On the Optimality of Resetting Executive Stock Options

Abstract

Recent empirical work has documented the tendency of corporations to reset strike prices on previously-awarded executive stock option grants when declining stock prices have pushed these options out-of-the-money. This practice has been criticised as counter-productive since it weakens incentives present in the original award.

This paper presents a theoretical analysis of the optimality of resetting executive stock options based on a dynamic agency framework. The firm's shareholders (the "principal") provide an effort-averse manager (the "agent") with long-term incentives in the form of call options on the firm's equity. Given an initial compensation contract for the manager, suppose interim information becomes available on the state of the world. From the standpoint of ex-ante value maximization, can it be optimal for the principal to agree to amend the terms of the original option award to reflect this additional information?

We show that although the anticipation of resetting can have a substantial negative effect on initial incentives, resetting provides superior incentives for continuation. Resetting can thus be an important, value-enhancing aspect of corporate compensation contracts, even from an ex-ante standpoint. We find in a precise sense that some resetting is almost always ex-ante optimal. By allowing dependence on interim information, resetting allows the manager's final payoffs to incorporate a greater degree of sensitivity to the realized path; this flexibility is lost if the principal commits not to reset the contract.

We also characterize the conditions that affect the relative optimality of resetting. We find, for example, that resetting becomes relatively less optimal (i) as managerial ability to manipulate contractual resetting increases; (ii) as direct or indirect costs of replacing the incumbent manager decrease; and (iii) as external (economy- or industry-wide) factors increase in importance relative to managerial input in return generation. The last feature offers one possible explanation for why resetting has been far more common in small firms than large ones. We find that our results are robust to expanding the menu of compensation contracts to allow for equity, cash, bonuses, etc.

In summary, our results suggest that much of the criticism of the practice of resetting may be misguided.

JEL Classification: G32, J33, L14