In recent years, the practice of motivating CEOs and managers with stock options rather than pure stock has been linked to corruption and fraud. As a result some companies are rethinking the wisdom of using stock options.
Dropping stock options may be jumping the gun, according to two professors in the Olin School of Business at Washington University in St. Louis. Ohad Kadan, assistant professor of finance and Jeroen Swinkels, the August A. Busch, Jr. distinguished professor of managerial economics and strategy, say moving away from stock options as a way to reward good work may be a bad business move. In their paper “Stock or Options? Moral Hazard, Firm Viability, and Design of Compensation Contracts” the professors argue that in most cases stock options provide better incentives to motivate employees and they’re less expensive for the company to issue.
On the other hand, the researchers say, when a company issues stock options as a way to motivate managers, then a rise in the stock’s value results in a much larger — and more valuable — payback for everyone regardless of income level. Say a manager has a base salary of $100,000, with 10,000 shares in the company that have a current stock price of $50. If the stock price ends up at $60, the manager ends the year with $600,000. If the stock price remains flat at $50, the manager is still worth $500,000. On the other hand, if that same manager is given 10,000 options with a strike price of $50 and the price goes up to $60 then the manager ends up with $200,000. But if the stock price holds steady at $50, the manager gets only his base salary of $100,000.
“You can imagine that to the manager, having $200,000 versus $100,000 makes a bigger difference than having $600,000 versus $500,000,” Swinkels said. “The downside, of course, is that a fall in the stock price from 50 to 40 costs the manager with stock a hundred grand, but it makes no difference to the manager with stock options. So, there is a trade-off.”
Because of this trade-off, Swinkels and Kadan show that when a firm is stable with little or no risk of bankruptcy, then stock options make the best business sense.
“Why should options dominate when a company is healthy?” Kadan asks rhetorically. “Because, one, they provide better incentives so managers work harder. And, two, from the owner’s point of view it’s like magic: I pay you less and still you work harder.”
However, there are times when offering pure stock as an incentive is best. The researchers found that if a company is just starting out or facing possible bankruptcy, then stocks are your best bet.
“Stock pays you something even if it doesn’t do well, which isn’t the case with options, Kadan says. “And a company in jeopardy of becoming non-viable needs to offer employees some hope that their hard work will pay off.”
When looking at the use of stocks or options over the past decade, Kadan and Swinkels found that companies facing viability issues did tend to use pure stock as incentives more than those companies facing no possibility of bankruptcy.
“For a firm where bankruptcy is a significant risk, it makes sense to have the wealth of the managers tied to whether the stock price is a small number instead of an even smaller number. That’s a motivation if you’re managing TWA or USAir, but much less of a motivation if you’re managing Anheuser Busch or Microsoft,” Swinkels says.
Swinkels and Kadan say businesses need to consider the long-term costs of moving away from stock options when it’s not necessary for the company’s survival.
“It’s misguided to think that options alone are problematic and that they are responsible for the spate of scandals that we recently saw,” Kadan says. “Options align the interest of managers with that of the stockholders, so we’re saying don’t kill options too quickly.”