Friday, July 4, 2008

Alignment of Interests with Stock Options

During the tech boom, employee incentive stock options were widely used by companies to provide extra income to employees. Management justified stock options by saying that they aligned the interests of employees and shareholders.

Aligning the interests of a company’s owners and employees is very important to the survival of the company as I explained in this post about alignment of interests. On the surface, it would seem that stock options can do the job. After all, if the company’s stock price goes up, it benefits both the shareholders and the employees holding options.

Unfortunately, closer examination will show that stock options do a very poor job of aligning interests. To begin with, most employees do not have enough influence within a company to affect the stock price perceptibly. From middle management down to the workers, stock options are just lottery tickets whose payoff is unrelated to the employee’s performance. Stock options do almost nothing as an incentive for these employees to do what the company’s owners want.

This leaves the top management of the company. These people do have enough influence to affect the value of the company. They are usually given a large block of stock options as a strong incentive to run the company well. In fact, the potential value of the stock options is usually so large that it dwarfs salary, bonuses, and other benefits.

The lure of a huge stock option payday is so strong that top management becomes completely focused on finding some way to drive the stock price up quickly. This can lead to taking wild chances that are not in the interests of shareholders. Consider the following example.

ABC Company’s stock currently trades at $20, and management’s stock options are struck at $20 (meaning that they will be able to buy shares for $20 each at some future time). Management at ABC is considering a bold new plan. There are three equally likely possible outcomes from implementing this plan. One of them results in the stock price jumping to $35, and the other two will result in the stock dropping to $5.

Let’s look at this from both the shareholder and management points of view:

Shareholders: The average outcome is (35+5+5)/3=$15, a loss of $5 per share. This is clearly a bad plan.

Management: If the stock drops to $5, then the stock options become essentially worthless, but employees won’t lose any money. If the stock jumps to $35, then the stock options will be worth $15 each. For the CEO who might have 2 million stock options, this would be a $30 million payday. The average outcome is (15+0+0)/3=$5 per stock option. This is a great plan.

The stock options have created a very strong incentive for management to focus on the short term and take wild chances. This is clearly not in the interests of shareholders. Carefully crafted bonus schemes that measure desirable employee behaviour are a far better than stock options for aligning the interests of employees and shareholders.


  1. Great post. I agree with your assertion that employee compensation should be tied to each employee's influence. The janitor should not be paid based on the company's stock price.

    I would have thought your post was written by Warren Buffett. He has talked about this in the past.

    Stock options can also affect dividend policy and stock buybacks. Option-laden executives would rather buy back stock, share price be damned, than pay a dividend. A stock buy-back increases price, while a dividend tends to lower it.

  2. Gene: I've read many of Buffett's writings, and it's likely that he has influenced my thoughts on stock options. I also got to see the effect of stock options on a company first hand. The results were good for some of the employees, but the company's long-term fortunes suffered terribly.

  3. Stock options are just an all-round bad idea imo to the long term future of a company. Creating stock is dilutive to existing shareholders, just like printing more money. This should not be done lightly in the first place. Creating stock should be used to raise much needed capital, not to reward employees. A first good start would be to restrict stock options to only be exercisable against the existing stock base of the company. The company should first have to acquire the stock through bidding on an exchange, before selling it to an employee.

  4. Jim: I agree that the stock acquired through stock options should be accounted for properly either by the method you describe or as a charge to earnings. Even when accounted for properly, though, stock options just don't create the right incentives.