• 02 Dec 2002
  • What Do You Think?

How Will We Respond to the “Moment of Truth” in Option Plans?

by James Heskett

Summing Up

Are We Getting More Sensible About Management Incentives?

Respondents to this month's column suggest ways of fixing or selectively using various methods of providing incentives to management. They join the chorus of voices expressing, in one way or another, the view that the use of options should be rethought in many organizations.

First, there is the issue of whether options are the best means of promoting shareholders' best interests in established companies. While making an exception for "cash-poor start-up companies where stock options can provide a valuable way to align key personnel to the development and survival of the business," Shann Turnbull suggests that cash bonuses may be a better alternative in established, cash-rich companies, where "bonuses eliminate the problem of valuing options or misleading investors."

One possible way of aligning management's actions with the long-term interests of an organization and its investors is, of course, to delay payment of options until long-term performance has been proven. Charlie Cullinane suggests, for example, that an organization should "delay payment of any option until five years after a recipient leaves the company or fully retires."

Measures on which options are based also came under fire. As Moris Simson pointed out, "In the last few years our society has ... ignored the need to have satisfied customers, employees and other parties to make a company truly successful. As long as stock options are so directly linked to company valuation alone (i.e. uni-dimensional) the system might be open to inevitable abuse."

Some might argue that these well-intended suggestions either ignore or reduce the value of options as an incentive. But do they? The point is, do we really know? Has enough attention been focused on what is an admittedly difficult issue to examine, considering that compensation is only one of many factors in an organization's performance? Given the fact that we're talking about tens of billions of dollars of either real or lost value here, does the matter warrant more careful investigation? Or must we continue to rely on the compensation consulting community to guide us in these matters? What do you think?

Original Article

Stock option plans are thought to be under attack. Corporations are being encouraged to expense their options at the time they are granted. Some corporations whose option expenses represent a relatively modest charge—often due to low betas resulting from low stock price volatility—have done so already.

On another front, organizations that are being forced to return once again to shareholders to ask for option program expansion may face longer odds in getting approval. This is the result of scandals in executive compensation, many of which are associated with the fruits of large stock option awards.

It is reasonable to assume that stock options, which go in and out of favor every decade or so anyway, will be waning as a means of compensation in the coming years. At the very least, there will be fewer options available. This raises the questions: Who will get them and in what proportion?

Aaron Bernstein, the co-author of a new book on the matter, suggests in a recent BusinessWeek article that because forces are working to restrict options, fewer middle managers will get them in order to insure that grants to senior managers won't have to be reduced. In short, top management will receive an even greater proportion of a declining option pie, which in the past yielded the top five managers in the 1,500 largest organizations an average of 30 percent of all options granted. This occurred despite evidence suggesting that beyond a certain size of grant (well below the "mega" level) there is a much greater payout from granting options to middle vs. top managers.

Anyone who has served on the compensation committee of a major corporation knows that the coming "proposals" for the preservation of option grants at the top (supported by compensation consultant recommendations) will be based on such things as reward for past effort (at a time when disappointing results reduced bonuses and option values) as well as the importance of retaining rare top management talent.

All of this raises some interesting questions. Who is served by cutbacks in stock option availability? Will the cutbacks benefit investors in the long run? And what, if anything, can be done to encourage senior managers, compensation committees of corporate boards, and investors themselves to make better informed decisions regarding the use of such incentives? What do you think?