Human Capital & Careers

Fixing Long-term Incentive Compensation

By taking some of the luster off options, the expensing rule proposed by the Financial Accounting Standards Board will help alleviate several probl...
Stephen TaubJuly 9, 2004

When stock options first took off in the early 1990s, many investors greeted them as the answer to a long-standing problem: how to make managers act like owners without rewarding them even if they botched the job. Compensation committees embraced options for another reason: granting them incurred no charge to earnings.

But fixed-price options created perverse incentives. Because there are no restrictions on when an executive can unload options upon vesting, they invite steps to fuel a short-term rise in stock price, even if the decision doesn’t make long-term sense. In a survey by CFO magazine of finance executives at 131 public companies, 23 percent of respondents think stock options have led to such actions at their companies.

A number of academic studies have established a link between options and earnings manipulation. One new paper, by Jap Efendi, Anup Srivastava, and Edward P. Swanson of Texas A&M University, shows that the likelihood of an accounting restatement is higher at companies where CEOs have large holdings of in-the-money options. The study also found that these CEOs realized more cash from their options in the two years preceding a restatement than did their counterparts in other firms.

Options are also inefficient. Research shows that employees value options at a small fraction of their Black-Scholes value, because of the possibility that they will vest underwater. “You might have to give managers a lot of options to make them feel as well off as they would if they were paid in cash or stock,” says Jesse M. Fried, a professor of law at the University of California, Berkeley. “From the board’s perspective, these options might seem free, but you’re actually taking a lot of money out of shareholders’ pockets to pay employees.”

By taking some of the luster off options, the expensing rule proposed by the Financial Accounting Standards Board will help alleviate these problems. Our survey shows that under expensing, companies would continue to move away from options and increase their use of virtually all other forms of compensation.

For example, while the proportion of companies granting options would drop from 87 percent to 71 percent, the percentage using performance-vesting equity would rise from 35 percent to 47 percent, and the proportion using restricted stock would go from 66 percent to 75 percent. Companies also expect to use more stock-option substitutes, such as stock appreciation rights (SARs) and phantom stock. One reason: both pay executives for stock-price appreciation without causing as much dilution. If an employee has 100 options and the share price rises from $5 to $10, he’ll make $500. With an SAR or a phantom stock, the company would just settle that spread by giving the employee 50 shares of stock — 50 fewer than would be needed with options. (For more, see “Better Carrots?“)