Stock Options Are Not All Created Equal

Stock options dominate the pay of top executives today, but are often poorly understood both by those who grant them and those who receive them. In this excerpt from an article in the Harvard Business Review, HBS Professor Brian J. Hall describes three types of stock option plans and the incentives and risks they entail.
by Brian Hall

Most of the companies I've studied don't pay a whole lot of attention to the way they grant options. Their directors and executives assume that the important thing is just to have a plan in place; the details are trivial. As a result, they let their HR departments or compensation consultants decide on the form of the plan, and they rarely examine the available alternatives. Often, they aren't even aware that alternatives exist.

But such a laissez-faire approach, as I've seen over and over again, can lead to disaster. The way options are granted has an enormous impact on a company's efforts to achieve its business goals. While option plans can take many forms, I find it useful to divide them into three types. The first two—what I call fixed value plans and fixed number plans—extend over several years. The third—megagrants—consists of one-time lump sum distributions. The three types of plans provide very different incentives and entail different risks.

Fixed Value Plans. With fixed value plans, executives receive options of a predetermined value every year over the life of the plan. A company's board may, for example, stipulate that the CEO will receive a $1 million grant annually for the next three years. Or it may tie the value to some percentage of the executive's cash compensation, enabling the grant to grow as the executive's salary or salary plus bonus increases. The value of the options is typically determined using Black-Scholes or similar valuation formulas, which take into account such factors as the number of years until the option expires, prevailing interest rates, the volatility of the stock price, and the stock's dividend rate.

Fixed value plans are popular today. That's not because they're intrinsically better than other plans—they're not—but because they enable companies to carefully control the compensation of executives and the percentage of that compensation derived from option grants. Fixed value plans are therefore ideal for the many companies that set executive pay according to studies performed by compensation consultants that document how much comparable executives are paid and in what form. By adjusting an executive's pay package every year to keep it in line with the other executives' pay, companies hope to minimize what the consultants call "retention risk"—the possibility that executives will jump ship for new posts that offer more attractive rewards.

But fixed value plans have a big drawback. Because they set the value of future grants in advance, they weaken the link between pay and performance. Executives end up receiving fewer options in years of strong performance (and high stock values) and more options in years of weak performance (and low stock values). To see how that works, let's look at the pay of a hypothetical CEO whom I'll call John. As part of his pay plan, John receives $1 million in at-the-money options each year. In the first year, the company's stock price is $200, and John receives about 28,000 options. Over the next year, John succeeds in boosting the company's stock price to $150. As a result, his next $1 million grant includes only 18,752 options. The next year, the stock price goes up another $50. John's grant falls again, to 14,000 options. The stock price has doubled; the number of options John receives has been cut in half. (The exhibit The Impact of Different Option Plans on Compensation" summarizes the effect of stock price changes on the three kinds of plans.)

Now let's look at what happens to John's grants when his company performs miserably. In the first year, the stock price falls from $100 to $65. John's $1 million grant provides him with 43,000 options, up considerably from the original 28,000. The stock price continues to plummet the next year, falling to just $30. John's grant jumps to nearly 94,000 options. He ends up, in other words, being given a much larger piece of the company that he appears to be leading toward ruin.

It's true that the value of John's existing holding of options and shares will vary considerably with changes in stock price. But the annual grants themselves are insulated from the company's performance—in much the same way that salaries are. For that reason, fixed value plans provide the weakest incentives of the three types of programs. I call them low-octane plans.

Fixed Number Plans. Whereas fixed value plans stipulate an annual value for the options granted, fixed number plans stipulate the number of options the executive will receive over the plan period. Under a fixed number plan, John would receive 28,000 at-the-money options in each of the three years, regardless of what happened to the stock price. Here, obviously, there is a much stronger link between pay and performance. Since the value of at-the-money options changes with the stock price, an increase in the stock price today increases the value of future option grants. Likewise, a decrease in stock price reduces the value of future option grants. For John, boosting the stock price 10% over two years would increase the value of his annual grant from $1 million in the first year to $2 million in the third. A 70% drop in the stock price, by contrast, would reduce the value of his grant to just $300,000.

Since fixed number plans do not insulate future pay from stock price changes, they create more powerful incentives than fixed-value plans. I call them medium-octane plans, and in most circumstances, I recommend them over their fixed value counterparts.

Megagrant Plans. Now for the high-octane model: the lump-sum megagrant. While not as common as the multiyear plans, megagrants are widely used among private companies and post-IPO high-tech companies, particularly in Silicon Valley. Megagrants are the most highly leveraged type of grant because they not only fix the number of options in advance, they also fix the exercise price. To continue with our example, John would receive, at the start of the first year, a single megagrant of nearly 80,000 options, which has a Black Scholes value of $2.8 million (equivalent to the next present value of $1 million per year for three years). Shifts in stock price have a dramatic effect on this large holding. If the stock price doubles, the value of John's options jumps to $8.1 million. If the price drops 70%, his options are worth a mere $211,000, less than 8% of the original stake.

Disney's Michael Eisner is perhaps the best known CEO who has received megagrants. Every few years since 1984, Eisner has received a megagrant of several million shares. It is the leverage of these packages, coupled with the large gains in Disney's stock during the last 15 years, that has made Eisner so fabulously wealthy.