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 ProblemIn 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.
