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.