Thoughts on Business and Technology

Perils of Stock Options

stock_options Stock options are treated as a matter of fact in the software industry, especially in Silicon Valley. The stock options granted to CEO’s of some of the well-known companies as part of their compensation are listed below.

Equity based compensation and incentives have gained considerable popularity across most industries in the past few decades. Most of us who have worked for a technology company or a startup have had stock options granted to us. Many of us have benefited from the appreciation of the stock price of these companies. In this regard, software companies are a rarity as most industries limit stock options or other equity based compensation to executives or top management.

There are advantages of using equity based compensation to companies and employees. A few of them are listed below

Advantages to the company

  • Companies ( especially startups ) need not spend cash to hire top talent; instead they can offer equity to attract talent that otherwise they couldn’t afford
  • By offering equity, companies try to align the employee’s interests with that of the company
  • By sharing the benefits of a rising stock price if the company does well, the management of a company can gain the loyalty and goodwill of its employees
  • Helps companies retain good employees for the longer term

Advantages to the employee

  • The upside is unlimited but there is no downside since the employee is not investing his or her money to buy the options that are granted
  • The potential of sharing a part in the company’s long term growth
  • Tax benefits to employees who opt to early exercise their stock options in a startup

Though there are significant benefits of equity based compensation to the company and employee, many respected investors have raised concerns about this practice. Equity based compensation has been misused in corporate america. For example, back dating of options has gotten a lot of press recently. Options backdating is when executives of a company are granted options with dates set prior to the actual grant date to take advantage of a lower stock price.

  Warren Buffet is one of the sharpest critics of this practice. In his annual letter to the shareholders of Berkshire Hathaway in 1986 he clarifies why he is not a big fan of stock options as a form of compensation.

He argues that the interests of the managers who are compensated based on fixed-price stock options are not aligned with the shareholders. Such managers focus on factors such as short-term revenue gains that lead to an increase in share price at the expense of the long term interests of the shareholders.

Buffett explains that a manager who increases earnings by employing more capital is not worthy of appreciation. He makes his point with this classic Buffett style example.

Companies and media regularly praise CEOs who have, say , quadrupled earnings of their company during their reign- with no one examining weather this gain was attributable simply to many years of retained earnings and the workings of compound interest.

If the company consistently earned a superior return on capital throughout the period, or if capital employed only doubled during the CEO’s reign, the praise for him may be well-deserved. But if return on capital was lackluster and capital employed increased in pace with earnings, applause should be withheld. A savings account in which interest was reinvested would achieve the same year-by-year increase in earnings and at only 8% interest would quadruple its annual earnings in 18 years.

The power of this simple math is often ignored by companies to the detriment of their shareholders.

Buffet admits in his letter, that despite their shortcomings, options can be appropriate under certain circumstances. However indiscriminate use of options may not be in the best interest of the shareholders. According to Buffet following three guidelines should be considered before granting options to management or employees.

  • Stock options are inevitably tied to the overall performance of a corporation. Logically, therefore, they should be awarded only to those managers with overall responsibility. Managers with limited areas of responsibility should have incentives that pay off in relation to results under their control. The .350 hitter expects, and also deserves, a big payoff for this performance-even if he plays for a cellar-dwelling team, and the reverse is also true.
  • Options should be structured carefully. Absent special factors, they should have built into them a retained-earnings or carrying-cost factor. Equally important, they should be priced realistically.
  • Some of the well-run companies have successfully used fixed-price options as a inventive. the leaders in these organizations have taught their colleagues to think like owners. Such a culture is rare and when it exists should perhaps be left intact.

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