Companies increasingly offer stock options to employees as both a perk and additional compensation. Executives and other members of a company’s management frequently receive large benefit packages with plenty of stock options. Paying company executives with stock options has many advantages for the company, but overuse can lead to problems for the company, the shareholders and the executives.
Stock options align management’s interests with those of the shareholders by making management owners as well. By paying executives in stock options, executives receive a direct and personal financial incentive to better the company’s performance. Executives also have a disincentive to mess up, because if share prices prices drop as a result of bad performance, executives lose lucrative options. Aside from their salary, bonus and other benefits, executives can cash in hundreds of thousands of dollars or more if their hard work results in higher share prices.
Cheap & Easy
Stock options are a cheap way to give executives lucrative benefits. When the company issues stock options, they must expense it as compensation. However, while that expense shows up as a cost in a profit report, the option requires considerably little cash on the company’s part. This makes stock options particularly attractive to companies that want to invest as much of their cash as possible into capital improvements, acquisitions and other things that grow the company.
The main disadvantage of stock options is that they dilute the profit per share of existing shares and the ownership of outside shareholders. Dilution frustrates existing shareholders and drives down the price of individual shares. Companies must choose between dilution and buying back shares at market price to resell to employees at a loss. The stock market information website Trading Stocks Guide points out that the latter takes money straight out of profits and dividends and instead subsidizes employees, a practice that also frustrates shareholders.
In 2007 the New York Times reported on several studies that tracked executive stock options and risk-taking. The studies found that executives receiving a large portion of their compensation in stock options take more extravagant risks, the majority of which go badly. Executives do not lose money when projects fare poorly because an option is not worth anything until used. However, when projects go well, executives cash in on their options and reap the benefits. The studies proposed balancing options with other forms of compensation and finding new ways to build penalties for irresponsible risks into the system.
Calla Hummel is a doctoral student studying contraband in international political economy. She supplements her student stipend by writing about personal finance and working as a consultant, as well as hoping that her investments will pan out.