of paying management for specific actions that create shareholder value, they pay (to a large degree) based on how the market is doing.

Microsoft’s missed opportunity was the chance to link compensation to effective implementation of an appropriate strategic performance management framework. Many alternatives are available. CharterMast Partners uses a framework developed by Callard Research LLC, widely recognized for providing top-ranked investment insights to institutional investors. This approach, based on over three decades of extensive empirical research, provides a detailed understanding of the relationship between a company’s operating performance and its stock price.

This knowledge allows CharterMast to filter out “noise” associated with market volatility and other external factors, thereby creating a highly accurate measure of how shareholder value management actually created.

Not only does it provide a mechanism to pay management for the value they actually create, having a precise relationship between operating performance and stock price also provides a practical decision-making tool for evaluating future strategic and operational decisions.

Incentive compensation is a difficult and complicated subject, with issues ranging from relatively mechanical accounting and tax disclosures, to the subtle challenges of crafting incentives that reward productive behaviors while protecting against inappropriate over-motivation. Although published reports cited employee relations

as the principal reason for Microsoft’s action, financial reporting, Microsoft’s growth prospects, and other considerations undoubtedly influenced their decision as well. Regardless of Microsoft’s motivation, certain principles remain paramount: Shareholders expect the greatest benefit for every dollar they pay in compensation, while capable managers command and deserve compensation that fully rewards them for identifiable contributions to shareholder value. An effective and cost-efficient compensation plan needs to reward management for performance, not for luck.

Incentive compensation represents a major, and particularly visible, corporate expense. The financial impact is even more significant considering the business consequences of giving management the wrong signals. In this environment, basing compensation primarily on stock price, whether through options or restricted stock, represents not only an ineffective use of resources but a potentially dangerous incentive policy.

At one extreme, it’s “pay-for-stock-market-speculation." At the other extreme, it becomes “pay -for-pulse.” The responsible “pay-for-performance” solution is to identify precisely those factors that determine sustainable shareholder value, and to compensate management directly for their success or failures at delivering accordingly.