The Trouble with Stock Options

Summary of working paper 9784
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The company cost of stock options is often higher than the value that risk-averse and undiversified workers place on their options.

Stock options have become contentious. The root of the problem lies in widely held misperceptions concerning the cost of granting such options, according to Brian Hall and Kevin Murphy writing in The Trouble with Stock Options (NBER Working Paper No. 9784).

Stock options are compensation that give employees the right to buy shares at a pre-specified "exercise" price, normally the market price on the date of grant. The purchasing right is extended for a specified period, usually ten years. Between 1992 and 2002, the value of the options granted by firms in the S&P 500 rose from an average of $22 million per company to $141 million per company (with a high point of $238 million reached in 2000). Over this period, CEO compensation skyrocketed, largely fueled by stock options. Yet the CEO share of the total amount of stock options granted actually fell from a high point of about 7 percent in the mid-1990s to less than 5 percent in 2000-2. Indeed, by 2002 more than 90 percent of stock options were being granted to managers and employees.

Hall and Murphy argue that, in many cases, stock options are an inefficient means of attracting, retaining, and motivating a company's executives and employees since the company cost of stock options is often higher than the value that risk-averse and undiversified workers place on their options. In regard to the first of these aims - attraction -- Hall and Murphy note that companies paying options in lieu of cash effectively are borrowing from employees, receiving their services today in return for payouts in the future. But risk-averse undiversified employees are not likely to be efficient sources of capital, especially compared to banks, private equity funds, venture capitalists, and other investors. By the same token, paying options in lieu of cash compensation affects the type of employees the company will attract. Options may well draw highly motivated and entrepreneurial types, but this can benefit a company's stock value only if those employees- that is, top executives and other key figures -- are in positions to boost the stock. The vast majority of lower-level employees being offered options can have only a minor affect on the stock price.

Options clearly promote retention of employees, but Hall and Murphy suspect that other means of promoting employee loyalty may well be more efficient. Pensions, graduated pay raises, and bonuses - especially if they are not linked to stock value, as options are - are likely to promote employee retention just as well if not better, and at a more attractive cost to the company. In addition, as numerous recent corporate scandals have shown, compensating top executives via stock options may inspire the temptation to inflate or otherwise artificially manipulate the value of stock.

Hall and Murphy maintain that companies nevertheless continue to see stock options as inexpensive to grant because there is no accounting cost and no cash outlay. Furthermore, when the option is exercised, companies often issue new shares to the executives and receive a tax deduction for the spread between the stock price and the exercise price. These practices make the "perceived cost" of an option much lower than the actual economic cost. But such a perception, Hall and Murphy maintain, results in too many options for too many people. From the perceived cost standpoint, options may seem an almost cost-free way to attract, retain, and motivate employees, but from the standpoint of economic cost, options may well be inefficient.

Hall and Murphy's analysis has important implications for the current debate about how options are expensed, a debate that has become more heated following the accounting scandals. A year ago the Financial Accounting Standards Board (FASB) announced that it would consider mandating an accounting expense for options, with hopes that this would be adopted early in 2004. Federal Reserve Chairman Alan Greenspan, investors like Warren Buffet, and numerous economists endorse recording options as an expense. But organizations such as the Business Roundtable, the National Association of Manufacturers, the U.S. Chamber of Commerce, and high-tech associations oppose "expensing" options. The Bush Administration sides with these opponents, while Congress is divided on the issue.

Hall and Murphy believe that the economic case for "expensing" options is strong. The overall effect of bringing the perceived costs of options more in line with their economic costs will be fewer options being granted to fewer people - but those people will be the executives and key technical personnel who can realistically be expected to have a positive impact on a company's stock prices. The researchers also point out that current accounting rules favor stock options at the expense of other types of stock-based compensation plans, including restricted stock, options where the exercise price is set below current market value, options where the exercise price is indexed to industry or market performance, and performance-based options that vest only if key performance thresholds are reached. Current rules are likewise biased against cash incentive plans that can be tied in creative ways to increases in shareholder wealth.

Hall and Murphy conclude that managers and boards can be educated about the true economic costs of stock options and other forms of compensation, and that the asymmetries between the accounting and tax treatment of stock options and other forms of compensation must be eliminated. Proposals to impose an accounting charge for option grants would close the gap between perceived and economic costs.

-- Matt Nesvisky