Why Stock Options are the Best Form of Executive Compensation (And How to Make Them Even Better)

Abstract

Stock options are the primary form of compensation for CEOs because they are the best way to align the interests of CEOs with those of diversified stockholders. Nevertheless, critics argue that the use of stock options leads to excessive pay because there is no effective bargaining between the CEO and the board of directors about the number of options to award. They argue that the cost is underestimated by boards and hidden from stockholders and that options induce CEOs to undertake risky business strategies. None of these objections withstands scrutiny. First, there is little reason to believe that options have resulted in excessive CEO compensation. Although CEO pay has increased dramatically in absolute terms, data show that total executive pay as a percentage of corporate income – including gain from the exercise of options – has remained quite stable since 1982. This is true even though equity compensation grew from a negligible amount to as much as 75% of CEO pay by the year 2000. It would thus appear that equity compensation has been substituted for cash compensation and that a larger share of aggregate pay goes to those who succeed in increasing stock price. Second, options are subject to powerful market forces that effectively control their use. Using options as compensation effectively requires a corporation to repurchase shares to control for dilution. Because cash is scarce, there is a natural limit on the number of options that a corporation can grant. In addition, stock options confer significant benefits that are difficult to achieve with other forms of compensation. Aside from the fact that options induce corporations to distribute cash in the form of repurchases to control for dilution, options also convey significant information to the market about a company’s prospects, because the need to repurchase stock requires the company to estimate future cash flows in deciding how many options to grant. Finally, options provide an unbiased incentive for acquisitions when appropriate and for divestitures when appropriate. Thus, options make sense for both growing companies and mature companies. Although other forms of incentive compensation may provide some of the same benefits as stock options, they are ultimately inferior to options. For example, restricted stock rewards the CEO who increases stock price, but it may also induce the CEO to engage in conservative business strategies designed primarily to avoid losses rather than generate gains, contrary to the interests of diversified investors. And the traditional bonus based on earnings may induce CEOs to grow the business by retaining cash and investing it in new but suboptimal ventures. To be sure, stock options can be abused through such practices as timing and backdating. But these problems can be addressed by announcing option grants in advance of fixing the strike price. Moreover, it is quite easy to design an option that addresses the problem of overvalued equity and eliminates the incentive to maintain a stock price that is inappropriately high. By indexing exercise price downward, options can provide an incentive for CEOs to minimize losses in falling markets. In light of the numerous advantages of options as compared to other forms of incentive compensation, it appears that complaints about executive pay are based largely on ex post results. From an ex ante perspective, investors are not likely to object to options because with options the CEO gains only if and to the extent that stockholders gain. Indeed, as a result of the use of options as compensation, it is arguable that the model of the corporation as one owned by the stockholders has evolved into something more like a partnership between stockholders and officers in which the officers work for an ownership share of the business. Under this model, the board of directors may be seen primarily as an arbiter between these two groups for purposes of dividing up the gain rather than as an active manager of the business. But even under the prevailing stockholder ownership model, it is the supposed duty of the directors and officers to maximize stockholder value. In practice, there are few situations in which that duty is enforced as a matter of law. Options fill the gap.

JEL Classification: J33, G12, M41