Finance: Acquiring and Using Funds to Maximize Value

Any Good Options Here?

Back in 1980, less than one-third of all chief executives working in public companies received stock options as part of their pay package. By 2006, companies granted nearly 80% of all chief executives such options. So theres no doubt that stock options for executives have become increasingly popular over the past 25 years or so.

Then why does prominent economist and former Federal Reserve Chair Paul Volcker express his disapproval of this method of rewarding executives for performance in no uncertain terms? I think we ought to get rid of them, he says.

Most top-level executives receive a particular type of option called incentive stock options (ISO). Like all stock options, an ISO gives the executive the right to buy, or exercise, a specific number of shares of their companys stock during a specified period of time at a set price (the strike price). The strike price is usually equal to the market value on the day the option is granted. If the market value of the stock goes up, executives makes moneyin some cases, lots and lots of moneyby selling their shares for more than they paid for them. For example, a strike price of an option was $5 a share. If the stock rose to $10 a share on the date the executive was permitted to actually make the purchase, he or she could turn around and sell the stock and realize an immediate profit of $5 a share. Multiply that by a million shares, and youre talking real money. The option is in the money if executives can sell their shares for more than the strike price; its underwater, if they stand to lose money on the sale.

So, is giving incentive stock options to top executives a good idea?

The Pros:

ISOs are good for stockholders. An executives main responsibility is to increase the value of the company for its owners, namely the shareholders. When executives personally benefit when the stock value increases, they are likely to work harder and do a better job.

ISOs are good for companies. Offering incentive stock options helps companies attract and keep entrepreneurial executives who arent afraid to take the risks you need to take to grow. Stock options are a particularly good deal for promising start-up companies that are strapped for cash.

Incentive stock options are good for the executives. Not only do they have a chance to strike it rich if they perform well, but the proceeds from ISOs are usually taxed at the lower capital gains rate, not the higher personal income rate.

The Cons:

ISOs dont really make the interests of executives the same as those of the stockholders. Thats because of the perfectly legal practice of repricing. If an executives option threatens to go underwater, the company can cancel the old options and reissue new ones at a lower strike price. When the firms stock price does well, the people in charge make out like lottery winners, writes John Cassidy in a 2002 New Yorker article. When the stock price plummets, they get another set of chances to win.

ISOs put undue pressure on managers. A good incentive plan ties a managers performance to factors that he or she has a reasonable chance of controlling. In reality, managers have little control over stock price. Although a companys earnings record certainly does affect share price over the long run, so also do political events, rumors, crowd psychology, and even the weather.

CONS Continued:

ISOs provide incentives, all right, but its likely to be a perverse incentive. When executives cant improve a firms performance, they work very hard at making their companys performance look better than it actually is. Intent on propping up stock prices, they sometimes do this in legal ways, such as having the company repurchase its own stock, thus reducing the total number of shares. After all, earnings per share automatically improve if you divide profits by a smaller number. In addition, executives sometimes resort to illegal methods, such as when companies such as Enron and WorldCom issued fraudulent financial statements.

You Decide

Do you think ISOs are on the whole a good idea, though perhaps in need of some reforms? Or do you agree with Paul Volcker, that they need to be scrapped? Explain your answer.

An executives chief obligation is to the stockholder, and his or her main task is to increase stock value. Do you agree or disagree? Explain.

Some companies offer rank-and-file employees nonqualified stock options. The proceeds that result from exercising the option are taxed at the higher personal income ratein other words, these options dont qualify for the special tax advantages that ISOs do. And they are never repriced. Does this seem fair to you? Does it raise any ethical issues? Explain your answer.