-----BEGIN PGP SIGNED MESSAGE----- Hash: SHA1 MDJ 2003.04.08 (April 8, 2003) ============================== Copyright 2003, GCSF Incorporated. All rights reserved. Top of the day -------------- **Being Steve Jobs' boss** It took us the better part of a week in SEC and NASDAQ documents, but we believe that Apple Computer's recent changes in corporate governance are now explainable, if not always on the leading edge of reform. First is Apple's appointment of a new director, generating a political firestorm that other politicians in similar circumstances did not. Then there's Apple's other announcements, released a day later to pass them under the radar, largely because they're controversial and not that novel. We look at which of Apple's reforms was actually required, which aren't very interesting, and what the massive changes in stock options mean. Finally, there's Steve Jobs again, and his new compensation package that will save Apple tons of money if the stock price soars - and the evidence for motivations that hasn't been explored. It's four features in one, a super-sized single issue sorting through the problems well before Apple's quarterly results next week. Too many options, page 1. **Still to come** Up next for us is the next Mac OS X update. This issue was originally to have been MDJ_ 2003.03.31, but during the feature's preparation time, we found it useful to include material released after that date. We've extended MDJ_ subscription by ten days for March's releases, bringing the total extension in 2003 to date to 24 days, and we're working on ways to make such things clearer. Meanwhile, back to the technical stuff! MDJ Analysis: On Gore and governance ------------------------------------ **Celebrity director obscures important changes** The essence of the bait-and-switch is to use an attention-grabbing task to distract your target from your real intent - a different task the target would protest if he noticed it was happening. It's the magician's trick, the sleight-of-hand that keeps you from seeing what's really going on. It's too strong a term to use for Apple Computer's recent changes in corporate governance, but it comes to mind - the company very clearly split changes initiated by its board of directors into two parts, and the first one garnered so much predictable attention that not many people paid attention to the second. **Al Gore, director** On 2003.03.19, Apple Computer announced that former US Vice-President Albert Gore, Jr., had been elected to the company's board of directors. Apple's corporate bylaws limit the number of directors to six: the company originally had nine director seats, but after ascending to the board of directors and the interim CEO position in July 1997, Steve Jobs cleaned house and remade the board of directors in his image. Four directors resigned in the purge- NPR head Delano Lewis resigned [1] in late July, leading the way. In August, long-time Apple investor and executive A.C. "Mike" Markkula, Katharine Hudson, and Bernard Goldstein all left the board, Markkula after sitting on it for twenty years. These three resigned in a single day [2], the day that Jobs ascended to the board of directors and brought with him three new directors: former IBM and Chrysler CFO Jerry York (before York bought a controlling interest in MicroWarehouse, parent of MacWarehouse), former Apple executive and then Intuit CEO Bill Campbell, and Larry Ellison, CEO of Oracle CEO and self-proclaimed "best friend" of Jobs. [1] [2] At the beginning of July 1997, Apple had seven directors with two open slots: Amelio, Woolard, Hudson, Goldstein, Markkula, Lewis, and Hughes Electronics executive Gareth Chang. After Jobs reimagined the board, it was down to six directors (Jobs, Woolard, Chang, York, Campbell, and Ellison), with a seventh slot to be filled by a CEO the company supposedly was seeking. In May 1999, Apple's board elected Gap CEO Millard "Mickey" Drexler to the seventh authorized position, having already eliminated two other empty director seats. Steve Jobs repaid the favor four months later by joining the Gap's board of directors (MWJ_ 1999.09.11). In early 2000, however, Woolard decided not to stand for re-election to the board. At that time, the remaining directors thought about eliminating that seventh authorized director position (MDJ_ 2000.03.15), even getting shareholder proxy votes to do so, but didn't: in August 2000, the board elected [3] Genentech CEO Arthur Levinson to the open position. From there, the board's machinations are a bit mysterious: Gareth Chang, the only director appointed before Steve Jobs retook the company, somehow vanished from the board in 2001. Apple never announced his resignation, nor could we find it in any SEC filings. Even so, Chang was nominated and re-elected to a one-year director term in May 2001, but was not nominated for re-election in 2002, at which point his name simply vanishes from Apple's SEC filings. [3] That dropped the board to six active directors, or five plus Ellison. After spending much of 1997 through 1999 embarrassing Apple with public and incorrect pronouncements about Apple's plans to endorse his unpopular "network computer" concept, Ellison had been missing at least 25% of Apple's board meetings every year since his appointment. It may have been much more - the 75% attendance threshold is the only one Apple is required to report). Ellison therefore decided to resign his seat (MDJ_ 2002.09.24). With Chang perhaps consumed by ravenous Cocoa programmers, that left Apple's board of directors at five, and that was a problem. The board controls how many directors are elected each year, and before Ellison's resignation, that number was steady at six. With Ellison gone, it was down to five: Campbell, Drexler (now at J. Crew after leaving the Gap during a time of poor performance; Jobs similarly quit [4] the Gap's board), Jobs, Levinson, and York. All of these are obviously tied to Jobs, and most are financially tied to Apple. Campbell is chairman of Intuit, an Apple developer. Levinson is CEO of a major Apple customer and partner in scientific computing (for example, Apple/Genentech BLAST [5]). York is owner and CEO of MacWarehouse, a vendor that accounts for about 3% of Apple's annual sales. Only Drexler has no direct ties to Apple's business, and one out of five is not good. [4] [5] What's more, the corporate bylaws require that Apple's board contains at least five members and no more than nine: as long as the board has only five members, none of them can resign or the board must immediately appoint a replacement just to conduct business. It's not easy to find people suitable for Apple's board: the company spent much of the 1980s and 1990s with "complete outsider" directors that sometimes barely had any understanding of the Macintosh, and their immediate focus always seemed to be selling Apple to IBM, Sony, Sun, or any other company they thought would pay for Apple's shares (MDJ_ 2002.09.27). Apple clearly needed another director, preferably a recognizable technology name with no financial ties to the company or its policies, and someone who actually uses and understands the Macintosh. It took the board six months, but they found their man in Gore. The board also announced that it is actively seeking to fill a seventh director position with another "outside" person to help strengthen corporate governance. **Gore's qualifications** -- The former Vice President is, like the other directors, a Friend of Steve. Jobs supported Gore's bid in the 2000 US Presidential election, and Jobs had often hosted President Bill Clinton and his family in his peninsula estate. Gore did not announce until December 2002 that he would not seek his party's nomination for President in 2004, though he had been an advisor to Google of late, and vice-chairman of Metropolitan West Financial [6] since 2001.11.19. He is also a technology wonk who edits his own videos using Final Cut Pro, according to Apple's press release, and approves of Apple's open-source project for the core of Mac OS X. [6] He is also one of the most polarizing figures in US politics. Despite being the US Vice President during eight years of peace and prosperity (which, in many countries, is more than enough to secure a legacy), Gore was relentlessly attacked during his time in office and his Presidential campaign by media sympathetic with the opposition party, particularly US talk radio, a medium with a large and largely conservative audience. Gore was also ridiculed by US entertainers for appearing "wooden" or "robotic" in public appearances and for engaging in the kind of policy minutia that bore most people silly. Although Gore won a slim majority of votes in the 2000 US Presidential election, the US Constitution mandates an Electoral College to elect the president. Electoral College electors are chosen, state by state, based on the popular vote in that state, with more populous states granted more electors. The vote in one populous US state, Florida, was a statistical dead heat, prompting both sides to urge and fight recounts in various parts of the state. When the legal mess cleared over a month later, Gore's opponent, Texas governor George W. Bush, had a very slim majority of counted and certified votes. Bush was therefore inaugurated President in January 2001, and Gore returned to private life after the longest and most bitter post-Presidential election struggle in US history. Gore has since taught courses at a few colleges, written two books with his wife, and begun a schedule of consulting and public speaking. Normally, gaining a director who uses your products, is familiar with your industry, and won the last US popular vote for President is considered a "big win." However, the polarization of US politics is such that Gore's traditional political opponents immediately expressed dismay at his appointment, often using spin points from the party that opposed him in 2000. Hundreds of stories [7] appeared that day, many of them sarcastically declaring Gore a good fit for Apple's board because he claimed to have "invented the Internet." [7] Actually, as the snarky but non-partisan rumor-busting Snopes site points out, Gore never claimed [8] to have "invented" the Internet, though he did say similar words in what would usually have been regarded as campaign hyperbole in earlier years. The choice of words was poor for the point Gore apparently was trying to make, but it's clear that using the wrong word, claiming outrageous accomplishments, or even mangling sentences beyond recognition, has never been a barrier to service as either President [9] or Vice President [10] of the United States. (Snopes debunks plenty of other myths about Gore and Bush, too.) [8] [9] [10] Nonetheless, the political protests continued at sites ranging from Slashdot [11] to the Mac Observer [12], as pointed out by David Zeiler in another excellent article [13] for the _Baltimore_Sun's_ Web site. He noted that other people, including analyst Charles Wolf, criticized Apple for naming a director who had, to paraphrase, "no business experience." Wolf told Zeiler, "I cannot identify anything he can contribute to the board. He hasn't been in private industry, he hasn't been a manager at any point in his career, he has no background in economics." Declaring someone who spent eight years in the US House of Representatives, eight years in the US Senate, and eight years as the US Vice President to be "not a manager" is at the very least a questionable definition of "manager." Each position requires leading a staff of anywhere from half a dozen to several dozen workers in complex surroundings. [11] [12] [13] It's also a double standard. The last major party candidate to lose a Presidential election before Gore, Senator Bob Dole, generated no outcry when he was appointed to various corporate boards, including TB Woods Corporation, the Concours Group [14], and private hospital firm Community Health Systems [15], aside from numerous charitable organizations. Dole is a distinguished public servant, but he was first elected [16] to public office in 1951, before he'd even received his law degree in 1952. From 1951 to 1996, Dole was a continuous occupant of some local or statewide elective office, starting with state legislator and moving to county attorney, US Representative, and US Senator. Yet there was no outcry upon Dole's entry to corporate boards in 1997 that he "had no business experience" or was "not a manager." [14] [15] [16] Similarly, the previous former Vice President of the United States, Dan Quayle, started working for government agencies in 1971, earning his law degree in 1974. He won election to the US House of Representatives in 1976 and the US Senate in 1980, followed by election to the office of Vice President in 1988. Quayle has just as little "business experience" as Gore or Dole, but there were no complaints when Quayle was appointed to boards including that of American Standard Companies [17], where he serves on the compensation, governance, and nominating committees. [17] For better or worse, high-level national politicians have moved from office to high-level corporate positions for decades, and it's somewhat ridiculous to blast Gore for doing it when politicians in similar positions of the other party get by with a nod. As headhunter Kerry Moynihan told Zeiler, "I wouldn't want a vice president chairing my financial committee," Moynihan said, "but with the glare of even more stringent public disclosure, I'd want somebody with a good sense of how to deal with the regulatory community." Zeiler adds, "Adding diverse skills and experience to the selection criteria makes the choice of Gore much less of a head-scratcher." **The switch** At the same meeting that it elected Al Gore to its membership, Apple's board of directors also adopted some medium-scale changes [18] in corporate governance. It may have been even earlier than that: in its annual proxy statement [19] preparing for the annual meeting on 2003.04.24, Apple said that at least one of the changes - expanding the board's nominating committee to also include corporate governance matters - happened in "February 2003." Nevertheless, Apple didn't announce that change, or any others that took place during the meeting of Gore's election, until the day _after_ the Gore election announcement. [18] [19] Apple had to know that news of Gore's selection to the board, and mockery thereof, would generate hundreds of headlines for a few days. Dozens of non-technology media outlets were willing to run a single Apple and Al Gore story, but most of them weren't willing to give Apple more ink a day later for boring corporate governance issues. If the company announced all the changes at once, almost all of those stories would have included news of both Gore's appointment and Apple's revamped governance standards. That would have been less optimal for Apple, and the timing of the announcements mostly avoided it, assisted by a compliant personality-focused media. Reuters, in particular, deserves particular scorn for filing a second Al Gore story [20] ten days later (2003.03.31) that contained almost no news of any kind. The story, also picked up [21] by outlets ranging from the Mac Observer [22] to television stations [23] in Gore's home state of Tennessee, reported the "news" that Gore was awarded 30,000 Apple stock options for his appointment to the board, vesting in three annual installments of 10,000 options each starting one year from the date of appointment. [20] [21] [22] [23] The only news in this story was the option striking price: US$14.95 per share, the stock price on the day of Gore's election. The Mac Observer correctly highlighted that the 30,000 options are Apple's "standard compensation package for non-executive directors." In fact, Apple changed its director compensation package to award stock options instead of cash for service in _1998_, and it's been in Apple's annual filings ever since. There was no reason to believe Gore would have received anything other than the three-year, 30,000 option grant, but because the name of a polarizing political figure was involved, Reuters pretended it was news - and dozens of outlets reprinted it. If the media cycle is this predictable, it's hard to blame Apple's board for taking advantage of it. Why would Apple want to avoid coverage of improvements to corporate governance? For the same reason the company doesn't like publishing specifics about bug fixes: announcing what you fixed is admitting that something important was broken. The company's board of directors came under fire from several sources last week for not being independent enough, particularly from _BusinessWeek_ magazine's widely reported 2002 survey of Worst Corporate Boards [24] that Apple topped. [24] As MDJ_ reported last September, though (MDJ_ 2002.09.27), the magazine was too eager to condemn Apple: it missed several violations of its own "Principles of Good Governance" [25] and neglected to take a broader picture of the stability Apple's current board brings to the company. The directors may all be friends of Steve, but previous boards were largely composed of people who didn't understand Apple's unique business model and, apparently, did not want to. Much like financial analysts, many of Apple's past directors saw the company as nothing more than any other computer company or any other software vendor, and when Apple failed to dominate 80% of the market, they wanted the company sold. The board fired John Sculley for failing to sell Apple to IBM, and a later board fired Michael Spindler for failing to sell Apple to Sun. There is no evidence that the current board has tried to sell Apple Computer, Inc., to anyone. [25] That makes its failure to report what happened in March all the more inexcusable. **Baser motivations** -- Apple's press release is full of the language of strength, such as the directors described as having "approved several measures to enhance corporate governance." Jobs is quoted as saying, "Apple makes the best personal computers in the world and there is no reason why it shouldn't be among those companies with the best corporate governance in the world." But there is a reason: Apple hasn't historically been interested in that distinction, and none of the new actions move the company much above the new generally accepted baseline. Let's look at them one by one. **Independent directors** - First, Apple says that it is strengthening the board's independence by appointing two independent directors: Gore and a draft pick to be named later, hopefully by the end of summer as the result of a formal search. "With the addition of the second independent director, five out of seven Apple directors will be independent under SEC and NASDAQ rules," says the company. Alas, that means that right now, four of six directors are independent. Before Gore came along, it was just three of five. It's even worse if you consider the nature of the guidelines. According to proposed NASDAQ rules [26] that are slightly tighter than the SEC's rules, an independent director cannot be an employee of the company, and cannot receive more than US$60,000 per year from the company for anything other than service on the board. Nor can any of the director's family members, unless they're non-executive employees of the company. NASDAQ does not bar a director's family from working for the company, but if a director's family member is an executive for the company, or has been in the past three years, the director is not independent. The US$60,000 limit includes political contributions, and is stricter for members of the audit committee, who cannot receive _any_ compensation from the company other than for board service. That's actually part of the recent Sarbanes-Oxley Act of 2002 to improve corporate oversight. [26] Furthermore, a director is not independent if he serves on the compensation committee and any executive of the company serves on the director's own compensation committee. For example, Mickey Drexler served on Apple's compensation committee while he was CEO of Gap, Inc. Steve Jobs was on the Gap's board of directors at the same time. Had Jobs served on Gap's compensation committee, Jobs would be a non-independent director for Gap, and Drexler would be a non-independent director for Apple. The new proposed rules say such directors are non-independent until three years have elapsed since the interlocking relationship ended. By these rules, four of Apple's six current directors are independent, with Gore clearly the least dependent of the slate. Jobs is an employee and the CEO, and therefore can't be independent. York is not independent because of the relationship between MacWarehouse and Apple. The others all qualify as independent, but many shareholder activist groups think that shouldn't be. _BusinessWeek's_ proposed principles of governance would prohibit more than two directors from being current or former company executives, and say that no director should do business with the company. The only two current or former executives are Jobs and Campbell, but both York and Levinson do business with Apple Computer, so the magazine and many activist groups would not count them as "independent." So while Apple is crowing that five of seven directors will be independent under NASDAQ rules, the definition of independent is a lot more forgiving than some would like. By BusinessWeek's definition, only two of Apple's current directors are "independent" (Gore and Drexler), and the seventh board member will make that three - not a majority. More importantly, the proposed NASDAQ rules require that a majority of directors be independent. Starting with three independent directors out of five (by NASDAQ's lenient interpretation), Apple had no choice but to appoint at least one independent director: three of six is not a majority. The second independent director, filling the seventh seat on the board, will improve the situation somewhat, depending on how truly independent that person turns out to be. However, you should also remember the last time Apple's board undertook a formal search to fill a position: it was for a permanent Apple CEO to replace Steve Jobs, who only wanted to lead Apple on an interim basis. **Expanded committees** - "Apple's Board of Directors has expanded the role of its independent Nominating Committee to include corporate governance as the new Nominating and Corporate Governance Committee, and has expanded the role of its Audit Committee in accordance with the Sarbanes-Oxley Act and proposed SEC and NASDAQ regulations. These two committees are chaired by independent directors and staffed by a majority of independent directors," says the press release. Proposed NASDAQ rules do not require a separate corporate governance committee, so Apple's slightly ahead of the curve here. However, the rules do require either an independent nominating committee or director nominations approved by a majority of existing independent directors. Other rules provide that more tasks belong to independent directors as well. Apple's move mostly takes an existing, independent nominating committee and adds corporate governance to its charter [27]. [27] In fact, all three of Apple's board subcommittees now have their own written charters, including the audit and finance committee [28] and the compensation committee [29]. Much of the documents are corporate babble - for example, Apple's new corporate governance guidelines [30] read, in part: "the directors will take a proactive, focused approach to their position, and set standards to ensure that the Company is committed to business success through maintenance of the highest standards of responsibility and ethics." It is, however, an improvement: it's the first time Apple's board has made such written statements public, if in fact they were previously recorded at all. [28] [29] [30] However, new laws and proposed NASDAQ rules don't leave Apple with much wiggle room here, despite the new openness. The proposed rules require a majority of independent directors on the board, require the independent directors to meet regularly without the non-independent directors, and strengthen the requirements for audit committee members (including requiring all of them to be independent). The independent directors, either as a group or through independent committees, must approve all director nominations, CEO and executive officer compensation, and all auditing-related activities (through the audit committee). The board, including all directors, must create a public code of conduct for all directors and employees, and must publicly disclose any waivers granted to directors. **Shareholder-approved option plan** - Skipping the most controversial provision for a moment, Apple's board also announced that it wants to cancel the 1997 Employee Stock Option Plan and replace it with the 1998 Executive Officer Stock Plan. The former plan grants stock options to employees who aren't officers of the company, typically in blocks that vest in three equal installments on the first, second, and third anniversaries of the grant. The latter plan typically grants options that vest in four or five years, but more importantly, was approved by shareholders as 1998 rules required. On first blush, this looks like a good move: board of directors can issue massive amounts of stock options to employees to prevent compensation from showing up on the balance sheet. As has been widely reported in the past few years, corporations do not have to list the cost of stock options as an expense or as employee compensation. If Apple pays an employee US$100 in salary, it's reported as an expense each quarter. However, if Apple gives that employee ten options to buy stock at US$10 per share when the stock is trading at US$20 per share, the employee can exercise the options, buy the stock, and sell it at market price for a profit of US$100. It's a "cost" to Apple in the sense that Apple issued shares for US$100 less than it would have received had Apple itself sold the shares on the open market, but it's not recorded as an expense. Apple's shareholders must vote on a proposal to require the company to list stock options as expenses; Apple's board recommends against the proposal, largely because its competitors won't have to adhere to the same standard. Without the board's support, the proposal is extremely unlikely to pass. Shareholders, however, approved the 1998 Executive Officer Stock Plan. It has specific numbers of shares available for awarding, and that number can't be increased without a vote of the shareholders. The terms of the plan are documented and specific, and only shareholders can change them. This promotes more accountability and clarity in compensation, and helps reduce the chances that the board will issue so many stock options that the company's shares become diluted, as has nearly happened now. So, not to invoke the specter of Martha Stewart too much while talking about stock, it's a good thing. And, again, it's a required thing - almost. The first of the proposed NASDAQ rule changes will "require shareholder approval for the adoption of all stock option plans and for any material modification of such plans." There is room for exemptions, and existing option plans are explicitly grandfathered in "unless there is a material modification made to the plan." But that's exactly what would likely have to happen soon. According to Apple's proxy statement, there are only 2.5 million shares left in the 1997 plan, with over ten million options currently awarded to employees but underwater (the price to exercise the option is higher than the stock's current trading range). The board has therefore offered a repricing plan: any employee can turn in options that strike at US$25 per share or more for a "smaller" number of options at fair market value to be issued six months plus one day after the underwater options are cancelled. It's a small risk for Apple employees: if the stock price rises in the next six months to above the option price, or if the employee leaves Apple in that time, the options are more worthless or lost altogether, and the new grant is for fewer options. However, if the employee's options strike at around US$50 per share, it could be a significant windfall. Apple gets employee satisfaction out of it, but it also gets back more shares in the 1997 plan. The company plans to use those shares to issue the new option grants, and then cancel the plan and absorb any remaining shares back into Apple's general pool of authorized but non-issued shares. Apple expects the exchange plan to reduce the number of outstanding stock options for non-executive employees by around five million shares. Apple's board says that the number of unexercised options is beginning to dilute the stock, for when those options are eventually exercised, it dumps millions more shares of Apple stock on the market when demand isn't exactly at its peak. The exchange program should insure that about five million of those shares never see the light of day, at the expense of lower strike prices for the repriced options. Apple spends a little more money, but each share remains a bit more valuable, and existing shareholders like that. While smaller supply may not always lead to greater demand, a huge supply almost always depresses prices. **Back to BusinessWeek** -- So what makes _BusinessWeek's_ coverage [31] so awful? In a double-length "Byte of the Apple" article dated 2003.03.27, Alex Salkever takes Apple Computer and its board to task for poor decisions. He frowns upon the choice of Gore, writing, "The last thing Apple shareholders want or need is a celebrity director with zero business experience, aside from the business of fund-raising and politicking." Salkever does his point better, though, by emphasizing that it's all politicians he suspects, not just Democratic ones: "I think the larger truth...is that politicians generally make lousy board members. Investors invariably view such appointments as, well, political, and not necessarily in their best interests." It's a far more valid argument than ignoring other political directors just to blast Gore. [31] Salkever also makes excellent points in discussing his magazine's past impatience with Apple's board, including the long-time Apple practice of granting interest-free loans to new executives to help them buy houses. He points out that two large union shareholders have filed motions to force Apple to "create a more independent board," as well as the suggestion that a shareholder right activist may make a good seventh board member. In fact, Salkever explicitly says, "Apple is now looking for a seventh board member." Why is that important? Because it's not mentioned in the Gore press release, only in the next-day one outlining Apple's governance changes, meaning that Salkever almost certainly read it. Why is _that_ important? Because in his two-page bashing of Apple's board and nominees, Salkever never _once_ mentions any of the other changes Apple's board has made. There's no mention of a formal corporate governance committee even as he writes, "corporate governance could become a very major issue as big shareholders agitate for accountability." There's no mention of Apple's commitment that the seventh director be independent even as he complains about all the interrelationships among existing directors (nor does Salkever point out that Gore has none of these business ties). There's no mention of shareholder-approved stock option plans, formal written charters for board committees, or a commitment not to reprice options in the future without shareholder approval. It's one thing for _BusinessWeek_ to advance its own ideas of good corporate governance and the qualifications of directors. It's another entirely to blast a company for poor governance without mentioning _any_ of a series of improvements that the writer, Salkever, clearly knew about and withheld from readers. Most of them are simply keeping up with proposed NASDAQ rules, and Salkever could easily have poked holes in them, possibly with more conviction than other writers given _BusinessWeek's_ attention to the subject. But mentioning improvements in governance, no matter how limited or externally required, blunts the point of calling Apple's board uninterested in the subject. Salkever writes, "Gore's appointment underscores that Steve Jobs doesn't really take the idea of a board of directors very seriously." Drawing reader attention to brand new principles of governance, written charters, and other adherence to proposed regulations exposes that as false. Rather than address the board's actions and perhaps point out they don't go far enough, Salkever omits them altogether. It's hard to understand _BusinessWeek's_ insistence that shareholders have all necessary director information when the magazine clearly doesn't believe its own readers deserve the same courtesy. **Jobs costing** If you had to point to a single reason why Apple fronted Al Gore's appointment the day before announcing other corporate changes, the revision to Steve Jobs' compensation package would probably be it. It's easily the most controversial of all of Apple's changes, and the self-appointed guardians of Apple's money are already calling for pitchforks and boiling oil. Steve Jobs was granted 20,000,000 Apple stock options at US$43.5975 per share on 2000.01.19 to show the board's gratitude for his service to the company. That was the same day Apple's board gave Jobs a Gulfstream V jet, which accounts for all but US$1 of Jobs's compensation from the company since 1997. The options vested in two annual installments, and all were fully available for Jobs to exercise, but that would have been pointless since the stock price sank far below US$43 per share in 2001 and shows no signs of rising above it. The board therefore voted in October 2001 to grant Jobs 7,500,000 _more_ stock options at US$18.30 per share, vesting in four equal installments of 1,875,000 shares each. 3,750,000 of those options had already vested; the other 3,750,000 were not yet available to Jobs. Apple announced that Jobs had voluntarily surrendered all 27,500,000 options back to the company in exchange for 5,000,000 restricted shares stock in three years. In Apple's securities reports, the term restricted shares normally applies to shares granted from a stock option plan because there are some restrictions on them if an employee owns the shares when his employment with Apple ends, but there seem to be no restrictions on normal kinds of sales. There's a chance Jobs would lose the shares if he left the company before selling them, but even that's not completely clear from the securities filings. The difference between the options and the shares is huge. Let's suppose Apple's stock is trading at US$20 per share. If Jobs exercises a single option priced at US$18.30 per share, he gets the right to buy one share at that price. He can then sell it on the open market for US$20, and pocket US$1.70 in profit. Apple Computer pays an opportunity cost of US$1.70 per share because the company could have put the same share on NASDAQ itself and sold it for US$20. Instead, Apple only got the US$18.30 striking price for issuing the share, hence the opportunity cost. It's not listed as an "expense" on the quarterly reports, but it's money Apple voluntarily gave up to Jobs. Now change it to a share of stock. Apple issues the share and gives it to Jobs outright, and he sells it on the open market for US$20. Jobs pockets US$20 in profit because he didn't have to buy a share at some option price first. Apple's opportunity cost is US$20 because the company doesn't sell the share to Jobs at any price. It just gives the share to him. And that's an expense: the US$20 shows up on Apple's quarterly results statement as a charge against earnings. The shares obviously seem like a much better deal, but Jobs gets 5,000,000 shares in exchange for 27,500,000 options at various striking prices, and that complicates the equation. **The finger pointers** -- Alas, complications mean nothing to the business press and consultants that have appointed themselves as guardians of CEO compensation. Such folks have reported Jobs' compensation as Apple CEO at anything between US$90 million and US$850 million over the past few years, based on the "value" of Jobs' massive stock option grant. Compensation columnist Graef Crystal has ridden this story hard, initially estimating Jobs's grant of twenty million options as worth US$471 million, and second 7,500,000 option grant as worth US$52 million. However, in a recent Apple-bashing column [32], Crystal estimates that the present value of the 27,500,000 options as of 2003.03.20 was about US$89 million, while five million shares of Apple stock that day would have been worth around US$74.5 million. "Allowing for some elasticity in the assumptions that go into the Black-Scholes option-pricing model [33], exchanging US$89 million of underwater options for US$75 million of free shares is pretty much an even exchange," he writes. [32] [33] And, as always, that's the rub. Option-pricing models use stock price statistics over time to put a present value on stock option warrants because people like to trade them, just as they like to trade all kinds of commodities. If someone offers to sell you an option to buy 100 shares of Apple Computer stock for US$30 per share in two years, it would be nice to have some history-based way to estimate how much that option is worth. But as experts like Crystal continually refuse to tell their readers, Jobs _can't_trade_ his stock options. If they're worth US$523 million, they're worth that only to Steve Jobs. Apple employees and directors cannot transfer their stock options; they can only sell the shares themselves once the stock options are exercised. Remember that: those 27,500,000 shares are worth exactly US$0 to anyone other than Steve Jobs. He can't even use them as collateral for a bank loan because the bank can't get the options and exercise them itself if he defaults on the loan. Option warrants that are traded have an estimated present value because if you buy the warrant, you can exercise the options. If you took possession of Jobs' options, they'd automatically be cancelled. This makes trading them more difficult. Compensation henny-pennys usually also usually have a fluid concept of time. They tend not to mention that the Black-Scholes model estimates a value for the option on the last day it can be exercised. Jobs' options are good for either seven or ten years, so if they're worth US$523 million, they're worth that much in 2009 or later, not before. Also, as noted above, Jobs doesn't receive the five million shares for three years. Crystal's calculation that five million Apple shares are worth US$74.6 million is based on the fact that, as of the date of calculation, they were trading at US$14.91 per share. That's manifestly irrelevant: Jobs doesn't have the shares today. Nor does Crystal bother to estimate what the stock price will be in three years when Jobs actually gets the shares. It's much more fun to throw around large but irrelevant numbers to use in denouncing Apple and Jobs. Crystal's animosity towards Jobs' compensation is, well, crystal clear: he calls the 20,000,000 option grant "the largest option grant made on a single day in the history of mankind," because comparing it to thousands of years of civilization makes it look a lot worse than comparing it to the three decades or so that options have been granted as compensation. Crystal and other Jobs-bashers refuse to look at the most significant evidence about Jobs: since he took control of the company, he hasn't exercised one stock option, even though he owns tens of thousands of them that are above water. At least 30,000 of Jobs' options probably strike under US$10 per share thanks to Apple's very low 1997 stock price and the 2001 stock split. Jobs simply doesn't need the money: he earned a few hundred million dollars from the sale of NeXT in 1997, and he's a billionaire from his ownership of 70% of Pixar Animation Studios. **Other motivations** -- Crystal gets some numbers right, but draws questionable conclusions from them. He writes, "Jobs' acceptance of this exchange implies that he isn't particularly bullish about his company's future. Comparing his 5 million free shares to his 27.5 million option shares, if Apple's stock price were to rise to US$44.85 a share, just about what it was in January 2000 when he received his first grant, he would break even between the two alternatives. If the stock price rose above US$44.85, he would be shown, in retrospect, to have been foolish in making the exchange, because the 27.5 million option shares would be worth more than the 5 million free shares. On the other side of the price spectrum, any future price less than US$44.85 would vindicate his judgment in taking the 5 million free shares." This presumes, as most pundits do, that Jobs is in it for the money, but there's just not much evidence of that. Crystal derides the title of the press release, "Apple enhances corporate governance," because he considers giving Jobs five million free shares to be a horror somewhere near the scale of Enron. And his calculations are correct: at any price below US$44.85 per share, Jobs makes more money on the new deal than he did with the much larger option grants. However, Apple said that the point of the exchange was to reduce option overhang, defined as the number of stock options granted and outstanding expressed as a percentage of outstanding common stock. Apple Computer has far fewer shares outstanding than most of its competition, somewhere around 360,000,00 shares. Microsoft, thanks to repeated stock splits, has around 10,700,000,000 shares outstanding; Dell has 2,580,000,000 shares outstanding, or seven times as many as Apple. The 27.5 million shares Jobs had options to exercise were a significant overhang on the company, around 6% of all outstanding shares and options. The options that Apple expects employees to trade back in are another 1%, for a total overhang reduction of over 32,000,000 shares. Crystal refuses to even consider this as a motive for the company's actions, even though Jobs has repeatedly refused to exercise his options, has declined all salary beyond US$1 per year, and has accepted no actual compensation in almost six years of leading the company other than an admittedly expensive Gulfstream V jet. So far, Apple's total compensation expenditures on Jobs amount to just over US$90 million in just under six years, or around US$15 million per year. That's certainly high, but nowhere near the top of the compensation list - and admitting that would deprive Crystal of a favorite target, so he doesn't. So why didn't Jobs just give up the options completely? Jobs' conduct over the past several years indicates that what he really wants is to run Apple Computer the way he wants to, and to be respected and recognized for it. Accepting a huge stock option grant is a headline-grabbing way to say Jobs is worth millions of dollars without actually requiring Apple to spend a single dollar - as long as Jobs doesn't exercise any of the options, and he hasn't exercised a single one since joining the board. However, if Apple announced that he had "voluntarily cancelled" 27,500,000 stock options, the entire business and technology press would put on their Kremlinology hats and immediately conclude it was a rebuke by the board. Why would they take back potentially millions of dollars worth of options if they weren't unhappy with Jobs? Canceling that kind of grant without replacing would be seen as punishment, no matter how Apple tried to present it. Similarly, Apple couldn't simply reprice the options, because the goal isn't to give Jobs more compensation (according to the board's statements), but to reduce overhang. Repricing 27,500,000 options wouldn't accomplish that, nor would it be easy to find some smaller number of options to issue Jobs that would reduce overhang and not be seen as a big financial take-back. As Crystal reports, the swap is basically a wash if the share price in three years is US$44.85 per share. If the price is actually higher than that, no one's going to call Jobs an idiot for engineering a massive stock price increase just because he doesn't become another billionaire from it. **The true costs** -- If the stock price stays low, Apple Computer will take a big financial hit. For example, if the stock trades at US$15 per share in three years, the cost of the five million shares will be US$75 million, but Jobs would have had no profit on the 27.5 million options because they'd all be underwater. On the other hand, if the stock trades at US$50 per share in three years, the cost of issuing five million shares is US$250 million, but because of the sheer size of 27,500,000 shares, Jobs would have made US$366 million in profit exercising them. That means the new plan benefits Apple by US$116 million. True, that's money Jobs doesn't get, but there's no evidence he wants the actual money - just the respect that comes with it. Crystal is eager to make Apple look as bad as possible, writing of the employee stock option exchange offer (for options striking above US$25 per share), "I doubt that anyone gave the employees any choice." That's a gutless accusation: Apple's proxy statement, released long before Crystal's column, makes it clear that employees are free to choose whether or not to exchange options, as they have been in every exchange program the company's ever had. Nor does he point out the blindingly obvious effect of the option exchange. When Apple's board granted Jobs the 20,000,000 options, the shares were trading in the US$43 range, and there was every reason to believe they'd go even higher. And they did - to a five-year high of US$72.09 per share (split adjusted) on 2001.03.22. None of Jobs' options had vested by then, but if the stock stayed in that range, he would have earned _US$570,000,000_ in profit on the full set of options. This is what the board expected to happen, and why Crystal was so upset about it at the time. On 2000.09.28, when Apple announced it would lose money in the September 2000 quarter (the start of a technology sales bust that no analysts saw coming before that month), the stock was still trading at US$53.50 per share, which would have given Jobs a profit of nearly US$10 per share (or US$200,000,000 for the whole option grant). Again: the board of directors expected Jobs to make a few hundred million in profit from his options. The new plan, however, doesn't cost Apple US$200,000,000 until the stock rises back up to US$40 per share. That's definitely lower than the same profit under the old plan, but is still nearly three times the stock's current trading price. The break-even point is US$44.85 per share, because at that price, both the 27.5 million options and the five million shares incur a cost to Apple (and a profit to Jobs) of US$224,250,000. If the stock price goes higher, the options would have become much more profitable. Under the new plan, if the stock rises back to its five year high, Jobs will pocket around US$360 million instead of around US$973 million. In 2000, Crystal complained that Jobs would make way too much money if the stock did well. Now, if the stock does well, Jobs will make much less money than he did before, and Crystal is complaining that the board shouldn't have changed the deal. One thing that is crystal clear: the only compensation package that would please Crystal is an ordinary one that doesn't set Jobs apart from the crowd of Silicon Valley CEOs, the only thing Jobs really seems to want. There's no question this is a lot of money for a chief executive officer. If the stock is trading at a respectable US$30 per share in three years, Jobs's compensation over his nine years of service leading Apple will total around US$240,000,000, including the Gulfstream. That's over US$26 million per year, a hefty sum in anyone's book. According to the 2002 _Forbes_ survey of CEO compensation [34], that's enough to keep Jobs at about #30 (the magazine should be updating its list in the next week or two), but puts him well behind both Michael Dell and Larry Ellison. In six years, Jobs has yet to receive any actual compensation beyond the US$90 million airplane and US$6 in salary, a package that keeps him in the top 50 but not by much. Now try imagining what Apple would have been like since 1997 without Steve Jobs and decide if you think the compensation is worth it, even in the top 30. [34] **The balancing board** Apple stock options are more of a crapshoot than for some other companies, because unlike some businesses, Apple's stock price depends less on its business than on Wall Street's perception of its business. Apple has survived several periods in its history when it was profitable and growing, and yet despite such positives, conventional wisdom maintained that Apple should behave more like other companies: sell only hardware, sell only software, compete on Intel machines, and so on. No one can present even the slightest bit of evidence that such plans would make Apple more profitable, but they would certainly make covering Apple easier for analysts and pundits, so they turn up every year. Apple refuses to torpedo itself for the convenience of experts, so the stock has therefore spent most of the past fifteen years right where it is now: stuck in the US$15 to US$20 per share range. That's why naming directors is so difficult for Apple: far too many board members, mired in this lazy idea of expertise, have pushed Apple into unprofitable conformity or urged the company's outright sale. Directors need to understand the value of the difference Apple brings to the market, not look for any excuse to extinguish it. When rumors fly of Apple's imminent demise or complete reconfiguration, it's bad for sales, bad for customers, and bad for long-term stability. Apple's current board brought an end to years of that fruitless speculation, and everyone ha been happier for it - other than the pundits. That said, it's still too easy for people in power to surround themselves with people who share their views. All of Apple's current board members have some kind of tie to Steve Jobs, and more independent representation on the board could bring in fresh ideas and better oversight than people who are too close to the issues. They just need to be people who understand why Apple can't make Mac OS X for Intel or sell Intel-based machines. It's a small group of people who qualify, but the harder the board searches for unexpected candidates that qualify, the more it will be rewarded. Thanks to Wall Street's misunderstanding of Apple, the company's stock price is a fickle mistress. It achieved its highest prices of the past five years in 2000. In 1998 and 1999, the analysts had repeatedly said that Apple didn't have much long-term chance, that new "trick" products like the iMac wouldn't make a difference, and that Apple's stock wasn't a good long-term buy. Yet Apple's products continued to capture the public imagination, sales continued to rise, and profits continued to pile up. Even though nothing changed, the analysts couldn't deny the truth, and reversed themselves to start recommending Apple stock (though a few, like Charles Wolf, had correctly pegged Apple as an up-and-comer back in 1998). They didn't understand why people were buying Apple products, but as long as they were, they were on Apple's side. None of them saw the technology bust coming either, and when Apple caught the early edge of it, the stock lost half its value in one day and has never recovered. The analysts didn't understand why people were buying Apple products but supported the company. Now they don't understand why people aren't buying Apple products, so thirteen out of fifteen analysts [35] that Yahoo tracks recommend a "hold" or worse on Apple. Only one has it as a "strong buy," and none list it as "buy." This lack of comprehension has been an unpleasant fact for Apple directors since color came to the Macintosh. [35] The directors know that Apple would still be stalled in product hell if Jobs was not running the company, and they're facing an almost insurmountable problem: how do you reward and motivate a billionaire who wants to look respected but doesn't really care about money? Initial plans to provide option-based compensation of around US$240 million through a massive option grant fell apart when the stock price tanked, and because Jobs never exercised any options in either large grant, the company faced unacceptable overhang. The only way to fix it without making Jobs look bad was to give him either cash or shares. The value of cash does not increase if Wall Street wakes up, but shares do. Boards usually pick the compensation that has more motivating power. Don't expect controversy over any of this to fade away. As long as conventional wisdom wants Apple to be either Dell or Microsoft, the board will be under the same pressure to pacify Wall Street [36] instead of doing what's best for Apple's customers, developers, and product cycles. The lessons of Enron and WorldCom _should_ be that making Wall Street happy at any cost is a bad idea, but Wall Street still doesn't seem to think so. Apple's board has to let new ideas and new voices into the process while remaining focused on what's good for Apple, not what's easier for Wall Street. [36] It's a tough job when you've tied your stock-based compensation a share price that only goes up if you do the wrong things. So far, Apple's board has been able to resist the temptation of big personal profits in favor of doing what's right for the company, and so has Jobs. "Compensation experts" don't include that in their analysis, but they should. History shows that the only way Apple can drive its stock price higher is through sales so strong Wall Street can't ignore them, not just moderate profitability. It's the only real key to a stronger Apple and big compensation for the board of directors. If that's not incentive, nothing is. ----------------------------------------------------------------- MDJ_, The Daily Journal for Serious Macintosh[tm] Users, is published by GCSF, Incorporated. Publisher: Matt Deatherage Staff: Justin Seal Nathaniel Irons John C. Welch Jerry Kindall John Gruber Copyright (c) 2003 GCSF, Incorporated. All rights reserved. All trademarks are the property of their respective holders and owners. The symbol **[D]** indicates potential conflicts of interest, but for readability, the necessary disclaimer has been omitted from the text. Such disclaimers may be found online at . MDJ_ contains news, information, strong opinion, parody, biting sarcasm, and things you need to know. Those easily offended should seek information elsewhere. Humans often answer the telephone between 10 AM and 6 PM Central (US) Time, Monday through Friday. Voicemail is available at any hour. This file is formatted as setext. For more information, send email to . A file will be returned shortly. It is also digitally signed using PGP technology to verify the integrity of the transmission. Our DH/DSS corporate PGP key maybe obtained at . GCSF, Incorporated. P.O. 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