June 29, 2002
From the desk of Jane Galt:So there's been a lot
So there's been a lot of noise lately about stock options and whether they're a good idea or a bad idea, with the liberals and conservatives predictibly screaming across the ideological chasm, and the sense getting lost in the meantime.
Well, here's a little explanation for those of you who slept through this part of CorpFin 101.
Why do we use stock options?
Stock options are a solution to the principle-agent problem, which is a fancy way of saying that the professional executives who run companies have conflicts of interest with the shareholders who own said firms, and we can't just rely on the executive's altruistic sense of what is right and good to bridge the gap, any more than we can hope that if we sing Kum-bah-yah enough times Bin Laden will sashay out of whatever hole he's hiding in and stick a daisy in the rifle of the first Green Beret he sees.
We can't watch the bastards every minute; after all, we've got jobs and kids and bathrooms to regrout and the Lord of the Rings DVD we haven't even looked at. Think of a big corporation, say Exxon, as the equivalent of a gas station whose owner is on an extended vacation. When the cat's away, the mice will play.
While liberal commentators would have you believe that the sixties and seventies were a halcyon era of corporate responsibility and managerial modesty, they were also the era of bloated conglomerate empires, seven-figure expense accounts, and the Chrysler bailout. Managers, believing that forcing American consumers to buy whatever crap they made was their God-given right, were less concerned with innovation or competitiveness, and more concerned with building immense private fiefdoms for themselves, from which their vassal lords would bring them tribute in the form of junkets, three-martini lunches, and ludicrous perks suh as a corporate jet to fly you to the Tasti-Freez.
They also failed to optimize shareholder value, because their risk-reward profile was far different from the shareholders. When times were good, they were unwilling to take potentially profitable risks, because they weren't going to see much of the upside, while the downside meant they would lose their jobs.
When times were bad, they were willing to take insane risks, because hell, they were going to lose their job anyway, and if there was any chance that that bionic tweezer could turn things around, why not try? After all, they were going to lose their jobs anyway. Why leave assets to be repatriated to all those ungrateful shareholders when there was still the possibility that the CEO's corporate jet might be saved?
Stock-based compensation is meant to align the interests of the managers with those of the shareholders, by making a substantial portion of their compensation dependant on the share price.
So why didn't stock options work as well as we thought?
Well, for one thing, stock prices are an imperfect measure of a company's worth; the managers of a company, unless they are deluding themselves, always have a better picture of the actual health of a company than outside investors. This difference between insider and outsider knowlege is most pronounced over the short term.
Which brings us to the real problem: the risk-reward pattern of stock options is not identical to that of shares.
To understand why, we need to look at the relative compensation patterns of equally-valued stock and stock-option compensation packages. You there in the red shirt! Take your mouse off that "Back" button. This is important! You can look at naughty pictures later.
Let's look at two executives, both getting $1 million in salary, and $4 million worth of stock-based compensation.
Executive A, who we'll call Annabelle, is getting 4,000 shares valued at $100 apiece.
Executive B, who we'll call Belinda, is getting 16,000 options to buy shares at their current price of $100, excerciseable within 3 months.
[Why don't they get the same number of grants, you ask? Because we're not trying to equalize grants; we're trying to equalize the expected value, or the probability-weighted value, of the compensation.]
We'll assume, for the sake of the model, that we have perfect knowlege of probable outcomes, and that there is a 50% chance that the stock will be worth $50 in three month's time, and a 50% chance that it will be worth $150.
Wake up! We're through the boring part. Okay, so in three months time, what happens?
Annabel's stock is worth either $2 million or $6 million. Expected value: $4 million.
Belinda's stock options are either worthless, because the stock price is lower than $100; or very valuable, as she excercises her options at $100, sells them at $150, and pockets an $8 million profit. Expected value: also $4 million.
[How can this be? I hear you cry. Do the math:
Annabelle: (50% * $2 mm) + (50% * $6 mm) = $4 million
Belinda: (50% * $0) + (50% * $8 mm) = $4 million
And now you know how to do an expected value calculation. Isn't that exciting? I'll wait while you run out to phone your friends.]
Now, what does this tell us?
First, that Belinda is now willing to take more risks than Annabelle? Why? First of all, because Belinda's grant is all up-side. If Annabelle takes a risk that could put the company out of business, she loses everything. Belinda, on the other hand, loses no more if she puts the company out of business than she does if she just misses her earnings targets by a little; either way, she can't cash in.
The second reason is even more interesting. It's something called loss-aversion. What does that mean? It means that we'll do more to avoid losing what we have than to get more. This can lead to unhealthy risk-taking behavior. But it also leads to personal sacrifice and hard work to preserve the value of what you have. The executive with stock wants to avoid losing money more than the executive with options wants to gain it.
So in two important ways, the stock-option holder's interests are not aligned with those of the shareholders.
So why do we use stock options instead of stock grants
Two reasons: taxes, and financial accounting. Stock options allow you to play with the timing of expenses on both in order to maximize value.
Even more importantly, stock options don't show up on the balance sheet. Oh, they show up in the notes. But who cares about the notes? They don't show up in analysts model or the almighty EPS the same way that stock grants would, and that's the important thing. I'd explain the exact difference to you, but if you fall asleep that suddenly you might hurt yourself when your head hits the corner of your desk, and I couldn't live with that.
So what should we do?
You may not be aware of this, but Harvey Pitt is not knocking down the doors of Live From the WTC's editorial board to seek our opinion on this crisis. However, here is our opinion:
1) Change the accounting for stock options. Yes, we know that Black-Scholes has issues with long-term stock options, but not as bad, in our ham-fisted opinion, as the current valuation method.
2) Change the term and the blackout periods so that executives can't sell immediately after they excercise.
3) Eliminate the practice of re-pricing options, where an executive's pet board gets to decide that the stock decline wasn't really his fault and he should get to make a profit off his options anyway.
4) Preferably, move away from options and towards either a stock grant with a lengthy blackout, or the elegant solution proposed by Mindles H. Dreck: base compensation on the company's stock's outperforming stocks in it's industry sector; after all, we don't want the executive to benefit or be penalized by changes in the sector, but for how well said executive manages to maximize profits given market conditions.
I hope this answers your questions.
Posted by Jane Galt at June 29, 2002 6:05 AM | TrackBack | Technorati inbound links