what to know about stock options in salary
Twenty years ago, the biggest component of executive bounty was cash, in the course of salaries and bonuses. Stock options were but a footnote. At present the reverse is true. With phenomenal speed, stock option grants have come to dominate the pay—and oftentimes the wealth—of tiptop executives throughout the United States. Final yr, Jack Welch's unexercised GE options were valued at more than $260 meg. Intel CEO Craig Barrett'southward were worth more than $100 meg. Michael Eisner exercised 22 million options on Disney stock in 1998 alone, netting more than than a half-billion dollars. In total, U.S. executives agree unexercised options worth tens of billions of dollars.
It would be difficult to exaggerate how much the options explosion has changed corporate America. But has the change been for the better or for the worse? Certainly, selection grants have improved the fortunes of many individual executives, entrepreneurs, software engineers, and investors. Their long-term bear upon on business concern in general remains much less articulate, all the same. Even some of the people who accept profited about from the trend express a deep discomfort about their companies' growing dependence on options. Do nosotros actually know what we're doing? they enquire. Are the incentives we're creating in line with our business goals? What'southward going to happen when the balderdash market ends?
Option grants are fifty-fifty more than controversial for many outside observers. The grants seem to shower ever greater riches on acme executives, with little connexion to corporate functioning. They appear to offer great upside rewards with little downside risk. And, according to some very vocal critics, they motivate corporate leaders to pursue short-term moves that provide immediate boosts to stock values rather than build companies that volition thrive over the long run. Every bit the utilize of stock options has begun to expand internationally, such concerns have spread from the Us to the business centers of Europe and Asia.
I have been studying the use of option grants for a number of years at present, modeling how their values modify under different circumstances, evaluating how they interact with other forms of compensation, and examining how the diverse programs back up or undermine companies' business goals. What I've institute is that the critics of options are mistaken. Options practice not promote a selfish, nigh-term perspective on the part of businesspeople. Quite the opposite. Options are the all-time compensation mechanism we have for getting managers to act in ways that ensure the long-term success of their companies and the well-being of their workers and stockholders.
Merely I've also establish that the full general nervousness near options is well warranted. Stock options are bafflingly complex financial instruments. (See the sidebar "A Short Form on Options and Their Valuation.") They tend to be poorly understood by both those who grant them and those who receive them. Every bit a result, companies often cease upwards having option programs that are counterproductive. I accept, for example, seen many Silicon Valley companies proceed to use their pre-IPO programs—with unfortunate consequences—after the companies have grown and gone public. And I've seen many large, sleepy companies use option programs that unwittingly create weak incentives for innovation and value creation. The lesson is clear: information technology's not plenty just to take an selection programme; you need to have the correct program.
Executive stock options are "phone call" options. They give the holder the right, but not the obligation, to buy a company's shares at a specified price—the "do" or "strike" price. In the vast majority of cases, options are granted "at the money, "which ways that the practice price matches the stock price at the time of the grant. A small minority of options are granted "out of the money," with an exercise price higher than the stock toll—these are premium options. An even smaller minority are granted "in the coin," with an practice cost lower than the stock price—these are discount options.
The options issued to executives normally have important restrictions. They can't exist sold to a third party, and they must be exercised earlier a defined maturity date, which is typically ten years from the grant date. Most, but not all, have a vesting period, normally of between 3 and five years; the option holder does not actually ain the selection, and therefore may non exercise it, until the option vests. Option holders do not usually receive dividends, which means they make a profit only on whatsoever appreciation of the stock price beyond the practice price.
The value of an selection is typically measured with the Black-Scholes pricing model or some variation. Black-Scholes provides a skilful gauge of the cost an executive could receive for an option if he could sell it. Since such an option cannot exist sold, its actual value to an executive is typically less than its Blackness-Scholes value.1 Nevertheless, agreement Blackness-Scholes valuations is helpful because they provide a useful benchmark.
Blackness-Scholes takes account of the many factors that affect the value of an option—not only the stock price, only also the exercise price, the maturity date, the prevailing interest rates, the volatility of the company's stock, and the visitor's dividend rate. The terminal two factors—volatility and dividend rate—are particularly of import considering they vary greatly from visitor to company and have a large influence on option value. Let's look at each of them:
Volatility. The higher the volatility of a company's stock price, the higher the value of its options. The logic here is that while the possessor of an option will receive the full value of any upside change, the downside is express—an option'south payoff hits zero one time the stock price falls to the practise price, just if the stock falls farther, the option's payoff remains at zero. (That'due south not to say that options accept no down-side. They lose their value quickly and can terminate up worth zero.) The higher expected payoff raises the option's value. Only the potential for higher payoff is not without a cost—higher volatility makes the payoff riskier to the executive.
Dividend Rate. The higher a company'south dividend rate, the lower the value of its options. Companies reward their shareholders in two ways: by increasing the price of their stock and by paying dividends. Nigh choice holders, nonetheless, exercise not receive dividends; they are rewarded only through toll appreciation. Since a company that pays high dividends has less cash for ownership back shares or profitably reinvesting in its business, it volition accept less share-price appreciation, all other things beingness equal. Therefore, information technology provides a lower render to option holders. Research past Christine Jolls of Harvard Constabulary School suggests, in fact, that the options explosion is partially responsible for the decline in dividend rates and the increment in stock repurchases during the past decade.
The nautical chart "The Result of Volatility and Dividend Charge per unit on Option Value" shows how changes in volatility and dividend rate affect the value of an at-the-coin option with a x-twelvemonth maturity. For a visitor with 30% volatility—about the boilerplate for the Fortune 500—and a two% dividend charge per unit, an option is worth almost 40% of the price of a share of stock. Increase the volatility to seventy%, and the option'south value goes upward to 64% of the stock price. Subtract the dividend rate to 0, and the option's value goes up to 56%. Do both, and the option'southward value shoots upwards to 81%.
It's important to note that Black-Scholes is just a formula; it's not a method for picking stocks. It tin't, and makes no attempt to, brand predictions about which companies will perform well and which will perform poorly. In the end, the factor that will determine an option'south payoff is the change in the cost of the underlying stock. If you are an executive, you tin can heighten the value of your options by taking actions that increase the value of the stock. That'due south the whole idea of option grants.
The Issue of Volatility and Dividend Rate on Option Value Option value is stated every bit a fraction of stock price. Volatility is stated as the annual standard deviation of the company's stock-toll returns. The figures assume a ten-year at-the-money option with a prevailing hazard-free rate (ten-year bond charge per unit) of vi%. For Fortune 500 companies, 30% volatility is about the boilerplate.
i. For a framework on how to measure the value of nontradable executive (and employee) stock options, see Brian J. Hall and Kevin J. Tater, "Optimal Practise Prices for Executive Stock Options," American Economic Review (May 2000).
Before discussing the strengths and weaknesses of different types of programs, I'd like to step back and examine why option grants are, in full general, an extraordinarily powerful grade of compensation.
The Pay-to-Performance Link
The main goal in granting stock options is, of course, to tie pay to operation—to ensure that executives profit when their companies prosper and endure when they flounder. Many critics claim that, in practise, option grants have not fulfilled that goal. Executives, they argue, proceed to exist rewarded every bit handsomely for failure as for success. Every bit show, they either use anecdotes—examples of poorly performing companies that recoup their top managers extravagantly—or they cite studies indicating that the total pay of executives in accuse of high-performing companies is not much dissimilar from the pay of those heading poor performers. The anecdotes are hard to dispute—some companies exercise human action foolishly in paying their executives—just they don't bear witness much. The studies are another affair. Nigh all of them share a fatal flaw: they measure only the compensation earned in a given year. What's left out is the most important component of the pay-to-performance link—the appreciation or depreciation of an executive's holdings of stock and options.
Equally executives at a visitor receive yearly option grants, they begin to aggregate large amounts of stock and unexercised options. The value of those holdings appreciates profoundly when the company'southward stock cost rises and depreciates just as greatly when it falls. When the shifts in value of the overall holdings are taken into account, the link between pay and performance becomes much clearer. Indeed, in a study I conducted with Jeffrey Liebman of Harvard'southward Kennedy School of Authorities, nosotros found that changes in stock and stock option valuations business relationship for 98% of the link betwixt pay and operation for the average chief executive, while annual bacon and bonus payments account for a mere two%.
By increasing the number of shares executives command, option grants accept dramatically strengthened the link betwixt pay and performance. Accept a look at the exhibit "Tying Pay to Performance." It shows how two measures of the pay-to-performance link have changed since 1980. Ane measure out is the amount by which an boilerplate CEO's wealth changes when his visitor'southward market value changes past $1,000. The other mensurate shows the amount past which CEO wealth changes with a 10% change in company value. For both measures, the link between pay and operation has increased nearly tenfold since 1980. While there are many reasons American companies accept flourished over the last ii decades, it's no coincidence that the boom has come up in the wake of the shift in executive pay from cash to disinterestedness. In stark contrast to the situation xx years agone, when most executives tended to be paid like bureaucrats and act like bureaucrats, today's executives are much more probable to exist paid like owners and act like owners.
Tying Pay to Performance
Given the complication of options, though, information technology is reasonable to ask a simple question: if the goal is to marshal the incentives of owners and managers, why not only hand out shares of stock? The respond is that options provide far greater leverage. For a visitor with an average dividend yield and a stock price that exhibits average volatility, a single stock option is worth only about 1-3rd of the value of a share. That's considering the pick holder receives simply the incremental appreciation above the do price, while the stockholder receives all the value, plus dividends. The company can therefore give an executive three times as many options as shares for the same price. The larger grant dramatically increases the affect of stock price variations on the executive's wealth. (In addition to providing leverage, options offer accounting advantages. Meet the sidebar "Accounting for Options.")
The thought of using leveraged incentives is not new. Most salespeople, for case, are paid a college commission rate on the revenues they generate higher up a sure target. For instance, they might receive 2% of sales up to $1 million and ten% of sales above $i million. Such plans are more difficult to administrate than plans with a single committee rate, but when it comes to bounty, the advantages of leverage often outweigh the disadvantages of complexity.
The Downside Gamble
If pay is truly to be linked to operation, it'southward not enough to deliver rewards when results are expert. You likewise have to impose penalties for weak operation. The critics merits options have unlimited upside but no downside. The implicit supposition is that options have no value when granted and that the recipient thus has nothing to lose. But that supposition is completely false. Options exercise accept value. Just look at the financial exchanges, where options on stock are bought and sold for large sums of money every 2nd. Yep, the value of selection grants is illiquid and, yes, the eventual payoff is contingent on the future performance of the company. But they have value all the same. And if something has value that can be lost, it has, by definition, downside risk.
In fact, options have even greater downside risk than stock. Consider ii executives in the same company. One is granted a million dollars worth of stock, and the other is granted a million dollars worth of at-the-money options—options whose do price matches the stock price at the time of the grant. If the stock cost falls sharply, say by 75%, the executive with stock has lost $750,000, but she retains $250,000. The executive with options, nonetheless, has essentially been wiped out. His options are now and so far under water that they are most worthless. Far from eliminating penalties, options actually amplify them.
The downside risk has get increasingly evident to executives as their pay packages have come up to be dominated by options. Take a look at the employment contract Joseph Galli negotiated with Amazon.com when he recently agreed to become the east-tailer'south COO. In addition to a large option grant, his contract contains a protection clause that requires Amazon to pay him upward to $twenty one thousand thousand if his options don't pay off. Ane could argue that providing such protection to executives is foolish from a shareholder's point of view, but the contract itself makes an important signal: why would someone need such protection if options had no downside take chances?
The hazard inherent in options can be undermined, withal, through the practice of repricing. When a stock price falls sharply, the issuing company can be tempted to reduce the exercise toll of previously granted options in guild to increase their value for the executives who concord them. Such repricing is anathema to shareholders, who don't savour the privilege of having their shares repriced. Although fairly mutual in small companies—peculiarly those in Silicon Valley—option repricing is relatively rare for senior managers of large companies, despite some well-publicized exceptions. In 1998, fewer than two% of all large companies repriced any options for their top executive teams. Fifty-fifty for companies that had big decreases in their stock prices—declines of 25% or worse in the previous year—the repricing charge per unit was less than 5%. And only viii% of companies with market-value declines of more than 50% repriced. In most cases, companies that resorted to repricing could have avoided the need to do so past using a unlike kind of pick programme, as I'll talk over later.
Promoting the Long View
It'south often assumed that when you tie compensation to stock toll, you encourage executives to take a brusk-term focus. They end up spending then much time trying to make sure that the next quarter's results encounter or beat Wall Street'southward expectations that they lose sight of what'south in the best long-term interests of their companies. Again, even so, the criticism does non stand to close exam.
For a method of compensation to motivate managers to focus on the long term, information technology needs to be tied to a operation measure that looks forward rather than backward. The traditional mensurate—accounting profits—fails that test. Information technology measures the past, non the future. Stock cost, still, is a forward-looking measure. It forecasts how current actions will affect a company's hereafter profits. Forecasts can never be completely accurate, of course. Merely because investors accept their own money on the line, they face enormous pressure to read the future correctly. That makes the stock market the best predictor of performance we have.
But what about the executive who has a dandy long-term strategy that is non notwithstanding fully appreciated by the market? Or, even worse, what about the executive who can fool the market by pumping upwardly earnings in the short run while hiding primal problems? Investors may be the best forecasters nosotros have, simply they are non all-seeing. Option grants provide an effective means for addressing these risks: slow vesting. In most cases, executives can only do their options in stages over an extended period—for instance, 25% per year over four years. That delay serves to reward managers who take actions with longer-term payoffs while exacting a harsh penalty on those who neglect to address basic business bug.
Stock options are, in brusk, the ultimate forward-looking incentive plan—they measure futurity cash flows, and, through the use of vesting, they measure them in the future as well as in the present. They don't create managerial myopia; they aid to cure it. If a company wants to encourage a more farsighted perspective, information technology should not abandon choice grants—information technology should simply extend their vesting periods.1
Three Types of Plans
Nearly of the companies I've studied don't pay a whole lot of attention to the mode they grant options. Their directors and executives presume that the important thing is but to have a plan in place; the details are niggling. As a result, they let their Hour departments or compensation consultants decide on the form of the programme, and they rarely examine the available alternatives. Frequently, they aren't even enlightened that alternatives exist.
Merely such a laissez-faire approach, as I've seen over and over once again, can lead to disaster. The way options are granted has an enormous bear upon on a company's efforts to achieve its business organization goals. While pick plans can take many forms, I find it useful to dissever them into three types. The commencement two—what I call fixed value plans and fixed number plans—extend over several years. The third—megagrants—consists of onetime lump sum distributions. The three types of plans provide very unlike incentives and entail very different risks.
Stock-still Value Plans.
With fixed value plans, executives receive options of a predetermined value every yr over the life of the program. A visitor's board may, for example, stipulate that the CEO will receive a $1 million grant annually for the side by side 3 years. Or information technology may tie the value to some pct of the executive'due south cash bounty, enabling the grant to grow as the executive's salary or salary plus bonus increases. The value of the options is typically determined using Black-Scholes or like valuation formulas, which take into account such factors every bit the number of years until the choice expires, prevailing involvement rates, the volatility of the stock price, and the stock'due south dividend rate.
Fixed value plans are pop today. That's not considering they're intrinsically amend than other plans—they're not—just because they enable companies to carefully control the compensation of executives and the percentage of that bounty derived from option grants. Fixed value plans are therefore ideal for the many companies that fix executive pay co-ordinate to studies performed past bounty consultants that document how much comparable executives are paid and in what form.2 By adjusting an executive'due south pay package every year to proceed it in line with other executives' pay, companies hope to minimize what the consultants call "retentiveness risk"—the possibility that executives will jump transport for new posts that offer more attractive rewards.
Merely fixed value plans accept a big drawback. Because they set up the value of future grants in advance, they weaken the link between pay and functioning. Executives end upwards receiving fewer options in years of strong functioning (and high stock values) and more than options in years of weak performance (and depression stock values). To see how that works, permit's await at the pay of a hypothetical CEO whom I'll call John. As function of his pay plan, John receives $one million in at-the-money options each year. In the get-go year, the company'southward stock price is $100, and John receives well-nigh 28,000 options. Over the next twelvemonth, John succeeds in boosting the company's stock price to $150. As a result, his adjacent $1 meg grant includes only 18,752 options. The next twelvemonth, the stock toll goes up another $50. John's grant falls again, to 14,000 options. The stock toll has doubled; the number of options John receives has been cut in half. (The exhibit "The Impact of Unlike Option Plans on Compensation" summarizes the effect of stock price changes on the three kinds of plans.)
The Bear upon of Dissimilar Option Plans on Compensation Option values are derived using the Black-Scholes model and reverberate the characteristics of a typical simply hypothetical Fortune 500 company; the annual standard deviation of the stock toll is assumed to be 32%, the risk-gratuitous rate of return is vi%, the dividend rate is iii%, and the maturity menstruum is ten years.
Now let's look at what happens to John's grants when his visitor performs miserably. In the get-go year, the stock price falls from $100 to $65. John's $1 million grant provides him with 43,000 options, upward considerably from the original 28,000. The stock price continues to plummet the side by side year, falling to simply $30. John'southward grant jumps to nigh 94,000 options. He ends upwards, in other words, being given a much larger piece of the company that he appears to be leading toward ruin.
It'due south true that the value of John's existing holdings of options and shares will vary considerably with changes in stock price. Simply the annual grants themselves are insulated from the visitor's performance—in much the same way that salaries are. For that reason, stock-still value plans provide the weakest incentives of the 3 types of programs. I telephone call them low-octane plans.
Fixed Number Plans.
Whereas fixed value plans stipulate an annual value for the options granted, stock-still number plans stipulate the number of options the executive will receive over the plan period. Under a fixed number plan, John would receive 28,000 at-the-money options in each of the three years, regardless of what happened to the stock cost. Here, manifestly, there is a much stronger link betwixt pay and performance. Since the value of at-the-money options changes with the stock toll, an increment in the stock price today increases the value of future option grants. Likewise, a decrease in stock price reduces the value of hereafter pick grants. For John, boosting the stock price 100% over 2 years would increase the value of his annual grant from $1 million in the start year to $ii million in the 3rd. A 70% drib in the stock price, by contrast, would reduce the value of his grant to only $300,000.
Since stock-still number plans practice not insulate future pay from stock cost changes, they create more powerful incentives than fixed value plans. I call them medium-octane plans, and, in near circumstances, I recommend them over their fixed value counterparts.
Megagrant Plans.
Now for the loftier-octane model: the lump-sum megagrant. While non as common as the multiyear plans, megagrants are widely used amid private companies and mail-IPO loftier-tech companies, peculiarly in Silicon Valley. Megagrants are the most highly leveraged blazon of grant because they non only fix the number of options in advance, they besides set up the exercise toll. To continue with our example, John would receive, at the start of the first year, a unmarried megagrant of nearly 80,000 options, which has a Blackness-Scholes value of $2.8 meg (equivalent to the net present value of $ane one thousand thousand per twelvemonth for three years). Shifts in stock price have a dramatic effect on this large property. If the stock price doubles, the value of John's options jumps to $viii.1 one thousand thousand. If the price drops lxx%, his options are worth a mere $211,000, less than 8% of the original stake.
Disney'south Michael Eisner is mayhap the best known CEO who has received megagrants. Every few years since 1984, Eisner has received a megagrant of several million shares. Information technology is the leverage of these packages, coupled with the big gains in Disney's stock during the last xv years, that has made Eisner and so fabulously wealthy.
The Big Trade-Off
Since the idea backside options is to proceeds leverage and since megagrants offer the most leverage, you might conclude that all companies should carelessness multi-year plans and just give high-octane megagrants. Unfortunately, it's not and then simple. The choice among plans involves a complicated trade-off between providing strong incentives today and ensuring that stiff incentives volition notwithstanding exist tomorrow, specially if the company's stock cost falls essentially.
When viewed in those terms, megagrants take a big problem. Look at what happened to John in our third scenario. Later 2 years, his megagrant was so far under water that he had petty hope of making much coin on it, and information technology thus provided little incentive for boosting the stock value. And he was not receiving any new at-the-money options to brand up for the worthless ones—as he would accept if he were in a multiyear program. If the drop in stock value was a effect of poor management, John's pain would exist richly deserved. If, however, the driblet was related to overall marketplace volatility—or if the stock had been overvalued when John took charge—then John'southward suffering would be dangerous for the company. Information technology would provide him with a strong motivation to quit, join a new company, and get some new at-the-money options.
Ironically, the companies that most oftentimes use megagrants—high-tech start-ups—are precisely those most probable to endure such a worst-instance scenario. Their stock prices are highly volatile, so extreme shifts in the value of their options are commonplace. And since their people are in loftier demand, they are very likely to head for greener pastures when their megagrants get bust. Indeed, Silicon Valley is full of megagrant companies that take experienced human resource crises in response to stock cost declines. Such companies must choose between two bad alternatives: they can reprice their options, which undermines the integrity of all future option plans and upsets shareholders, or they tin can refrain from repricing and picket their demoralized employees head out the door.
Adobe Systems, Apple tree Computer, Eastward*Merchandise, Netscape, PeopleSoft, and Sybase have all repriced their options in recent years, despite the bad volition it creates amongst shareholders. As one Silicon Valley executive told me, "Yous take to reprice. If y'all don't, employees will walk across the street and reprice themselves."
Silicon Valley companies could avoid many such situations by using multiyear plans. So why don't they? The answer lies in their heritage. Before going public, start-ups find the apply of megagrants highly attractive. Accounting and tax rules allow them to result options at significantly discounted exercise prices. These "penny options" take little take chances of falling under water (especially in the absence of the stock toll volatility created by public markets). The adventure contour of these pre-IPO grants is really closer to that of shares of stock than to the risk contour of what we normally recollect of equally options.
When they become public, the companies keep to employ megagrants out of habit and without much consideration of the alternatives. But at present they issue at-the-money options. As nosotros've seen, the risk profile of at-the-money options on highly volatile stocks is extremely high. What had been an constructive way to advantage key people all of a sudden has the potential to demotivate them or fifty-fifty spur them to quit.
Some high-tech executives claim that they have no choice—they demand to offer megagrants to attract good people. Nevertheless in about cases, a fixed number grant (of comparable value) would provide an equal enticement with far less adventure. With a fixed number grant, after all, you nevertheless guarantee the recipient a large number of options; y'all merely fix the practice prices for portions of the grant at dissimilar intervals. By staggering the exercise prices in this style, the value of the package becomes more resilient to drops in the stock price.
Many of the Silicon Valley executives (and potential executives) that I have talked to worry a lot nearly joining post-IPO companies at the wrong time, when the companies' stock prices are temporarily overvalued. Switching to multiyear plans or staggering the do prices of megagrants are good ways to reduce the potential for a value implosion.
Sleepy Companies, Sleepy Plans
Small, highly volatile Silicon Valley companies are non the just ones that are led off-target by old habits. Large, stable, well-established companies as well routinely cull the wrong type of plan. Simply they tend to default to multiyear plans, particularly stock-still value plans, fifty-fifty though they would ofttimes be better served past megagrants.
Think virtually your average large, bureaucratic visitor. The greatest threat to its well-being is not the loss of a few top executives (indeed, that might be the best thing that could happen to it). The greatest threat is complacency. To thrive, information technology needs to constantly milk shake up its organization and become its managers to remember creatively about new opportunities to generate value. The loftier-octane incentives of megagrants are ideally suited to such situations, yet those companies inappreciably ever consider them. Why not? Because the companies are dependent on consultants' bounty surveys, which invariably lead them to adopt the low-octane but highly predictable fixed value plans. (See the exhibit "Which Plan?")
Which Plan?
The bad choices made by both incumbents and upstarts reveal how dangerous it is for executives and board members to ignore the details of the type of option plan they use. While options in general accept done a groovy deal to get executives to think and act like owners, not all selection plans are created equal. Only by building a clear understanding of how options work—how they provide different incentives under dissimilar circumstances, how their form affects their role, how various factors influence their value—will a visitor exist able to ensure that its option program is actually accomplishing its goals. If distributed in the wrong way, options are no better than traditional forms of executive pay. In some situations, they may be considerably worse.
one. Companies would besides exist well advised to abandon the practice of "cliff-vesting" the options of executives who are voluntarily departing. In cliff vesting, the vesting periods of all option holdings are complanate to the present, enabling the executive to exercise all his options the moment he leaves the company. In other words, as soon as an executive's departure date is set, much of his incentive to recollect long-term disappears.
two. See Stephen F. O'Byrne, "Total Compensation Strategy," Journal of Applied Corporate Finance (Summer 1995).
A version of this commodity appeared in the March–Apr 2000 issue of Harvard Business Review.
Source: https://hbr.org/2000/03/what-you-need-to-know-about-stock-options
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