Average total potential dilution for major U.S. companies dropped 1.5 percentage points in 2006, in keeping with a three-year trend, according to Stock Plan Dilution 2007, a new ISS study that examines S&P 1,500 companies.

The data from 2006 not only confirm the recent trend of declining potential dilution, but also suggest that the pace of the trend is accelerating. From 2003 to 2005, overall average potential dilution for all companies fell by one percentage point from 17.0 percent to 16.0 percent. From 2005 to 2006, average potential dilution, or "overhang," dropped to 14.5 percent, the study finds.

A number of factors have contributed to the drop in overhang. First, the stock option, long a "free" compensation tool that enjoyed favorable accounting regulations, is no longer exempt from impacting a company's expenses. This development has resulted in a shift away from the use of stock options and toward the use of full-value awards, such as time-lapsing restricted stock and performance-vesting shares.

Since a full-value share has more intrinsic value than an option, whose tangible value is only the positive difference between the stock's market price and the option’s exercise price, the number of shares necessary to fulfill a company's equity compensation needs is declining.

Secondly, companies listed on a major U.S. exchange are no longer able to adopt or add shares to a plan without obtaining shareholder approval. The inability to circumvent shareholder scrutiny may be influencing the amount of shares being reserved under compensation plans.

Third, the growing attentiveness of institutional shareholders to proxy voting, aided by the Securities and Exchange Commission's requirement that mutual funds must establish proxy voting guidelines and disclose their votes publicly, also is having an impact.

Notably, falling dilution levels stem not only from companies' decisions to curb the number of shares reserved under stock-based compensation plans, which is generally favored by investors, but also by decisions to float more shares in the open market, which is generally less well-received by investors.

From 2005 to 2006, these two factors contributed almost equally to lowering average potential dilution. The percentage decrease in the aggregate number of shares reserved under stock plans was 5 percent, while the percentage increase in the aggregate number of outstanding shares was 5.2 percent.

The moderation of potential dilution is likely to continue as companies anticipate investor backlash from the growing scandal over option backdating and "spring-loading" practices. Dilution levels also may continue to drop given that average potential dilution remains above 2000 levels, when the stock market bubble peaked. That year, average overhang stood at 13.4 percent.

With respect to benchmark firms, 2006 was a milestone year for two reasons: It was the first year that the majority of all study companies had less than 15 percent overhang. Secondly, 2006 was the first year in which the key 75th percentile fell below the 20 percent threshold.

The S&P 500, Mid Cap, and Small Cap indices all witnessed a decline in average potential dilution from 2005 to 2006. Interestingly, the Small Cap index edged out the S&P 500 as the index experiencing the most significant decline.

Companies with High Levels of Dilution
The prevalence of companies that fall into what might be called "mainstream" practices on overhang is high and continues to rise. In 2006, 78 percent of study companies had potential dilution of less than 20 percent, a meaningful increase from 73 percent in 2005.

At the same time, companies with abnormally high potential dilution are becoming increasingly rare. The percentage of study companies with more than 40 percent overhang dropped from 2.8 percent in 2005 to 1.8 percent in 2006. Companies with dilution levels in excess of 50 percent stood at 0.8 percent (11 companies) in 2006, compared with 1.9 percent (29 companies) in 2005. Twenty-four companies, or 1.6 percent, had dilution levels in excess of 50 percent in 2004.

Eleven companies are listed on this year's top-10 list for highest dilution due to a tie for the 10th position. Coincidentally, the 11 companies also represent the only study companies with more than 50 percent potential dilution.

It comes as no surprise that all but two of the 11 companies maintain at least one plan with an evergreen feature, through which the plan's reserve periodically increases. More commonly adopted during the late 1990s and early 2000s, evergreen plans are rarely introduced today.

Five of the listed companies are in the information technology sector, which as noted earlier, carries the highest average potential dilution among all sectors.