Stock Compensation: The Most Expensive Way to Pay Future Cash
Calvin H. Johnson
University of Texas at Austin - School of Law
Southern Methodist University Law Review, Vol. 52, July 1999
Despite its popularity, stock compensation is the most expensive way to pay future cash to employees. Debt and deferred cash compensation are cheaper. The after-tax, after-inflation cost of debt to a corporation is near zero over long periods of time. Stock has an extraordinary premium discount rate, which represents a extraordinary cost to the issuer. Stock has a premium discount rate first because it is so volatile. Holders, including executives, have to be paid a premium to overcome risk aversion. But 80% of the volatility arises from market-wide or industry-wide volatility that the executives can do nothing about. Volatility unrelated to the firm is noxious waste that should not be imported into compensation. Stock has an extraordinary discount rate, secondly, because of market distrust of management. The market fears that management will misuse accumulations for self serving investments and overcompensation. But market paranoia about management does not need to be imported into compensation plans for and by management. Stock has such an extraordinary discount rate, thirdly, because of tax. Deferring compensation gives a benefit that is as valuable systematically as not paying capital gain tax. Giving evidence of debt, instead of stock, to executives would give the issuer a tax deduction for the discount rate, as well as decreasing the issuers cost by increasing its credibility. Stock compensation seems to be so popular because it allows management to convince itself and its shareholders that the compensation has no cost. Stock pushes the cash cost beyond management's horizon for evaluation and allows reporting to shareholders that the compensation is free. The real costs of the high discount rates are however extraordinary. Management that is faithful to the interests of the corporation do not responsibly use a format, stock compensation, that is the single most expensive format by which to pay compensation.
JEL Classification: J33, G32, G30, K34Accepted Paper Series
Date posted: June 25, 1999
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