Funny Money, Or Real Incentive?

A new study shows that options make poor CEO bait

Fantasize for a moment that you're a CEO candidate negotiating a pay package. Which would you rather get: $10 million in cash, or stock options with an open-market value of $20 million? If you're like most people, you'd take the cash because it's less risky than volatile options. In fact, when companies offer stock options to executives in place of salary, they often have to give them options valued at 250% or so of the cash.

While stock options may feel like funny money to their recipients, they represent a genuine cost to their issuers. To avoid dilution of shares when options are exercised, companies have to spend real money to buy back shares on the open market. If executives prefer cash, and options are expensive to issue, why do companies nevertheless rely so heavily on options? Good question. Finance scholars are beginning to conclude that extensive use of options is, to use a nontechnical term, stupid. "Options are, in fact, an unusually expensive and therefore inefficient way to convey compensation to executives and employees," write the authors of a major new study, Brian J. Hall of Harvard Business School and Kevin J. Murphy of the University of Southern California's Marshall School of Business.

Their report, "Stock Options for Undiversified Executives," was published in December by the National Bureau of Economic Research Inc. It's already getting favorable notice from other researchers and pay experts. "It's very, very interesting," says Ira T. Kay, the director of compensation consulting at Watson Wyatt & Co.

Other scholars, including a team from the University of Pennsylvania's Wharton School of Finance, have previously pointed out the big gap between the high cost of options to issuers and their low value to recipients. But Hall and Murphy are the first to follow that fact to all its implications for pay practices. They start from the observation that executives who hold lots of shares and options in their employers' companies are highly risk averse. Most of their eggs are in one basket, and they usually can't or don't hedge against the possibility of a decline in the value of their company's shares. (Although there are exceptions. See page 72.)

FEAR OF RISK. Even though pay packages of executives soared in the 1990s, Hall and Murphy conclude that the executives didn't feel much richer because most of their raises came in the form of options, which they didn't value highly. In a calculation for BUSINESS WEEK, they estimate that the median company in the Standard & Poor's 500-stock index in 1999 paid stock-based compensation that cost it $3.3 million, as measured by the widely used Black-Scholes formula, which takes into account factors such as timing and stock-price volatility. But from the point of view of the risk-averse recipient at the median of S&P 500 CEOs, stock-based compensation was worth just $1.1 million (chart). In other words, perceived value was one-third of actual cost.

Yes, the advantage of stock options over straight salary is that they give executives more of an incentive to get the stock price up. But Hall and Murphy say that advantage needs to be measured carefully against their disadvantages. Says Hall: "We're just saying that if they're going to be used, their cost needs to be outweighed by their incentive benefits."

The big winner in their study is restricted stock--that is, stock issued to executives that can't be sold before a certain date. Hall and Murphy say that restricted shares provide the correct incentives to recipients to get the stock price up. At the same time, they're less volatile than options, so executives value them more highly. Watson Wyatt's Kay says his firm has reached a similar conclusion and now recommends that companies get restricted stock into employees' hands by selling it at a discount. Executives love the idea, he says. "They sign up in droves."

Of course, all the disadvantages of options pale against one huge albeit artificial advantage: their accounting treatment. While salary, bonuses, and restricted shares count as compensation and thus raise reported costs and reduce reported profits, stock option grants don't affect earnings. Hall says the Financial Accounting Standards Board should renew its campaign to eliminate the accounting bias in favor of stock options. Finance theory says that investors should be able to look past the accounting treatment, but in the real world, reported earnings matter.

It was hard to argue that stock options were a bad form of compensation during the 1990s, when they rose invincibly in value year after year. But their popularity has declined along with the market averages. This important paper will undoubtedly add to the backlash against them.

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