STANFORD GRADUATE SCHOOL OF BUSINESS -- Stock options are supposed to be one of the most direct ties between pay and performance. While critics of executive compensation at some of the nation's largest corporations have been crying foul, the Business School's Richard Lambert has taken a close look at the value of stock options in entrepreneurial firms.
Lambert, who is the Joseph McDonald Professor of Accounting, believes options remain a useful tool in start-up companies because compensation, incentives and financing are much more closely linked in a start up than they are in larger corporations.
One important reason options work so well in small companies is that stock options used as compensation save cash. It is the equivalent of paying employees cash and then requiring them to purchase equity in the company with part of their compensation. This equity stake can provide powerful incentives. It is most effective in smaller, entrepreneurial firms because even employees below the executive level have a significant impact on the value of the firm. In larger companies, the direct effect of each employee is diluted. Options also do not show up as an expense on the income statement, hence the moniker "stealth compensation." That improves the firm's financial appearance compared to what it would be if cash bonuses were awarded.
In start ups, stock-based compensation can be used as a screening mechanism to attract the right people -- those who are willing to forego a safer financial package. They are likely to be bigger risk takers, to have more faith in their abilities and ideas, be more motivated to work hard, and even be more creative, says Lambert. Options are worth less than the stock price at the time they are awarded, so the company can grant more options for what it would cost to give actual stock. That magnifies the incentives, at least on the upside. If an employee's upside is unlimited while the downside is limited, he or she will be motivated to take risks, says Lambert.
In larger companies, stock options have been more controversial. Options came of age in the '80s and '90s because employers needed new incentives to keep good managers. A typical compensation package once meant a junior manager earned a fixed salary and climbed the corporate ladder. "That ladder doesn't exist anymore," says Lambert. "Companies have flattened the organization and all those mid-level management jobs are gone now." Essentially, corporations can't buy loyalty through the promise of promotions, increased responsibility and raises long term. They need other ways to reward people.
One problem with options is that too many are granted at the same price and all at once. If the stock price skyrockets in a bull market and a manager cashes out all his options, he has no incentives left. Even if the manager does not cash in his options, he now has an incentive to become more conservative in order to "protect his winnings." If too many options are granted all at once, problems also occur if the stock price falls. Many companies have had to re-issue options at the new lower price to restore incentives and keep their employees from leaving. Critics of option re-pricing argue that this practice protects employees too much from stock price decreases and therefore dilutes the incentives in these plans. These problems could be reduced if options grants were stretched out over yearly or multi-year intervals pegged to new stock prices, says Lambert.
In the last couple of years some companies have tried to head off this type of problem by factoring in industry peer group performance or overall stock market performance when determining year-end cash bonuses. In that way, executives' pay is not tied simply to macroeconomic trends that affected the stock market, but on how they did relative to an industry or market index. Lambert believes many companies have resisted the idea of pegging option exercise prices to performance indices because, unlike the current "stealth" method of recording options compensation, accounting standards would require expenses to be recognized on the income statement for index-pegged options.
For more information, contact Barbara Buell, [email protected], 650 723-3157.
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