The Employee Ownership Update
January 3, 2011
New Study Shows Broad-Based Stock Option Plans Improve PerformanceOne of the most comprehensive and convincing studies to date on the effect of broad-based option plans on company performance was released in November. Yael V. Hochberg of the Kellogg School of Management at Northwestern University and Laura Lindsey at the W. P. Carey School of Business at Arizona State University found that companies that granted options broadly to their employees showed a significant improvement in industry-adjusted return on assets (ROA) while companies that granted options more narrowly showed a decline in performance. The study, "Incentives, Targeting and Firm Performance: An Analysis of Non-Executive Stock Options," appeared in the November 2010 (Vol. 23, No. 11) issue of the Review of Financial Studies.
The primary data source for the study was the Investors Responsibility Research Center (IRRC) Dilution Database. That contains company option plan information collected from public filings for firms in the S&P 500, S&P midcap 400, and the S&P small cap 600. The study period was from 1997 through 2004. The identification of companies with broad grants is inferential. Following prior researchers, they identify companies where the bottom 90% of the workforce gets half the option value. To do this, they calculate ratios between the amount of equity granted to the CEO compared to next four most highly paid employees (available in public data) and the amount of equity overall . From that, they can rely on prior research that shows that, generally, the next 10% of employees will receive a certain percentage of additional equity. If the amount then going to the top 10% calculated this way is less than half of the total equity made available, prior research indicates the plan is likely to be broad-based.
This complex calculation cannot assure that the data set they are using is entirely composed of companies that actually grant options to more than half their work force (the definition of broad-based used by other studies on this topic). They identify 44% of the companies as having broad-based plans by this definition.
Looking at non-executive options and the subsequent firm operating performance as measured by the firm's industry adjusted ROA, the authors found that "both the existence of a broad based option plan and the implied incentives of an option plan exert a positive effect on firm performance... [H]olding all other variables constant, a move from the 25th percentile of per-employee delta [that is, increased option grants per employee] to the 75th percentile of per employee delta implies an increase of 0.17% in ROA and a 0.15% increase in cost-adjusted ROA. The effect we estimate is approximately a 0.4 percentage point change in industry-adjusted ROA for every $1000 increase in per employee delta. Since the average per employee delta in our sample is about $760, a $1000 increase represents a little over a doubling of pay to performance sensitivity."
By contrast, companies with grants focused on executives did worse: "for both performance measures [ROA and cost-adjusted ROA?], the coefficient on aggregate option incentives for firms with broad-based option plans is positive and statistically significant and the coefficient on incentives for firms without broad-based plans is negative."
The relation between incentives and performance was confined to smaller firms in the bottom half of total employment, however. The authors also segmented the companies into those where an increase in the share price had a potential impact on option values above and below the median amount. Companies with this greater leverage opportunity do significantly better.
The full study is at this link in PDF format.