Peeling away financial reporting issues one layer at a time

Are Stock Options an Efficient Form of Executive Compensation? – No!

Have you noticed how a large number of companies curtailed or eliminated their stock option grant programs when FAS 123R became effective?  You frequently hear proponents of stock option programs spout the line that stock options, like nothing else, provides incentives for management to create value for shareholders.  Well (can you hear Ronald Reagan?), that's a myth, and I'll prove it with a simple example:

The CEO of a company has one asset at the beginning of the year, $1,000,000 cash, and his only job is to decide how to invest the money.  The CEO's only compensation is in the form of an option to acquire 20% of the company at the end of the year.  The option is granted at the beginning of the year, and has an exercise price of $200,000.  (Note: since 20% of the company is worth $200,000 at the beginning of the year, we see that the option is granted at the money.)

The CEO has found only two projects to choose from, as follows:

  • Project A will pay $1,050,000 for certain at the end of the year.  Therefore, the executive's option to purchase 20% of the company would be worth $10,000 (= 20% x $1,050,000 – $200,000).
  • Project B has a 10% chance of paying $2,000,000 at the end of the year, and a 90% chance of paying $500,000.  Therefore, its year-end value is $650,000, and the executive's option would be worth nothing 90% of the time, but $400,000 (=20% x $2,000,000 – $200,000) 10% of the time.

Which project do you think the CEO will choose to invest in?  For sure, a lot of CEOs would be tempted to choose the value destroying Project B.  It also stands to reason, that the higher a CEO's cash salary (zero in this case, but rarely observed in reality), the more attractive a CEO would find Project B.

The point of the example is to demonstrate that the risk characteristics of options do not align with the risks that accompany holding shares of stock.  That's why so many companies have replaced options with shares, post the effectiveness of FAS 123R.  If the CEO's salary in my example was, say, shares of stock for 5% of the company, we could safely say that the CEO would always choose Project A–the choice in line with shareholders' interests.

OK.  I've now demonstrated that stock options as a form of executive compensation are inefficient.  Imagine the huge transfers of wealth from shareholders to managers in the supposed name of shareholder wealth creation, when just the opposite was happening. 

The analysis I have provided you is not groundbreaking, so it must be asked what has driven the propensity to award options?  For sure, the fantasy accounting under APB 25, which allowed companies to portray options as if they were costless to shareholders, was a huge factor.  Anyone (the APB, FASB, SEC and Congress–to name the principle classes of culprits) who had any involvement in establishing or perpetuating such a ridiculous accounting rule should feel ashamed for their complicity in a vast scheme to deceive the investing public and impair the competitiveness of the U.S. economy.

Before I conclude this post, I need to issue a caveat.  I am not saying that stock options are inefficient under all circumstances.  Labor markets may dictate that stock options be a part of the pay package for many key employees.  I am only pointing out the inefficiences created by giving stock options to executives who allocate corporate resources.  For other key workers, it is often the case that stock options are an essential means of retaining their employment. 

1 Comment

  1. Reply George Weinbaum November 13, 2007

    I have made similar observations about stock options and likened them to dividends. If a company has $10 million of market cap on day one then issues an “at the money” for 10 years to an executive for 10% of the stock. The stock price should fall as the company is still worth $10 million but some market cap was given the executive. I suspect the effect would only be noticeable in small companies. If no academic has looked at this, it would make a decent PhD thesis, options as dividends.

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