Executive Stock Options

Abstract

As a part of the compensation package many companies provide executives with executive stock options, which are call options with additional restrictions. They provide some financial advantages to the executives and help the company retain the service of the executives who improve the company’s earnings and management.

Until recently the values of the executive stock options were not required to be disclosed in the company?s financial reports. But recent statements from the Financial Accounting Standards Board (FASB) have made it necessary to value these executive stock options. The valuation of executive stock options is also required for investors and financial practitioners. This paper considers the award of performance-based executive stock options when the stock price at the time of stock option award exceeds a given preassigned value. It is assumed that the stock price follows a geometric Brownian motion, and that the number of stock options awarded at any time depends on the stock price at that time.

A valuation formula is derived using the method of Esscher transforms for a multiyear award plan. The closed-form formula derived is similar to the Black-Scholes formula for options and utilizes the standard bivariate normal distribution function, which is available in statistical software. In this paper the number of stock options awarded is assumed to be in a specific form, but the theory presented can be modified to suit other forms of award structure. Moreover, by suitable choice of parameters, a valuation formula is also presented for the award of fixed-value executive stock options grants; this formula is also in a closed form and involves cumulative distribution values of the standard normal random variable. Numerical illustrations of the use of the valuation formulas are presented.     

GOLF TOURNAMENTS AND CEO PAY—UNRAVELING THE MYSTERIES OF EXECUTIVE COMPENSATION

Leading financial economists and activist institutional investors have long argued that the proper alignment of manager and shareholder interests requires the use of performance based compensation. Partly in response to these pressures, and in combination with a change in the tax code that encourages performance-based pay, corporate boards have dramatically increased their use of stock grants and executive stock options. Combine this development with the longest bull market in U.S. financial history, and the result is unprecedented levels of CEO pay at the close of the 20th century. This review of executive compensation reveals that the economic theory of tournaments may provide a rationale for the pattern, if not the level, of executive pay. Specifically it finds that the total compensation of the five highestpaid executives in a cross-section of new and old-economy firms is very similar to the pattern of payouts to players in a golf tournament. The author also reports that recent studies show a significant increase in the pay-for-performance correlation throughout the 1990s. But whether that correlation is as high as it should be, and whether current levels of CEO pay are socially "optimal," are questions that remain unanswered.     

Financial crisis and bank executive incentive compensation

We study the executive compensation structure in 14 of the largest U.S. financial institutions during 2000–2008. We focus on the CEO's purchases and sales of their bank's stock, their salary and bonus, and the capital losses these CEOs incur due to the dramatic share price declines in 2008. We consider three measures of risk-taking by these banks. Our results are mostly consistent with and supportive of the findings of Bebchuk, Cohen and Spamann (2010), that is, managerial incentives matter — incentives generated by executive compensation programs are correlated with excessive risk-taking by banks. Also, our results are generally not supportive of the conclusions of Fahlenbrach and Stulz (2011) that the poor performance of banks during the crisis was the result of unforeseen risk. We recommend that bank executive incentive compensation should only consist of restricted stock and restricted stock options — restricted in the sense that the executive cannot sell the shares or exercise the options for two to four years after their last day in office. The above incentive compensation proposal logically leads to a complementary proposal regarding a bank's capital structure, namely, banks should be financed with considerably more equity than they are being financed currently.     

Companies' Modest Claims About the Value of CEO Stock Option Awards

This paper analyzes company disclosures of CEO stock option values in compliance with the SEC's regulations for reporting executive compensation data to stockholders. Companies appear to exploit the flexibility of the regulations to reduce the apparent value of managerial compensation. Companies shorten the expected lives of stock options and unilaterally apply discounts to the Black-Scholes formula. Theoretical support for these adjustments is often thin, and companies universally ignore reasons that the Black-Scholes formula might underestimate the value of executive stock options. The findings not only cast light upon how corporations value executive stock options, but also provide a means of forecasting compliance with controversial new FASB requirements for firms to disclose the compensation expense represented by executive stock options.     

The Subjective Valuation of Indexed Stock Options and Their Incentive Effects

We analyze the potential role of indexed stock options in future pay‐for‐performance executive compensation contracts. We present a unified framework for index‐linked stock options, discuss their incentive effects, argue that indexation schemes based on the capital‐asset pricing model (CAPM) are the most suitable for executive compensation, and derive a subjective pricing model for the class of CAPM‐based indexed stock options. Contrary to earlier work, executives would not be motivated to take on investment projects with high idiosyncratic risk once their lack of wealth diversification and degree of risk aversion are factored into the analysis.     

Expensing options solves nothing

The use of stock options for executive compensation has become a lightning rod for public anger, and it's easy to see why. Many top executives grew hugely rich on the back of the gains they made on their options, profits they've been able to keep even as the value they were supposed to create disappeared. The supposed scam works like this: Current accounting regulations let companies ignore the cost of option grants on their income statements, so they can award valuable option packages without affecting reported earnings. Not charging the cost of the grants supposedly leads to overstated earnings, which purportedly translate into unrealistically high share prices, permitting top executives to realize big gains when they exercise their options. If an accounting anomaly is the problem, then the solution seems obvious: Write off executive share options against the current year's revenues. The trouble is, Sahlman writes, expensing option grants won't give us a more accurate view of earnings, won't add any information not already included in the financial statements, and won't even lead to equal treatment of different forms of executive pay. Far worse, expensing evades the real issue, which is whether compensation (options and other-wise) does what it's supposed to do--namely, help a company recruit, retain, and provide the right people with appropriate performance incentives. Any performance-based compensation system has the potential to encourage cheating. Only ethical management, sensible governance, adequate internal control systems, and comprehensive disclosure will save the investor from disaster. If, Sahlman warns, we pass laws that require the expensing of options, thinking that's fixed the fundamental flaws in corporate America's accounting, we will have missed a golden opportunity to focus on the much more extensive defects in the present system.     

Stock option compensation and the likelihood of meeting analysts' quarterly earnings targets

One role of stock options in executive compensation packages is to counterbalance the inherently short-term orientation of base salary and annual bonuses. Managerial compensation plans frequently include stock options in order to better align the interests of managers and outside shareholders and reduce agency problems. However, since option values are sensitive to fluctuations in stock prices, and investors reward firms that meet or exceed earnings expectations, executives of firms with sizable option components in their compensation plans have increased incentives to report earnings that meet or exceed analysts' forecasts. We show that the propensity to meet or exceed analysts' quarterly earnings forecasts is positively related to the use of options in top executives' compensation plans. Further, firms that employ relatively more options in their compensation plans more frequently report earnings surprises that exceed analysts' forecast by small amounts (between 0 and 1 cent per share). These results suggest that the use of stock-based compensation intensifies top executives' focus on financial analysts' short-term earnings forecasts.     

Risk-taking incentives of executive stock options and the asset substitution problem

Various theoretical models show that managerial compensation schemes can reduce the distortionary effects of financial leverage. There is mixed evidence as to whether highly levered firms offer less stock‐based compensation, a common prediction of such models. Both the theoretical and empirical research, however, have overlooked the leverage provided by executive stock options. In principle, adjusting the exercise prices of executive stock options can mitigate the risk incentive effects of financial leverage. We show that the near‐universal practice of setting option exercise prices near the prevailing stock price at the date of grant effectively undoes most of the effects of financial leverage. In a large cross‐sectional sample of Canadian option‐granting firms, we find evidence that executives' incentives to take equity risk are negatively rather than positively related to the leverage of their employers.     

Option Awards for Australian CEOs: The Who, What and Why

The compensation structure for Australian CEOs, and especially the extent to which they receive executive stock options, is explored. Evidence suggests that the award of executive stock options is common in Australia, but not in as systematic a manner as has been documented for US CEOs. Where ESOs are awarded, they form a significant component of total compensation, even allowing for limitations in the way we approximate their value. Modelling the use of ESOs shows relatively few empirical regularities, other than a positive association between firm size and ESO use. This is consistent with a view that ESOs are a form of "rent extraction" by CEOs, but it may also reflect a bias towards their use created by accounting rules.     

Executive stock-based compensation and firms’ cash payout: the role of shareholders’ tax-related payout preferences

We hypothesize that the structure of executive stock-based compensation helps to align managers’ payout choices with shareholders’ tax-related payout preferences. Specifically, stock options, which are not dividend-protected, can deter self-interested executives from using dividends as a form of payout. In contrast, restricted stock, which is dividend-protected, is more likely to induce the use of dividends. Relatedly, shareholders’ preferences for dividends, which are taxed as ordinary income, can depend on the income tax consequences of dividends relative to those of long-term capital gains. To test our hypothesis, we investigate whether the exogenous changes in shareholders’ tax-related payout preferences following the 2003 dividend tax rate reduction result in predictable shifts in executive stock-based compensation and in managers’ payout choices. Consistent with our prediction, we find a positive relation between the increased use of dividends in firms’ payouts and the increased (decreased) use of restricted stock (stock options) in executive compensation, particularly for firms with a greater percentage ownership by individual investors and with lower costs associated with modifying the structure of their compensation plans. Our investigation of the role of shareholders’ tax-related payout preferences in the design of executive stock-based compensation extends the prior literature that has largely focused on the role of incentive contracts in inducing managerial effort, risk taking, and retention.     

Restricting CEO pay

We analyze several proposals to restrict CEO compensation and calibrate two models of executive compensation that describe how firms would react to different types of restrictions. We find that many restrictions would have unintended consequences. Restrictions on total realized (ex-post) payouts lead to higher average compensation, higher rewards for mediocre performance, lower risk-taking incentives, and the fact that some CEOs would be better off with a restriction than without it. Restrictions on total ex-ante pay lead to a reduction in the firm's demand for CEO talent and effort. Restrictions on particular pay components, and especially on cash payouts, can be easily circumvented. While restrictions on option pay lead to lower risk-taking incentives, restrictions on incentive pay (stock and options) result in higher risk-taking incentives.     

SIX CHALLENGES IN DESIGNING EQUITY-BASED PAY

The past two decades have seen a dramatic increase in the equitybased pay of U.S. corporate executives, an increase that has been driven almost entirely by the explosion of stock option grants. When properly designed, equity‐based pay can raise corporate productivity and shareholder value by helping companies attract, motivate, and retain talented managers. But there are good reasons to question whether the current forms of U.S. equity pay are optimal. In many cases, substantial stock and option payoffs to top executives–particularly those who cashed out much of their holdings near the top of the market–appear to have come at the expense of their shareholders, generating considerable skepticism about not just executive pay practices, but the overall quality of U.S. corporate governance. At the same time, many companies that have experienced sharp stock price declines are now struggling with the problem of retaining employees holding lots of deep‐underwater options. This article discusses the design of equity‐based pay plans that aim to motivate sustainable, or long‐run, value creation. As a first step, the author recommends the use of longer vesting periods and other requirements on executive stock and option holdings, both to limit managers' ability to “time” the market and to reduce their incentives to take shortsighted actions that increase near‐term earnings at the expense of longer‐term cash flow. Besides requiring “more permanent” holdings, the author also proposes a change in how stock options are issued. In place of popular “fixed value” plans that adjust the number of options awarded each year to reflect changes in the share price (and that effectively reward management for poor performance by granting more options when the price falls, and fewer when it rises), the author recommends the use of “fixed number” plans that avoid this unintended distortion of incentives. As the author also notes, there is considerable confusion about the real economic cost of options relative to stock. Part of the confusion stems, of course, from current GAAP accounting, which allows companies to report the issuance of at‐the‐money options as costless and so creates a bias against stock and other forms of compensation. But, coming on top of the “opportunity cost” of executive stock options to the company's shareholders, there is another, potentially significant cost of options (and, to a lesser extent, stock) that arises from the propensity of executives and employees to place a lower value on company stock and options than well‐diversified outside investors. The author's conclusion is that grants of (slow‐vesting) stock are likely to have at least three significant advantages over employee stock options:

• ? they are more highly valued by executives and employees (per dollar of cost to shareholders);
• ? they continue to provide reasonably strong ownership incentives and retention power, regardless of whether the stock price rises or falls, because they don't go underwater; and
• ? the value of such grants is much more transparent to stockholders, employees, and the press.

     

The impact of the market portfolio on the valuation,incentives and optimality of executive stock options

This paper examines the effect on valuation and incentives of allowing executives receiving options to trade on the market portfolio. We propose a continuous time utility maximization model to value stock and option compensation from the executive's perspective. The executive may invest non-option wealth in the market and riskless asset but not in the company stock itself, leaving them subject to firm-specific risk for incentive?purposes. Since the executive is risk averse, this unhedgeable firm risk leads them to place less value on the options than their cost to the company.

By distinguishing between these two types of risks, we are able to examine the effect of stock volatility, firm-specific risk and market risk on the value to the executive. In particular, options do not give incentive to increase total risk, but rather to increase the proportion of market relative to firm-specific risk, so executives prefer high beta companies. The paper also examines the relationship between risk and incentives, and finds firm-specific risk decreases incentives whilst market risk may decrease incentives depending on other parameters. The model supports the use of stock rather than options if the company can adjust cash pay when granting stock-based compensation.     

The role of equity compensation in reducing inefficient investment in labor

We investigate whether equity compensation incentivizes executives to make efficient labor investment decisions. In doing so, we examine the extent to which stock options and restricted stock differentially influence labor investment decisions. Consistent with theoretical predictions, we find that stock options exacerbate, while restricted stock mitigates, inefficient labor investment. The effect of stock options (restricted stock) are weaker (stronger) for financially constrained firms. Our results are robust to alternative proxies for inefficient labor investment and when addressing a range of endogeneity concerns. Our research demonstrates that stock options and restricted stock matter in executives' labor investment decisions, but in different ways. Our findings have implications for future research, suggesting that stock options and restricted stock need to be separately considered when examining the impact equity compensation has on capital or investment decision making; and for executive remuneration practice.     

Optimal strike prices of stock options for effort-averse executives

This paper evaluates the common practice of setting the strike prices of executive option plans at-the-money. Hall and Murphy [Hall, Brian, Murphy, Kevin J., 2000. Optimal exercise prices for executive stock options. American Economic Review 90 (2), 209–214] claim this practice to be optimal since it maximizes the sensitivity of compensation to firm performance. However, they do not incorporate effort and the possibility that managers are effort-averse into their model. We revisit this question while explicitly introducing these factors and allowing the reward package to include fixed wages, options, and stock grants. We simulate the manager’s effort choice and compensation as well as the value of shareholders’ equity under alternative compensation schemes, and identify schemes that are optimal. Our simulations indicate that, when abstracting from tax considerations, it is optimal to award managers with options that will most likely be highly valuable (i.e., substantially in-the-money) on their expiration date. Prior to 2006, the tax code and financial reporting standards provided incentives to award options that are closer to the money when issued than the options that were optimal in the absence of these considerations. Recent tax and reporting changes voided these incentives and thus we predict that these changes will induce firms to issue options with lower strike prices than those that were issued prior to 2006.     

American-style Indexed Executive Stock Options

This paper develops a new pricing model for American-style indexed executive stock options. We rely on a basic model framework and an indexation scheme first proposed by Johnson and Tian (2000a) in their analysis of European-style indexed options. Our derivation of the valuation formula represents an instructive example of the usefulness of the change-of-numeraire technique. In the paper's numerical section we implement the valuation formula and demonstrate that not only may the early exercise premium be significant but also that the delta of the American-style option is typically much larger than the delta of the otherwise identical (value-matched) European-style option. Vega is higher for indexed options than for conventional options but largely independent of whether the options are European- or American-style. This has important implications for the design of executive compensation contracts. We finally extend the analysis to cover the case where the option contracts are subject to delayed vesting. We show that for realistic parameter values, delayed vesting leads only to a moderate reduction in the value of the American-style indexed executive stock option.     

Management compensation contracts and distribution policies in the US technology sector

This paper examines the impact of executive compensation practices on (a) the decision to distribute and (b) the distribution channel employed by companies from the US technology sector. We report that firms that compensate their managers using executive stock options (ESOs) tend to distribute less and firms that use stock awards make more distributions. When we simultaneously examine the distribution and the channel used, we find firms using ESOs restrict their dividend payments but their propensity for stock repurchases is unaffected. Firms using stock awards to compensate managers make greater distributions across all channels. We also provide strong evidence in favour of the agency and leverage explanations for distributions.     

The Hybrid Option: A New Approach to Equity Compensation

Equity compensation can provide part of the expected reward needed to attract and retain talent while strengthening the unity of interest between management and its shareholders. But more can be done. Until now, managers and boards have used standard equity instruments such as restricted common stock and at-the-money stock options. Boards typically place various restrictions on these instruments to improve retention or alignment, or mix and match them according to taste or fashion. But each of these standard instruments has well-understood limitations. For example, employee stock options that are granted at the money are worth considerably less, on the day of the grant, to the managers that receive them than to the shareholders of the companies that give them. And the values of both options and restricted stock depend heavily on variables, like the general state of the economy, that have little or nothing to do with managerial performance.
An instrument designed specifically for executive compensation can overcome these limitations. More specifically, the author proposes the use of options that are both in-the-money —to limit their value-to-cost discount—and indexed to industry- and market-wide variables—to tie rewards more directly to firm-specific performance. Properly designed, such a hybrid instrument could meet all the equity-based compensation objectives for a given company, greatly simplifying its compensation plans, while improving the balance among the compensation governance criteria of retention, alignment, and cost control.     

Performance-vested stock options and interest alignment

This paper investigates the effects of performance-vested stock options (PVSOs) in aligning management interests and shareholder wealth. Using 4238 executive-level observations for 1383 executive directors from the largest 244 UK non-financial firms over the 1999–2004 period, we find that the use of PVSO schemes in executive compensation contracts is associated with greater interest alignment. The evidence also shows that PVSOs outperform traditional stock options (TSOs) in providing incentives. Moreover, the results suggest that difficult vesting targets negatively affect managers' choice of effort, resulting in the divergence of managers' and shareholders' interests.     

Recognition versus Disclosure of Stock Option Compensation: An Analysis of Judgements and Decisions of Nonprofessional Investors*/CONSTATER OU PRÉSENTER PAR VOIE DE NOTE LA RÉMUNÉRATION SOUS FORME D'OPTIONS D'ACHAT D'ACTIONS: UNE ANALYSE DES JUGEMENTS ET DES DÉCISIONS DES INVESTISSEURS NON PROFESSIONNELS

Given the importance of stock options in the aggregate compensation of chief executive officers and other firm employees in the 1990s and early 2000s, the International Accounting Standards Board issued an International Financial Reporting Standard on stock‐based payments on February 19, 2004, requiring that all share‐based payment transactions be recognized at fair value in entities' financial statements. The Canadian Institute of Chartered Accountants' Accounting Standards Board had already agreed to this principle and amended section 3870 of the CICA Handbook (stock‐based compensation) for financial periods beginning on or after January 1, 2004, making Canada the first major jurisdiction to require all public companies to expense employee stock‐based compensation awards. The revised section eliminated the possibility of disclosing pro forma net income and earnings per share only by way of a note. This research, conducted as a between‐subjects experiment with executive MBA students as nonprofessional investors, examines whether changes in the way stock option compensation is reported (recognition as an expense in the income statement or note disclosure of pro forma net income and earnings per share) affect financial statement users' judgements and investment decisions. Our results indicate that, consistent with the functional fixation hypothesis, the reporting method does indeed significantly influence subjects' judgement of the expected stock price direction, but has no material influence on their investment decisions.