Risky Behavior and Stock Options The study, which is summarized in the article “The Making of a Daredevil CEO: Why Stock Options Lead to More Risk Taking,” published by Knowledge@Wharton, looked at companies that had recently experienced an increased risk and evaluated which companies took steps to mitigate that risk based on the percentage of their managers’ compensation that is in stock options and the in-the-moneyness of the options.
The researchers found that firms where managers held more stock options took fewer mitigating actions. They felt that this is because once stock options are underwater, the value of the options can’t get any lower. When you think about it, with full value awards, there’s always upside potential but there’s also always downside potential–until the company is just about out of business, the value of the stock can always drop further. But once an option is underwater, it doesn’t matter how low the stock price drops, the option can’t be worth any less. As a result, managers in the study that held more options were less incented to take actions to keep the stock price steady.
Risk and In-the-Moneyness
Interestingly, and in line with this theory, the study also found that when managers’ had in-the-money options they took more mitigating action than when their options were underwater. If there was some spread in the options, the managers were motivated to preserve that spread and thus took action to keep the stock price from dropping. But where there was no spread, the managers were more incented to take risks (presumably in the hopes that the risks would pay off and the stock price would increase).
This is all very interesting; I’ve often wondered (probably here in this blog even) why the media and investors have a bias for full value awards over stock options–I think this is the first plausible explanation I’ve heard for that bias. But here in the NASPP Blog, we view studies like this with a healthy level of skepticism–it’s odd but I’ve never seen a study that didn’t prove the researchers’ initial hypothesis–so I wouldn’t scrap your option plan in favor of full value awards just yet (if you haven’t already done so).
A Nail in the Coffin for Premium-Price Options
I’ve never been a fan of premium-priced options because the reduction in expense is less than the premium, which, to my mind, makes them an inefficient form of compensation. I prefer discounted options, which provide a benefit that exceeds the additional expense to the company.
If this study can be believed, premium options would also discourage executives from taking steps to mitigate risk (whereas discounted options would presumably have the opposite impact). Maybe regulators and investors need to reconsider their bias against discounted options (although, in the case of the IRS, this bias may have less to do with concerns about risk taking and more to do with tax revenue–see my March 16, 2010 blog, “Discounted Stock Options: Inherently Evil or Smart Strategy“).
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Now that the scandal, media frenzy, investigations (internal and external), prosecutions, and shareholder litigation seems to be winding down, a recently published academic study suggests that backdated options may not have done much harm to shareholders after all.
The real cost of stock options to shareholders is dilution, which is disclosed via diluted EPS. This calculation takes into account the strike price of the option, whether backdated or not, therefore, shareholders were aware of the potential dilution caused by backdating.
The reduced exercise price is more valuable to employees than the company’s cost for the discount. Thus, companies that granted backdated options may have been able to grant smaller options that were less dilutive than the options they would have granted if the options had been at-the-money at grant.
A Case for Discounted Stock Options
I was excited to see the paper, not because I think backdating is okay, but because I am a fan of discounted options. Under ASC 718, discounting an option doesn’t necessarily result in a dollar-for-dollar increase in the fair value of the grant. This makes discounted options a bargain from a compensation standpoint: the expense for the discount is less than the value delivered to employees (for this same reason, I’m not a fan of premium-priced options). The paper does conclude that there are situations where discounted stock options can be beneficial to both the company and employees.
Unfortunately, the very real obstacle of Section 409A still stands in the way of actually granting discounted options and, from a tax-revenue perspective, there are some valid reasons to discourage discounting (see my blog entry “Discounted Stock Options: Inherently Evil or Smart Strategy?,” March 16, 2010), so I don’t see this changing any time soon, study or not.
Flaws in the Study
There are also a number of flaws in the study. First, the study assumes that the company never realizes a tax deduction for ISOs and that ISOs have to be subject to vesting requirements–any Level I CEP candidate knows that both of these premises are false. In addition, the study assumes that stock options never qualify as performance-based compensation under Section 162(m). The authors in general seem to be very confused as to the operation of this area of the tax code.
Word of the Day
I did learn a new word when reading this study: “Pareto-improving,” which refers to something which harms no one and benefits at least one person. The authors conclude that, at least in some situations, backdated options can be Pareto-improving. I still haven’t figured out what sunspot equilibria are, though.
Only a Few Days Left for NASPP Conference Early-Bird Rate The 19th Annual NASPP Conference early-bird rate expires this Friday, June 24. This deadline will not be extended–register for the Conference today, so you don’t miss out.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Register for 19th Annual NASPP Conference (November 1-4 in San Francisco). Don’t wait; the new early-bird rate is only available until this Friday, June 24.
Attend the Silicon Valley NASPP Chapter All-Day Conference this Thursday, June 23. As I blogged about last week, I’ll be presenting on one of my favorite topics: Pumping Up Purchase Plans: Re-Thinking the ESPP. I hope to see you there!
It looks like hope of being the next Randall Heron and Erik Lie (of the options backdating study fame) remains alive in the world of academia. Three studies relating to stock compensation have recently been published.
This study looks for patterns in decisions to exclude stock compensation expense from non-GAAP earnings and earnings forecasts.
Somewhat predictably, the study finds that companies exclude stock compensation expense from non-GAAP earnings when doing so presents a more positive financial picture of the company to investors (e.g., increases or smoothes earnings, or helps the company achieve earnings benchmarks). Financial analysts, however, exclude stock compensation expense from earnings forecasts when doing so helps them to better predict future earnings performance. Hmmm, now that I’ve written this, it seems hard to believe a 52-page study was needed to figure this out.
In a nice counterpoint to the study “Employee Stock Options and Future Firm Performance: Evidence from Option Repricings,” that I blogged about in August (“Repricing and Company Performance,” August 31, 2010), this study finds that companies with broad-based options programs have better operating performance (based on return on assets), at least in smaller companies and in companies with higher growth opportunities per employee. The authors believe that options encourage cooperation and mutual monitoring among employees and may also serve to attract and retain higher quality employees.
This study looks at whether executives that exercise their stock options on the vesting date are motivated to do so by confidential information they have about the company. The study concludes that vesting date exercises are more likely motivated by the executive’s need to diversify his/her portfolio.
Time Has Run Out! All NASPP memberships expire on a calendar-year basis–if you haven’t already, renew your membership for 2011 today.
Got Questions on Section 16? Alan Dye has the answers. Email your burning Section 16 questions to adye@section16.net and Alan will answer them during his popular, annual Q&A webcast on Section 16. This year’s webcast will be held on January 25; this is your one chance all year to get answers from one of the nation’s foremost authorities on Section 16–don’t miss it!
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
The Boston NASPP chapter wins the race to have the first chapter meeting of the year! If you are in the Boston area, don’t miss the meeting on January 14.