Beginning in September, the company will give employees shares of Microsoft stock over a vesting period of five years, rather than options that give employees the right, but not the obligation, to purchase stock at a set price -- usually tied to the day they started working at the Redmond, Wash.-based software giant.
"This is going to cost Microsoft several billion dollars," said Vadim Zlotnikov, analyst with Sanford C. Bernstein. "But even if it costs the company as much as $10 billion, I would see it as a positive. For $1 a share you're completely eliminating the burden of dilution of the stock options going forward."
The new compensation plan is a major policy change to a stock-option based system that created thousands of millionaires at Microsoft alone. It puts Microsoft at odds with Intel and other large tech companies that continue to defend options as the best way to motivate employees.
The company's profit for the year ended June 30, 2002 would have been cut by 32 percent if the company had made options an expense. Accounting for a 2-for-1 stock split earlier this year, Microsoft had 1.6 billion options outstanding as of June 30, 2002, with an average price of about $27.
Of note is that Microsoft has been cutting back on stock option grants in recent years. The company issued 41 million stock options in fiscal 2002, with a Black-Scholes value of $1.3 billion.
Black-Scholes is a popular accounting method used to estimate the value of outstanding options. That's down from 224 million option grants in fiscal 2001 and down from 304 million in 2000.
The stock option growth mirrors sales growth declines in some of the company's most popular products, including its profitable Office suite of desktop computer software, and recently, slower-than-anticipated growth of its Xbox video game systems.
"I think Microsoft is saying they don't expect huge stock price growth in the future," said Terry Shevlin, accounting professor at the University of Washington. If Microsoft's stock did not appreciate, current and future options would be worth little to workers, he said.
Ballmer said in a conference call that Microsoft is making the change in part to reduce "anxiety or angst" over the company's compensation plan.
The real cost of the options to Microsoft has been reduced in recent years, partly because of stock price declines. Between 50 and 69 percent of the outstanding options were priced higher than the company's stock price at the end of last year, said Paul Chaney, assistant management professor at Vanderbilt University.
"While they will expense a lot of them, they will end up repurchasing a fair number of shares," Chaney said. Microsoft did not specify how the stock awards would affect previously reported earnings, or the company's earnings going forward. The company said it will give more details on the cost of options expensing on its July 17 earnings call, and at an analyst meeting scheduled for July 24.
Unlike stock options, current accounting rules require companies to fully expense the cost of stock awards immediately. As a result of the compensation changes, Microsoft said it will begin expensing all equity-based compensation, including previously granted stock options, starting in 2004.
Microsoft also said that a "significant portion" of stock-based compensation for more than 600 senior executives will depend on growth in the number and satisfaction of Microsoft customers.
"Our compensation philosophy is simple," Ballmer said. "We want to be a magnet for the best people by paying smarter. We want to attract and retain employees by offering real ownership and great long-term financial incentives."
Microsoft also said it is working on a plan to let employees get back some value on the portion of their stock options that currently cannot be exercised because they're set at prices above the current stock price. The employees would sell their worthless options to a financial institution. If regulators approve the plan, Microsoft expects to start allowing employees to trade in those options by year's end.
While Microsoft is expected to become one of the first large technology companies to fully expense the cost of options, management did not come out and say that other technology companies should necessarily do the same.
"We agree with others in our industry that there's no one-size-fits-all approach when it comes to equity compensation programs and the resultant accounting for them," said John Connors, Microsoft's chief financial officer. "Every company has a unique set of circumstances, and this is the appropriate accounting treatment for our new compensation plan."