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Observations on Employee Ownership

What Do Options Really Reward?

Corey Rosen

August 2006

(Corey Rosen)The storm over options grant timing has highlighted a critical problem with stock options as an employee incentive. As options valuation models show, the single most important factor in determining the value of an option is volatility. To understand this, imagine two companies. The stock of Stolid, Inc., goes has gone up between 8% and 12% every year for the last five years. At the end of the five years, its shares are up 60%. Meanwhile, Up & Down, Inc., has share prices that went up 70% in year one, down 60% in year two, up 80% in year three, down 70% in year four, and up 120% in year five. Both stocks started at $10. Stolid shares were worth $16 after five years; Up & Down's were worth just $12. But say you had an option with that vested in year one of this stock price sequence and had five years left in its term in each company. Which one would yield a better result? Clearly, Up & Down. In each up year, you could have made more money than you could with any strategy you followed with Stolid. The result is that Up & Down's employees-including its top officers who are making strategic decisions-are being rewarded for movement in the company's stock, not for long-term growth.

The example, of course, assumes you make the right choice about when to sell the shares you acquire upon exercise. But that does not yield a more encouraging result in terms of incentives. The idea of an incentive is to reward employees for corporate performance, not for their ability to make good judgments about when to exercise their options. The volatility assumptions also look more like 1999 than 2006, but there are still a lot of volatile stocks out there, and all companies have some volatility. The inescapable fact is that volatility is what most determines option value, so the more volatile the shares, the less effective the options are as incentives.

This has a number of additional insidious effects. First, it can encourage excessive risk taking by top decision makers, especially if their expected time horizon with the company is short (as it tends to be these days). Second, it introduces a lottery effect into the incentive structure. If Joe goes to work when the stock is at $7, and Mary joins a little later when it is at $14, Joe has a chance to make a lot of money, but Mary can only make a fraction as much. It was this very problem that apparently induced Microsoft and other companies with broad-based plans to issue options at the lowest price in the month after new employees joined the company. Finally, it can engender cynicism among employees who view options as a lottery whose benefits may go to the lucky and to the insiders who know best when to exercise.

These observations are not exactly new, of course. But fixed-price options became common practice in the 1990s because of accounting rules, and their momentum is only shifting slowly.

Creating Closer Alignment

One obvious solution is simply to can the options and put in something else, such as restricted stock. Full-value awards are much less prone to the volatility problem. In the example above, for instance, an employee would be better off in Stolid than in Up & Down because at all times the award had value, and its terminal value is much higher. To be sure, if the restrictions lifted at just the right time, the employee could do better, but that is a random result subject to considerable risk, not a choice the employee can make to exercise at a favorable price. On the other hand, some shareholders resent the idea that the employee gets a reward even if the stock price declines. In that case, stock appreciation rights that pay out at times determined in advance can provide an alternative. Their value would then be set at vesting and not be subject to decisions by the employee to exercise at more favorable times (albeit the plan could be designed that way).

If options are kept, they can be improved in various ways:

Avoid large sign-on grants: These introduce far too much of the lottery effect. Promising an employee the same number of awards over a reasonable time period removes part of that, provides the employee more reason to stay, reduces employee risk, and lowers the initial accounting charge.

Grant often in smaller amounts:
Making more frequent grants in smaller chunks tends to average out the volatility effect.

Trigger required exercise when the stock price hits target amounts: This can limit the volatility peaks and significantly lower accounting charges, while probably having little effect on most employees' incentive. Telling people in advance that there will be automatic exercise if the shares double, for instance, will still sound very good. However, this method takes the timing of taxation out of the hands of the optionees, which could upset them.

Having said all this, options still can be the right choice in less volatile companies. They provide a more leveraged reward than most other equity incentives and can have more favorable tax consequences. But for many companies, they reward luck more than performance.

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