Employee Stock Options: Powerful Tools When Used for Good

Two recent articles prompted me to write a short note concerning employee stock option plans, specifically addressing: (1) the appropriate use of employee stock options; (2) certain misconceptions that have arisen due to the recent options backdating scandal and other historical abuses of stock option plans, and; (3) the SEC's recent adoption of a rule governing how option costs should be presented in proxy materials.

In today's Wall Street Journal
Bosses' Pay: How Stock Options Became Part of the Problem

In today's New York Times
S.E.C. Changes Reporting Rule on Bosses' Pay

It's almost as if the editors of these two esteemed publications went bowling, with the WSJ and NYT coming out with different but related stories on the issue. This is a very difficult topic to be sure, cutting across disciplines such as behavioral psychology,  compensation design, financial engineering, and accounting and taxation, to name a few. We should, however, keep our eye on the goal: the recruitment, retention, motivation and compensation of employees in order to create maximum value for the firm's shareholders, after taking into account the costs of delivering these plans. And it is this "net value" concept that is critical to the determination of appropriate plan structure and quantity of options granted, and should be viewed as a guiding principle to ensure analytical rigor and discipline when designing these programs.

Appropriate Use of Options

So what are the objectives achieved through the use of employee stock options? (1) Recruitment, (2) retention, (3) motivation and (4) reward, right? So why not just use cash? Well, what about the companies that don't have a lot of cash but have attractive growth opportunities? Ok, I guess this is why start-ups have long used options as a compensation tool. But what about companies that have the cash required to accomplish these objectives? Maybe the favorable tax treatment of options versus cash? Certainly. Possibly the clear alignment of motives between a company's share price performance and an employees' compensation? I'd say. Perhaps the more favorable accounting treatment of options versus cash? Unfortunately, yes. Now these are pretty good reasons (with the exception of accounting treatment, which is a real problem), though many will argue that a given employee, unless they are a high-level executive, has little to no impact on a companys' share price.

But is rewarding a direct impact on stock price really the point? Or does granting options at all levels of an organization create an esprit de corps, a sense of ownership and pride that really does positively impact performance notwithstanding the weak relationship between payoff and effort? I personally think it does have a positive effect on performance, even at lower levels of an organization, with one notable exception: when share price performance sucks. And this impacts employees at all levels, from C-level executives to entry level worker bees. A falling stock price  literally transforms an option plan into a karma boomerang, turning what was once a beautiful landscape into an ugly hell hole. And this, to me, is the single biggest weakness of option plans versus, say, restricted stock grants. Sure, the value of your stake goes down if you hold stock and stock price drops, but you've at least got something. With options, in the absence of an ability to monetize time value (which Google has just started to do with its employees), you've got nothing. And instead of fostering motivation and teamwork it creates a depressing, divisive work environment. Clearly not the goal, right? We've seen this story play out across the technology landscape in the wake of the 2001 downdraft, crushing companies like Microsoft in the process.

So what is the answer? Without question, options are both a powerful and necessary tool for achieving the four key objectives listed above for small, rapidly growing companies. This is clear. So what about larger, more established companies? If a company is large but still growing rapidly, options will continue to be a tool of choice because of (1) tax efficiency, (2) alignment of motives and (3) creating a "we're all in this together" culture. Like Google. And this makes sense. But what about the Microsofts of the world, or the Proctor & Gambles for that matter? I'd say some options should be a component of a senior executives compensation package, along with cash and restricted stock, but that options should likely not go too far down the hierarchy as they will not be valued anywhere near their theoretical value and, as such, will only serve to dilute existing shareholders without getting the motivational benefits promised. Principally cash with some restricted stock is likely best for people at lower levels of these companies, in my opinion. And to focus on the tax efficiency angle (or the accounting treatment, for that matter) without thinking about how this particular piece of compensation will be valued by employees would be a grave, grave error. So while I am not a compensation expert, based upon my observations of which option plans have worked, and which have not, I offer you my $0.02.

Popular Misconceptions

There has been a tremendous amount of noise around stock options for a long, long time, and this was very well outlined in the WSJ story. Clearly the volume has recently been turned up due to both the option backdating scandal and the magnitude of options granted guys like Bill McGuire of UnitedHealthcare. And this makes sense. Boards of Directors have done some tremendously stupid, irresponsible, un-shareholder friendly things related to options over the past two decades. And this, to me, is where the problem really lies. Should senior executives of successful companies be highly compensated? Yes. What defines success? Long-term share price outperformance relative to peers (though short-term performance matters as well, just not as much). Should senior executives get sickly rich by running a company in the wake of a massive bull market? Not unless they are outperforming their peers.

I kind of think of a payoff grid akin to GE's grid for employee assessment. Let's say in our case the x-axis is time horizon - short-term, intermediate-term and long-term. And the y-axis is relative stock price performance - outperformance, median performance and underperformance. As a Board member, I would want to develop a plan rewarding senior executives that was skewed towards long-term outperformance, but also gave credit for short-term outperformance. So, at the end of the day, if an executive team could achieve both short- and long-term outperformance, they would max out on their bonus compensation. However, if they missed on short-term outperformance (say due to heavy capital investments necessary to attain long-term goals) but scored on long-term outperformance, then they would capture the lion's share of the potential bonus payout. Conversely, if the team scored on short-term outperformance but whiffed on long-term outperformance, they would only get a fraction of the possible bonus payout. And these bonus payouts could be a mixture of cash, restricted stock and outperformance options (where a base-line value is created for the peer group, and serves as the benchmark against which company share price performance is compared). Again, I am certainly not that knowledgeable in this area, but this seems like a straight-forward, commonsense construct that should be workable from both management motivation and shareholder value perspectives. In other words, the alignment of motives that matters - management and shareholders. BUT IT IS UP TO THE BOARD TO MAKE THIS HAPPEN.

So the punch line is, at the end of the day there has been a lot of bad stuff that has gone on with employee stock option plans. But I trace much of the problem back to Boards of Directors. Sure, you can blame the Congressional restriction on tax deductions for executive pay beyond $1 million, aggressive compensation consultants and lots of other parties for why things spun out of control. But at the core the fiduciary responsibility resides with the Compensation Committee of the Board - and, in general, they have failed miserably. So let's not throw the baby out with the bath water - options, used prudently, are extremely powerful tools for compensating and motivating employees. But when misused they can be virtual WMDs for shareholders.

The SEC

Chris Cox, et al just enacted a rule governing how stock option expense should be presented to investors. They backed off a July ruling that would have showed 100% of the value of a current grant in current years compensation in the summary table, instead opting for a rule that amortizes the value between grant date and vesting date. This creates symmetry with stock option accounting under FAS 123R. Consistency is good. The problem is the asymmetry between, say, a cash bonus, a restricted stock grant and a stock option grant that all have the same value (with the option value measured using Black-Scholes, a binomial model, whatever), though only a fraction of the stock option grant's value is reflected in the current year. This is a very hard problem to reconcile. I am happy at least that some measure of stock option expense is running through the income statement, and that investors will have all the information at their disposal to adjust their models for option expenses how they see fit. As has been the case, I'm pretty happy with how Mr. Cox has handled the issue. Enough about the SEC - let's move on.

The Punch Line

I am sick of the stock option echo chamber. I just wanted to get some common sense thoughts down that hopefully brings down to earth some of the issues thrown around by those with agendas, be they in corporations, lobbying groups, regulatory bodies or politics. Stock options are good. They are. It's just that Boards have to step up and do their jobs. Or step off. Now.

Comments

[Jing]

I've heard executive compensation issues (particularly for the larger, established Fortune 500 companies) come up a lot in different discussions. I had no idea regarding the complexity of the matter though - seems like a headache to really align everyone's incentives!

Just a few weeks back, I heard a speech from Mike Critelli, CEO of Pitney Bowes, who came to Wharton. He told us one of the key things he did was change the executive compensation structure. He found that senior executives of the various divisions were more inclined to care just about their division's profitability rather than the profitability of the firm as a whole (which created a lot of conflicts of interest). Thus, he changed it, so compensation wasn't division-specific.

[EC]

I tend to agree with Peter on this one regarding stock options. I apologize in advance for the length of this, but it's a topic dear to my heart. For whatever it's worth, I've tended to find specific situations to be so different that I would be oversimplifying to speak generally about what a "good" compensation plan should look like.

The root cause, in my opinion, of problems with compensation plans are (1) lack of relevance and (2) encouraging excessive risk taking.

2 funny examples come to mind of (1). One is CMI. The stock was languishing. Their performance was based, at the time, on a combination of 'median ROE' of a bunch of industrial companies and stock price performance. The thing was, what the hell does median ROE of industrial companies represent? CMI was presented with its own set of unique problems and circumstances, as do all companies at any given point in time, so compensating an executive on his ability to outperform over a 1 year time interval what was basically a random performance metric was arbitrary. They switched to internally generated FCF targets for everyone, jacked the magnitude as a % of base salary, forced mandatory stock ownership, and guess what? One can visibly see attention to FCF.

The other funny example is a little closer to home-- it's the compensation plan of a store manager at a local New Balance store. The owner of the portfolio of stores has said that each store needs to grow SSS at 10% or more each month. If they do so, the store manager gets a $1k bonus for the month. If not, no bonus. Well, it just so happens that this one particular store in question happens to naturally do well over 20% with no problems due to trends in local demography. The store manager is content to sit on his hands collecting his bonus every month, and while there are things he could do to improve the performance of the store further, why bother? He might as well put them in the cookie jar for when things get difficult.

Heavy stock option ownership has some other problems which have yet to be mentioned. I'll again use an example-- LCCI. It was your typical case of "old management team sucks, new CEO will come to fix things up" story. Dean did a great job in his prior lives, he knew the industry like the back of his hand, he accepted a pay cut to his base salary to make the switch to a much more shaky job, and he accepted a huge slug of options which will only make him money if the stock dramatically outperformed under his tenure. Great story, right? And the market loved it. Problem is, if you talk with this guy, I get the impression he's spending half his time thinking about useless crap that will move the stock price. From personal experience I can tell you that at any given time he knows what the stock price is. He thinks about what shareholders might think if he were to do certain things, and he was downright distraught when they sold their deployment business ("the stock market doesn't get it!"). Now he's eliminating the class B shares. If he were to spend half that energy on teh business, maybe they might actually be able to grow their top-line for once. The point of this example is these guys aren't hedge fund managers, and the vagaries of stock prices can skew their decision making in a bad way.

If there are 2 crucial components to a good comp package, I tend to think of the following:
(1) Strong Board of Directors-- incentivized as part owners, independent of management.
(2) Unbiased internally generated targets for both the executive team and the business unit heads by the BoD as the driver for target and stretch bonuses.

There will always be imperfections, but that combo of strong BoD and internally generated targets can do a pretty damn good job of hammering out the relevancy problems. That plus a relevant set of performance metrics can do wonders from my experience.

[Bill a.k.a. NO DooDahs]

The business goals are both immediate and future; you want profits now but want to position for future profits. In some businesses, you know what your profit now actually is, in others, you don't, but you put an *estimate* on the books and later might revise it. There's some judgment and error involved, even in the *now* profit. And how does one decide whether the company is better positioned for future profits? Even more judgment and error involved. It would be difficult to create a metric that captured these things, while still being simple enough to implement and not significantly "game"-able by management. Ultimately it would be best for the company if they tried, and tied compensation to such metrics.

Tying compensation to the stock price not only disconnects the compensation from the performance (compared to a direct performance metric), but allows significant gamesmanship in stock price manipulation as well as the options dating shenanigans.

I don't think options are the best solution to the "agency problem" for most companies. I don't even think they are a GOOD solution.

Given the tax treatment, and the fact that it is easier for a Board to grant options than it is to directly tackle the issue of "what is good management" – use of options will continue. It is the EASY solution.

[Peter Clark]

Thanks for making it clear that the failure of board oversight is the key issue here. I still have a bit of difficulty with the granting of executive stock options for mature firms (which you indicate might be appropriate) - I think the skewed return distribution, when combined with falling average tenures for CEOs, can lead to a swing-for-the-fences mentality, particularly as options go under water. Restricted stock (or profit sharing, as another commenter suggested) seem better aligned with the returns that the majority of shareholders can be expected to receive.

First time commenter but a long-time reader - keep up the good work!

[Bill a.k.a. NO DooDahs]

"Alignment of motives?" As a partial owner of the business ("investor" LOL) I wouldn't want management concerned with the stock price AT ALL. I would want them concerned with the company's viability and profitability.

Now, as a trader, I know those two don't go together (price and company performance) except over very long horizons – often longer than the lifespan of many execs, don't you think?

Options will always be around, can't fight that. I agree with the tax reasons and use by highly speculative, cash-poor firms. I don't think they are a better choice than cash, just an EASIER choice, because it's easier to measure the stock price than it is to metric company performance. That, and the "government" incentive via theft, er, taxation, is enough to keep them around indefinitely, even for larger firms.

[Yaser Anwar]

Just like every other instrument, like there are twos sides to a coin, in the business options have their pros and cons.

At the end of the day firms are expected to make greater use of stock options (i.e. ISOs in which the employee is able to defer taxation until the shares bought with the option are sold. The company does not receive a tax deduction for this type of option, and, NSOs in which the employee must pay infome tax on the 'spread' between the value of the stock and the amount paid for the option. The company may receive a tax deduction on the spread) and non traditional instruments because I believe all instruments will be treated the same under the current standards and options have the potential to allow firms to better accomplish their equity based compensation program goals and reduce compensation expense.

No wonder we are hearing top notch companies such as Fortress going public to benefit from this valuable compensation currency.