New Study Says Options Improve Performance When Targeted at Mid-Level Employees

A new study of 217 new economy companies by Christopher Ittner, Richard Lambert, and David Larcker at the Wharton School of Business at the University of Pennsylvania finds that returns to shareholders increased when the ratio of options to salary increased for mid-level employees. Increased ratios for executives and hourly employees, however, did not improve performance.

Data for the study were collected in surveys in 1999 and 200 by iQuantic, a compensation consulting firm. The surveys provided detailed information on options and compensation practices. The researchers hypothesized that deviations up or down from the sectoral norm in terms of the ratios of option grants to salary would result in lower returns to shareholders than would be the case for companies closer to the norm. Their analysis focused on shareholder returns in 1999 and 2000 as they correlated with equity grants for 1998 and 1999. All the sampled companies made grants to a broad cross-section of employees. Almost all the companies (97.2%) made grants at least annually. Option grants were valued using a simple discounted expected gain model that assumed a 15% per year stock growth and five-year holding period. The expected spread between grant and exercise price at the end of the five-year period was discounted using a 5% risk-free interest rate assumption.

The researchers found that larger firms have lower dilution from options but higher ratios of option value to salary. Companies with more cash and less debt also provide larger grants. Other variables, such as volatility, tax rates, and research expenditures, showed no consistent relationship to the size of grants.

To look at the results, the researchers constructed a model with a variety of variables that might have an impact on performance (company size, industry, R&D expenditures, etc.), including the ratio of the value of options to annual salary. The model then used multiple regression (a statistical technique that shows the relationship between two variables holding all the other variables in the model constant) to see how much each factor correlated with stock price performance. The study found no relationship between "burn rates" (the percentage of shares made available for grants each year) or higher stock option overhang (the potential dilution from options) and stock price performance. By contrast, grants to non-executive level managers, technical employees, and "individual contributors" (individuals getting discretionary performance-based options) show a positive relationship to performance. Grants to executives and directors make no difference, while grants to hourly and sales employees had a somewhat negative correlation, although many of these companies would have a relatively low number of such employees. The amount of dilution caused by grants to hourly employees would also be nominal, so its not clear how any change in option grants to this group could effect stock price performance.

The study did find that a 20% increase in the ratio of equity grant value to salary for managers below the senior executive level resulted in a 4.7% increase in the following years stock return. A 20% increase in the equity to salary ratio for grants to all technical employees yielded a 5.1% increase in stock value, while a 20% increase in the equity to grant ratio for all non-technical, non-executive employees produced a 2.7% increase. This calculation was not made for grants to hourly employees. 20% increases in grants to top management had no impact on share performance.

The authors make it very clear that these findings do not establish causality. The findings could be a marker for some other practice; companies that grant options to hourly employees, or make high grants to executives, may be systematically doing other things that affect performance. The period studied was obviously an unusual one in stock market history, the study period was short, and the performance measure (stock prices) is subject to all sorts of fickle, random variation outside the impact of what a company is actually doing. A previously reported study by Sesil, Krumova, Blasi, and Kruse on this site looked at a before and after analysis of companies with broad-based plans and used several measures of performance, finding that broad options do seem to improve company performance.

Nonetheless, this is an important contribution to our understanding of the impact of stock options and, as the authors conclude, shows that the conventional wisdom that it is grants to top management that really drive performance may be unsupportable, while lower-level grants may have a significant impact. The complete Wharton study is available online at Wharton's Web site.