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Observations on Employee Ownership

Who Should Get Options? What Research, Not Theory, Tells Us

Corey Rosen

May 2003

In the face of the now seeming certainty that stock options will have to be expensed, there is a great deal of conversation about how companies will and should handle broad-based equity compensation plans in the future. Surveys suggest as many as half the companies will cut back the number of people eligible for options, although some may change their minds when faced with cutting back employee benefits. Arguments for this approach are based mostly on theories of behavior and assumptions about outcomes. Fortunately, we have actual data on many of these issues. Rather than relying on arguments, no matter how theoretically compelling, companies should instead rely on what the numbers actually show. After all, the theory that the sun moved around the earth seemed entirely plausible for a long time—until data proved the seemingly obvious to be untrue.

Myth 1: The Market Wants Companies to Cut Back the Number of People Who Get Options

The theory here is that investors want options to focus on those people who "really matter" to the company, not everyday employees. Only one study, however, looks at how the market reacts to the actual announcement of grants to broad groups of employees versus grants just to top people. Eric Hager at the University of British Columbia found in a 2003 report (to be published by the NCEO in the summer of 2003) that stock prices go up around 1% for U.S. companies that grant more than 1% of their equity value to employees broadly to employees, but do not react significantly to grants just to top people. This reaction is understandable; much of the negative press about options and other equity plans has been that excessive grants focus top executives far too much on short-term movements in stock prices, not long-term value creation for companies.

Myth 2: Broad-Based Ownership Doesn't Work Because Employees Aren't Interested

The theory here is that employees lack a "line of sight" between what they do and stock price. Even if they had it, they would only be one of many employees getting options and so could just slack off and ride the efforts of other people. These theories sound logical, but an equally plausible case can be made that people make more or less effort at work because they feel they are treated equitably, that their efforts are rewarded, and that they are "all in this together," all things sharing ownership can create. Again, however, we do not need to rely on theory. The most comprehensive analysis of the impact of broad-based stock option plans on corporate performance was done by Joseph Blasi, Douglas Kruse, Jim Sesil, and Maya Krumova at Rutgers, who found that productivity goes up almost 17% in the three-year post plan period over what would have been expected, while return on assets goes up 2.3% per year. Shareholders do as well or better after broad-based plans are started, depending on the measure used. Blasi and Kruse looked at all the studies on all forms of broad-based ownership and found that, overall, these plans had a clearly positive effect on performance and shareholder return. By contrast, studies on equity just for top executives are at best a mixed bag. Blasi and Kruse again did the most comprehensive analysis. They found that concentrating ownership in the top five officers actually is associated with a lower return for shareholders.

We don't know at this point whether employees view options as "ownership." That is research we are currently carrying out. We do know employees value ownership through ESOPs, however, and the concepts do not seem that far apart. But whatever the chain of causality might be, we do know that sharing equity broadly with employees seems to improve corporate performance.

Myth 3: Expensing Options Is Likely to Drive Down Share Prices

Underlying all these arguments is the assumption that expensing options will drive down share prices, so options or other equity need to be doled out more carefully. In fact, there are now several large-scale studies of this issue, and none find that expensing will change the market's perception of company's values. The information is already available anyway, and investors tend to focus more on cash than accounting conventions, something that has been true for previous accounting reforms as well. Instead of focusing on accounting costs of equity, companies should be focusing on actual economic costs to see whether the amounts they give out at various levels really generate an equivalent return.

Myth 4: We Tried Ownership, and It Didn't Work

The most pernicious myth is that just giving out some options or other equity to employees will lead to magical changes. Hardly anyone would suggest in public that just giving out options is enough, but our data show that most companies with broad-based ownership plans do not even bother to use more than one regular communication technique to explain how the plans work, let alone do what is really necessary, namely to set up structures for employee involvement programs that explicitly link their work efforts to how the company is performing. We know from ESOP companies that when these linkages are made, ownership is powerful. Options companies need to learn that too. What is remarkable is that options have worked as well as they have given this frequent lack of effort by companies to make them work.

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