An Ill-Advised Decision in Time Warner-AOL Merger

Here’s a hot investment tip: Go long on Hamptons real estate. That’s because, in a stunningly stupid move, every last employee stock option at Time Warner Inc. became instantly exercisable the minute the board approved the media company’s $153 billion acquisition by America Online Inc. By my rough estimation, that immediate vesting freed $1.8 billion in option profits. Pour that much money into New York, and the price of starter castles and McMansions on the Hamptons beaches has got to soar. In an age when every information company likes to extol the value of its “human capital,” Time Warner just dissolved an important bond keeping its employees from walking out the door. Normally, if a company’s stock options become exercisable in the event of a merger, the vesting does not take place until the transaction is completed, giving the buyer a chance to at least attempt to retain the target’s employees before they cash out. It’s hard to estimate exactly how much paper profit the move suddenly unlocked. I came up with the $1.8 billion figure by looking at the roughly 36 million option shares that were outstanding at the end of 1998 but could not have been exercised at that time. Some of those shares certainly would have become exercisable in 1999, even before Time Warner’s board approved the combination with AOL. But Time Warner’s board probably granted a ton of new option shares in 1999. My bet: The $1.8 billion figure is understated. Almost all companies attach restrictions on exercise to their stock option grants. At Time Warner, the usual pattern is to permit exercise of one-third of the options one year following the date of grant; two-thirds two years following grant; and all of the options three years following grant. Companies follow this practice for a simple reason: to get some holding power over the employees and prevent them from joining a competitor. So why is the immediate vesting on the America Online merger potentially calamitous? Well, for openers, what if the deal unravels? There is certainly a scenario out there that has the price of AOL dropping so much that Time Warner shareholders simply vote down the merger. Under that scenario, Time Warner’s shareholders may be unhappy, but the company’s executives will be ecstatic, because their options became fully vested (and were probably already exercised at a higher price before the deal unraveled). Then there is the vulnerability of Time Warner executives to the blandishments of the competition. Time Warner doesn’t exactly operate in some sleepy backwater of corporate America, where people spend their entire careers at one obscure company. Just the opposite. Time Warner has oodles of talent at its studios, cable networks, magazines and other businesses, and competitors like Disney, Viacom and Hearst would just love to get their hands on that talent. Their task just got a lot easier. Rosser Reeves, the legendary former chairman of advertising agency Ted Bates, once observed, “Ninety-five percent of my inventory goes down the elevator every night.” So too at Time Warner, and at least some of those people probably won’t be taking the elevator back upstairs in coming months. To hold onto its talent, Time Warner could promise that if the executive stays, he will be granted a large new option the minute the AOL deal closes. But that will increase the new company’s cost of business still more. Of course, Time Warner just might muddle through this period of maximum vulnerability. “If you’re a journalist, where else would you want to work?” spokesman Ed Adler told me. “If you’re a filmmaker, where else would you want to work? If you’re an executive like me, where else would you want to work?” Adler’s statements come across as a bit arrogant. But they may not be, because there is another way to hold onto people besides threatening to take money away from them if they join a competitor. That is to pay them the moon so no competitor in their right mind would go after them. Some 15 years ago, when I was working as a compensation consultant, I conducted the definitive survey of pay in the entertainment industry each year. Every studio and every network participated in the study, including the HBO division of what was then Time Inc. But Warner Bros. (which was then a unit of Warner Communications) was not in the study, and the other participants urged me to get them in. So I went to visit Bob Daly, who was then co-head of Warner Bros., who I knew from his days at CBS. Bob listened to my pitch but rejected it. As he was escorting me out to the lobby, he said, “Even though I don’t want to be in your survey, I want to take full credit for your even doing a survey.” He went on to explain that when he was head of CBS Entertainment, he was the one who pushed CBS to hire me to start the survey. Puzzled, I said, “I don’t understand. If you liked the idea back then of doing the survey, why don’t like the idea of doing it now?” Bob flashed his most disingenuous smile at me and replied: “Back then, I thought I was underpaid!” Graef Crystal, author of “In Search of Excess” and other books on executive compensation, is a columnist for Bloomberg News.