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Stock Options vs. Stock: An Incentives Perspective
A few months ago, I posted a link to this article, and a friend then asked me to clarify because he didn't understand the point. After I have now had a similar conversation with another friend, I thought it might be useful to write down my thoughts for future reference.
Both stock options and stock are compensation instruments for employees. The underlying goal is to align the company owner interests with those of the company employees, so that everybody is working towards increasing shareholder value.
- Stock is given out to employees who will thus automatically become shareholders.
- Stock options however work differently in that they give to the owner the right to later purchase stock at a predetermined price (strike price). Should the option owner exercise his right, he will become a shareholder too.
The biggest problem with stock options is that they align employee and shareholder interest much more on the upside than they do on the downside. Should the stock price fall under the strike price, an option holder does not have any interest to stop a further fall because he does not suffer further from a falling stock price. However, he has a large interest to make the stock price rise again. This is obviously a distorted incentive structure because it for once might not incentivize the employee to work much for a rising stock price if the current stock price is already very depressed. However, it might incentivize the employee to take on riskier strategies for the company than would be optimal. This "betting the company" effect arises because the employee will have large gains from a rising stock price but does not suffer from a falling one. This effect is not prevalent when an employee owns stock instead of stock options because in that case he suffers and gains from stock price movements just as regular shareholders do.
This is seemingly the most complicated issue to understand: Both stock options and stock align interests on the upside, but the former fails to align interests on the downside. Actually, to make it a little more complicated, stock options also only align interests on the upside starting from the stock price exceeding the strike price.
(Because I am not qualified enough to make a proper theoretical explanation, I'll just use an example in the following explanations.)
Let's say that a year ago the company's stock price was $10. Let's further say for simplicity's sake that the options were handed out during that time with a strike price of $10 as well. The current stock price is $4 because the company has not been having a good time recently (not an unrealistic assumption these days). An option holder who believes that the stock price can rise to perhaps $20 has very well-aligned incentives. However, an option holder who believes that at best a stock price of $8 is realistic in the foreseeable future does not have a monetary incentive to work for that. He can't exercise profit from his options in either case. Yet, shareholders would very much profit from the stock price going to $8 because it would double the value of their holdings. Even worse, the option holder does not at all care if the stock price would go down to $1 evaporating yet another 75% of shareholder value. The drastic conclusion is that, any stock price assumption between $0 and $9.99 has the exact same incentivizing effect for an option holder: none.
However, if the employee had been awarded stock by the company when the stock price was at $10, he would also have suffered from the decline to $4. More importantly, he would profit from a stock price of $8, and he would further suffer from a stock price decline to $1. He has an incentive to prevent the stock price from falling further (because he would lose even more), and he also has an incentive to increase the stock price beyond $4 (because he would participate in any gain).
Let's turn it up a notch and make it more complicated, but also more realistic: Although the option holder does not have an incentive to increase the stock price to $8 if he only believes that this is a realistic stock price, he might nevertheless see a tiny chance that some risky project might yield an extraordinary result which could catapult the stock price to $50 and thus make the employee rich (as well as the shareholder). However, the project only has a tiny chance of success and will in the most likely case bankrupt the company. Its expectancy value is a high negative number, and thus shareholders would not approve of it. But what the heck does the option holder care: For him, the option now is like a lottery ticket where he has a chance of influencing the outcome to some degree. Thus, the option holder becomes an actor with a huge risk preference. This is called an overinvestment problem. He is incentiviced to invest more and riskier than would be wise because losing does not matter. The lottery ticket is free for now and opportunity costs are zero.
Now that we have made clear the distorted incentive structure of stock options, there must be some incentive reason to do them, right? Sure, there is. It's actually the other side of the risk preference structure. Normal emplyoees without stock options (be it as stock holders or not) suffer from a risk preference that is too low. They do not want to take risks because the most important thing for them is to keep their job safe and get paid continuously. This problem arises from the fact that employees are usually underdiversified investors, i.e. they have all their eggs in one basket and want to protect this basket no matter what. Thus, they want to invest less (underinvestment problem). Shareholders, however, are usually pretty diversified investors and have spread their risk across a portfolio of investments. Thus, for each single investment they have a higher risk preference than employees and would like company employees to act more risk-oriented than those would do on their own. Thus, stock options are handed out to create a higher incentive for employees to work on the upside hopefully reducing their underinvestment problem.
Altogether, as to be expected in reality, there is no perfect solution. All the above effects are only working to some degree, they depend on other factors as well, and very often they relate to top management much more than just to employees. Anyway, perhaps one can make a few general observations:
- It is often said that options are better for venture capital-financed startups because keeping their job should not be a priority for those employees, but it should rather be to create an exit for the startup. This is mainly due to the fact that venture capitalists are extremely well-diversified investors and want their portfolio companies to undertake high-risk, high-reward strategies.
- For larger corporations, however, the problem is a little more complicated because shareholders on the one hand want the CEO to undertake (potentially risky) growth strategies and not just keep his job safe; this argument has led to the shareholder value discussions in the 80's and thus to the widespread use of options afterwards. On the other hand, shareholders of large corporations don't want their CEO to bet the farm too much potentially risking a healthy business (think Vivendi).
As can be seen, it is not easy to decide between stock options and stock for employee compensation. There are many more facets to the problem (taxes, bookkeeping, financial reporting, stock market reactions, just to name a few), but understanding some of the incentive structures is an important first step.