If judging options depends on the “who,” “why,” and “how,” investors should look carefully at each question.
Who Receives Options?
Most recipients fall into two groups. The first is senior executives, who have the ability to influence reported profits and disclosed risks and who make important business decisions that affect company practices and methods of doing business. Giving options to senior executives can materially change their behavior. For example, they may inflate profits or downplay or not disclose risks Because their options only give them the upside and no downside risk, they may be inclined to take inappropriate risks, knowing that even if stock price declines they can also get more options at a lower price with the potential for cashing them in when stock price rises.
The second group consists of employees, presumably valued ones, who do their jobs well, but who might work even harder or smarter by having the incentive of ownership in the enterprise. While giving options to employees may provide positive motivation, it may not always be the best way to compensate valued employees because the level of their compensation depends only on stock price increases, which they can’t control, rather than on factors they can control.
Why Are Options Issued?
Essentially, options are issued for four reasons. They can compensate for performance, offer incentives to improve performance, change behavior, or obscure actual compensation.
Using options to simply provide additional compensation makes little sense because there is no way to know how much compensation is being offered. Remember, the reported value of options when they are granted often bears no relationship to actual value realized. Recipients could easily be paid far more than estimated amounts (in a market bubble or if earnings are inflated), or they could be paid far less or not at all in a declining market.
As start-ups and struggling new comers, Amazon.com and many other high-tech firms used options as a way to compensate for their then lower-than-market salaries, and rank-and-file employees took them, banking on future stock price increases.
Making use of options as an incentive to change behavior makes sense as long as employees and managers work harder to achieve objectives that are aligned with investors’ interests. Investors should question how much “incentive” is useful. Most executives work hard and do their best because they have an internal work ethic and self-standard of excellence. It is unlikely that the effort applied increases indefinitely with incentive pay. What is clear is that incentive pay changes behavior—the application of effort. The widespread use of options is questionable when one accepts that raising stock price is not always a constructive primary objective. Increasing the real value of the company will result in higher stock price over the long run (assuming growth outweighs dilution). But it makes little sense to provide incentive to change behavior to focus solely on increasing stock price instead of long-term value, and options have been structured to do just that.
Investors should understand that if a company issues significant stock options to employees, it signals that the investors’ return will be limited.
Making use of options as an incentive makes sense as long as employees and managers work harder to achieve objectives that are aligned with investors’ interests.
In discussions with numerous compensation committees about large option grants, a troublesome consistency has emerged. Most members of these committees have said that they suspect that if their CEOs had been paid in cash at the same levels at which they were compensated through options, that shareholders would likely have rebelled. Whether or not they would have cannot be proven, but the fact that compensation committees have participated in keeping such information opaque from shareholders is troublesome indeed. One suspects that a primary purpose of options has been to provide “stealth” compensation to executives.
How Are Options Structured?
Minute-to-minute, stock price seldom reflects actual long-term value. But over extended periods, they tend to trend together. Constructing options so that profits cannot be realized for extended time periods will more likely result in returns that approximate real growth in value.
Executives’ Gains From Exercising Options
Executive Name
Biggest Recent gain from Options Exercise
Lawrence Ellison, Oracle
$706,076,907 (FY01)
Michael Eisner, Walt Disney
$569,827,702 (FY98)
Michael Dell, Dell Computer
$233,283,432 (FY99)
Sanford Weill, Citigroup
$220,162,892 (FY97)
Thomas Siebel, Siebel Systems
$174,613,276 (FY01)
Stephen Case, AOL Time Warner
$158,056,501 (FY97)
John Chambers, Cisco Systems
$155,980,290 (FY00)
Gerald Levin, AOL Time Warner
$152,590,000 (FY00)
Jozef Straus, JDS Uniphase
$150,295,997 (FY01)
Howard Solomon, Forest Laboratories
$147,252,540 (FY00)
Richard Fairbank, Capital One Financial
$142,231,274 (FY01)
Dennis Kozlowski, Tyco International
$139,739,099 (FY99)
Henry Silverman, Cendant
$129,146,928 (2000)
Kenneth Lay, Enron
$123,399,478 (2000)
David Pottruck, Charles Schwab & Co.
$118,900,210 (1999)
Louis Gerstner, Jr., IBM
$115,130,197 (2001)
Craig Barrett, Intel
$114,231,947 (1998)
Kevin Kalkhoven, JDS Uniphase
$106,171,030 (FY00)
Roberto Goizueta, Coca-Cola
$104,371,866 (1997)
Ralph Roberts, Comcast
$102,833,384 (1999)
Unfortunately, options have often been structured in ways that provide windfalls to a select few executives. lists the individuals who were the largest exercisers of options between 1992 and 2002. According to the Wall Street Journal, the source of the figures, “On balance, many of the executives were able to time these exercises to the peak of the stock price, while shareholders who held on longer lost value.” The newspaper also notes that the gain cited is “pretax and on paper—though it is typically counted as part of an executive’s overall net worth and compensation.” Although the article did not say how companies report executive compensation, major gains in executive compensation can usually be found in a firm’s SEC filings. Because they do not occur every year, however, such windfalls do not normally appear in reports that purport to show executive or director compensation.
One counter to the windfall profits problem would be to structure stock options programs for senior executives in such a way that they would not be able to sell those shares until a time when they have no ability to influence share price. If they can’t profit from their shares until after they have left the company, they have much less incentive to influence share price in the short term.