Rethinking CEO Stock Options

The stock option component of CEO compensation makes a dubious performance-incentive, says Tuck professor Sidney Finkelstein

By
Sydney Finkelstein

With the stock market in a possibly record-setting swoon, one of the
first things boards of directors and senior executives are thinking
about is: How soon can they reprice their stock options? Ironically, it
may well be the prevalence of stock options that has contributed to the
current economic mess. What's that, you say? How could anyone speak ill
of stock options, the engine of growth in Silicon Valley and a ready
path to wealth for millions of executives?

There are two big problems with most stock option plans, each of
which has potentially important consequences for managerial
decision-making.

First, stock options offer a one-way ticket to wealth generation,
but without any real downside. When your stock is up, you benefit. When
your stock is down, you don't so much lose money but rather make less
money. Stock options have turned out to be incredible engines of
risk-taking. And why not? There is little downside if you bet wrong,
but huge upside if you roll your number. Much the same logic explains
why so many bankers were willing to keep betting on subprime mortgages.
Bonuses, like stock options, can only help you; they carry no penalty
to personal wealth if you make the wrong choices.

Fueling Bad Judgment

Indeed, researchers have found that CEOs rewarded predominantly with stock options
relative to restricted stock were more likely to make poor
acquisitions, had more hits and misses that led to more volatile
financial results, and were even identified as having more accounting
irregularities.

What to do? Savvy boards will understand that a combination of stock
options and restricted stock grants retains the incentive to make it
big while ensuring that managers making extravagant bets like subprime
will pay a personal price via the reduction in the value of their
restricted stock. Similarly, bonuses should be scaled back, perhaps in
combination with higher salaries, to create a more equitable playing
field. Making bad decisions should hurt managers in the wallet, just as
making good ones should help them.

Second, stock options are usually granted without regard to the
performance of peer companies. This one is a little hard to believe
until you see for yourself. Most stock option plans pay out to
executives even if they perform much worse than their counterparts at
competitor firms. So, in a bull market, everyone benefits, even the
laggards in an industry as long as the overall market lifts all stock
prices. You may end up greatly underperforming competitors, but your
management team will still pick up the prize.

The solution should be straightforward. Stock option grants should
be tied to the relative, not absolute, performance of a company. If you
do better than your peer institutions in a rising market, you should
get big rewards for doing so; if you can't keep pace, why should boards
pay out in the same way? Be forewarned, however. There will be howls
from some quarters on this one. For an industrial class that has become
accustomed to generous stock option rewards in rising markets,
demanding superior performance will be a tough pill to swallow. But if
boards don't set the standard, no one will.

Real Downside

The rush to reprice stock options in this down market is a perfect indication of how imperfect this method of compensation
really is. It is not that repricing removes the downside from stock
options—you can't lose money with stock options; you can only make less
money. This will never happen, but why do boards not reprice stock
options when the stock has gone up dramatically? If it makes sense to
recalibrate options when they are under water to provide realistic
incentives for good management decision-making, why not do the same
when they no longer represent

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Posted by Dan Walter

Performensation: Equity Compensation for High Performance Companies.