New Paper Shows Option Grants Tend to Focus on Number, Not Value, of Award

A new study of option granting practices for CEOs in public companies finds that companies tend to grant options based more on a fixed number of options than on the value of these awards. The practice was especially notable prior to 2006, after which accounting changes required companies to show the present value of options on their income statements. The paper, Growth Through Rigidity: An Explanation for the Rise in CEO Pay, by Kelly Shue of the Booth School of Business and Richard Townsend of the Tuck School of Business, was published in April 2014 as a working paper by the two schools.

The authors point out that granting options based on a fixed number of underlying shares rather than their value tends to exaggerate returns upward in good years and downward in bad years. While the study focused on CEO awards, in the NCEO's experience, the same thing happens at all levels. The authors did find less rigidity in the practice after accounting rules changed, but option grants are still more rigid than would be expected in a more rational economic value model. The authors find that actual share awards, such as restricted stock, are sensitive to value, suggesting that even seemingly sophisticated compensation committees and executives distrust or do not understand option valuation models.

This same irrationality has shown up in companies replacing options with restricted stock because the restricted shares are less dilutive (each option award counts as one share for dilution purposes). Because corporate control is not an issue with equity awards, dilution in terms of nominal shares outstanding is not a relevant issue. The real issue is the economic impact of the awards on the company's finances. These practices underline the notion that the market for equity compensation is often not rational. Companies looking at making grants of any kind of equity need to compare apples-to-apples present values of awards to find the award value that make sense.