Options Are Useful--but Only If They're Used Right

Changing the way options are doled out would boost transparency while still pushing execs to strive for excellence

By Gary S. Becker

The growing use of stock options in the 1990s has been partly blamed for the bubble in tech stocks during that decade and for some of the misleading accounting practices of Enron Corp. (ENRNQ ) and other companies. But politicians and others have excessively criticized options, which are a valuable tool that can encourage management to work effectively for their companies.

Options only add to management compensation if a company's stock rises above the exercise price. This gives managers incentives to work hard to increase profits and raise share prices enough to make their options more valuable. Greater profitability usually also benefits employees, stockholders, and others with close ties to the company. Options also penalize managers when companies do not do well; their options then become of little value and are unlikely ever to be exercised.

To be sure, some boards of directors deserve severe criticism because they have given management too many shares that are too easily "in the money." But the misuse of options by some companies is not a sufficient reason to ban them, as several prominent money managers have recommended. Instead, a few reforms would allow stockholders and others to monitor a company's options commitment, and yet at the same time do an even better job of rewarding managers for superior performance.

Options are both compensation for executives and also potential costs to stockholders, since their exercise dilutes stockholder ownership rights. For this reason, and to provide clear information on the generosity of outstanding options, the value of the options given in any year should be deducted from revenue in that year. One way to estimate value is to use the Black-Scholes formula, which links the value of an option to such variables as the current share price, the exercise price, expected volatility in share prices, and expected dividends.

Business leaders have generally opposed efforts to require them to add the value of newly issued options to costs. That's true even though they might be able to reduce their tax liabilities by lowering reported profits when options are issued, rather than later when they are exercised. It is disturbing that most companies seem to prefer raising reported profits over cutting their taxes.

Still, I do not believe Congress should make it mandatory to account for options in this way. Coca-Cola Co. (KO ), Boeing Co. (BA ), and a few other leading companies recently made the right decision to include estimated values of new options as part of costs, and market forces will pressure others to follow their lead.

Many companies have been severely criticized because they often reprice options when a stock dips so low in value that the options are "deep out of the money." These critics oppose repricing because they believe it eliminates financial punishment to executives whose mismanagement caused a company's stock to fall. However, repricing is warranted when declines in stocks are not the fault of management.

Salaries and "normal" bonuses should compensate management for average performance compared with competitors. Options, on the other hand, should only reward business leaders who help their companies do unusually well. They should not be paid simply for succeeding in a booming industry. Moreover, executives should not be punished for declines in share prices that are due to hard times for the whole industry.

A simple way to reward management only for top performance is to make options depend on the performance of a company's shares relative to that of average shares in that industry. For example, instead of an exercise price that is equal to a company's share price on the issue date, options could be "at the money" when the ratio of its share price to the industry's average share price is equal to what that ratio was on the issue date.

With such a measure of relative performance, options on shares whose price has risen by less than the average for their industry would be out of the money. Yet, by the same token, they might be valuable if the company's shares have fallen by much less than those of competitors.

Such a system would punish management when a company's shares fall a lot relative to competitors', but that may not be enough punishment for substandard management that produces dismal results. I have long believed that boards are too lenient with badly performing CEOs. Just as coaches are often fired when they do poorly compared to competitors, many more CEOs who greatly underperform competitors should be let go.

Options are a valuable business instrument when they only reward unusually good management and punish bad management. And option values should be added to accounting costs when they are granted instead of when they are exercised, so that stockholders could see immediately if management is being excessively compensated relative to their performance.

Corrections and Clarifications "Options are useful--but only if they're used right" (Economic Viewpoint, Aug. 5) incorrectly stated that by expensing stock options, companies might be able to reduce their tax liabilities by lowering reported profits. In fact, expensing options can lower reported profits but it generally has no effect on taxes.

Gary S. Becker, the 1992 Nobel laureate, teaches at the University of Chicago and is a Fellow of the Hoover Institution.

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