During the last several months, the issue of stock options, especially for top executives, has become a front-page national issue. Unfortunately, this debate has often been fueled more by gut reactions than data on just what makes stock options work or fail. Do stock options align employee and shareholder interests while providing everyday workers with a stake in the system? Or are they just a way to disguise costs, provide excessive rewards to people already excessively rewarded, and give CEOs a reason to play games with earnings? It turns out they are all of these things. Stock options have gone from a relatively obscure and usually small part of executive compensation to an often unearned windfall of staggering proportions. At the same time, they have been extended downward. We estimate that while just one million employees got options in 1992, 10 million do today. Between 20% and 25% of public companies now make options available to most or all of their full-time employees, and some extend them to part-timers as well.
Contrary to popular mythology, it's not just technology companies that have extended options to ordinary workers, although almost all technology companies do have these plans. In fact, most employees getting options today work for large, publicly traded non-technology companies, such as Whole Foods, Southwest Airlines, Starbucks, and many others. These plans have provided significant financial benefits to non-executive employees in the past, and no doubt will again when the market recovers. Most companies now give out options on a periodic basis, so while employees have some options that may never regain any value, they will also get new options at low prices that will have value in the future. While the growth of broad-based options has been an important economic trend, our data nonetheless indicate that even in plans that do share options widely, executives still get an average of 65% to 70% of the total options granted.
A recent study by Douglas Kruse and Joseph Blasi at Rutgers University found that over a three-year post-plan period, companies that grant options to most or all employees show a 17% improvement in productivity over what would have been expected had they not set up such a plan. Their return on assets goes up 2.3% per year over what would have been expected, while their stock performance is either better or about the same than comparable companies, depending on how performance is measured. But these were companies that granted options broadly. Most of the comparison companies in the study grant options to key people only; clearly, they do not do as well.
Many of the advocates for stock options use the fact that they are now a benefit for ordinary workers to defend stock options against the various slings and arrows now being launched at them politically and economically. Putting executive and non-executive options in the same justification boat, however, is misleading. Options for ordinary employees can work out to a new car, college tuition, a down payment on a house, a great vacation, and maybe even a more secure retirement. Options for executives can amount to enough money to fund a small nation. The option packages some executives have received would amount to tens of thousands of dollars per employee in their company.
The incentives created by these wildly differing amounts are not comparable. For everyday employees, options are a reward for sharing ideas and information, for working harder, and for paying more attention to quality and customer satisfaction. The collective efforts of these employees can have a dramatic impact on corporate performance. Indeed, every CEO these days says that employees are the company's greatest asset. Based on the Rutgers data, shareholders have no gripe about broad-based options. But mega-grants to executives are another story.
If these grants are not specifically tied to above-average corporate performance, then they clearly are not rewarding executives for much more than living and breathing in a strong market. Just about everyone agrees that executive pay needs to be more carefully structured to avoid this. But mega-grants even in successful companies can be problematic too. Executives who can make decisions about the company's future have a real incentive to make the stock price more volatile. An option typically allows the executive to buy stock at a price fixed today for 10 years into the future. A stock that gyrates way up and falls way back down is a more valuable one to have than option on stock whose performance is more steady because the executive can exercise the option at high points and ignore low ones. Huge grants make this temptation hard to resist, not to mention the temptation to cheat outright. More modest grants to executives would help them focus on other corporate than short-term earnings. Prohibiting executives form exercising their options until they expire or the executives leave (as is more common in Europe) would also secure a more long-term focus.
Options do not currently show up on corporate income statements. That seems like companies are hiding pay. They do show up in footnotes, however, so all the curious analyst or shareholder has to do is flip to the back and subtract the number from the earnings statement, as now is commonly reported in the financial media. While showing the true cost makes sense, the problem is that no one has come up with a very good way to figure out what the cost is. The formulas used today were developed for options that can be traded on an exchange; employee options cannot be. Moreover, depending on how companies get employees shares when they exercise, the cost may be a cash cost or a cost to shareholders in dilution - or it may be no cost at all if the options expire before they have value. So requiring companies to use an inaccurate accounting method may provide misleading information to shareholders. It's like saying the only way we have to measure calories is the weight of food, and that's better than nothing, so we'll use it as a measure to guide our eating habits. If a more accurate measure were developed, expensing options would be an idea whose time should probably come.
Shareholder approval is another current hot-button issue. Shareholders should approve executive options; the amounts are too large to ignore. But employee options are more a form of ongoing compensation with fairly minimal dilution effects. Requiring a shareholder vote every time a company wants to provide options to its workers would create a cumbersome process that would discourage some companies from doing it at all.
Options are neither inherently good nor bad. But they need to be seriously reassessed to make them better.
Corey Rosen is the NCEO's executive director. He can be reached at CRosen@nceo.org.