Rethinking CEO Stock Options

The stock option component of CEO compensation makes a dubious performance-incentive, says Tuck professor Sidney 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 a tough, but attainable target? With an elevated stock price, stock options will pay out big even if managers don't do anything, and that's not much of an incentive after all.

Well, looking for equity in repricing is not something I would bet on. But when stock options are being repriced in this bear market, let's make sure they take on some of the real balanced incentive characteristics they should. And that means trading some stock options for restricted stock grants so there is a real downside when managers make flawed decisions, and ensuring that any stock options pay out only when managers meet or beat their competitors. Anything less and we will be repeating some of the same mistakes that helped get us into this mess in the first place.

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