FOOL ON THE HILL
Stock Options' Perverse Incentives

In the conclusion to a two-part column, Whitney Tilson highlights the many perverse incentives that stock options create and recommends that companies instead set up programs to encourage actual stock ownership.

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By Whitney Tilson
April 3, 2002

In my last column, I presented an overview of stock options, highlighted their good qualities, and began my critique by underscoring the insane accounting for them. Today, I'd like to continue my critique by analyzing the incentives -- often perverse -- that stock options create.

The differences between stock and stock options
A stock option is the right to buy a stock, for a certain time, at a certain price. While the value of an option is certainly tied to the value of the underlying stock, they are by no means identical. An option is essentially a leveraged way to own a stock: If the stock price rises, the option's value rises faster, and vice versa. For example, let's say an employee has an option with a strike price of $15 and the stock is at $20. Assuming the option has vested, the employee can convert the option into a share of stock by paying the strike price, then sell the stock and pocket the $5 gain.

Now let's consider what happens if the stock price rises 25% to $25: The option increases in value by 100% to $10. Conversely, if the stock falls 25% to $15, the option's immediate realizable value falls 100% to zero (assuming it can't be sold, which is the case with almost all employee stock options). Most importantly, if the stock continues to fall below $15, stockholders lose more money, while the option holder isn't affected very much, as the option was already worthless (though as the stock price falls further below the strike price of the option, the chances that the stock ever rises above the strike price in the future diminish).

Option holders benefit and suffer disproportionately as the stock price rises and falls -- as long as the stock price is above the option strike price -- but are less affected by stock price movements below the strike price.

Swing for the fences
Why does this matter? Because management teams are constantly presented with various opportunities to make acquisitions, invest to expand the business, issue debt, and so forth. Each decision has a certain risk-reward equation: Shareholder value can be enhanced, but it can also be destroyed, so making the right call is critical. At a bare minimum, as a shareholder I want to make sure that management has the same incentives I do: They profit if they make good decisions and the stock rises but also suffer if they behave foolishly and the stock suffers.

While stock options may appear to be a good tool for aligning incentives, they are less than ideal -- and in some ways provide perverse incentives. Consider Company A, which has the opportunity to make a large and difficult-to-digest acquisition of Company B. To vastly oversimplify, let's say there's a one-third chance the acquisition goes smoothly (roughly the actual odds, as I noted in my column, "Be Wary of Acquisitions") such that Company A's stock increases from $20 to $30 within a year, but a two-thirds chance it doesn't and the stock falls to $10. The expected value is $16.67, so management should clearly reject the deal.

But will it? What if management was just granted one million options with a strike price at the market price (e.g., $20)? These options cannot currently be exercised since they're not "in the money," and management faces the uncertain prospect of trying to steadily grow shareholder value such that over time the stock rises and the options become valuable. But if management does the acquisition, there's a one-third chance that the options are worth $10 million within a year (1 million options x ($30 share price - $20 strike price)). As for the downside, the options are certainly worth less if the stock falls to $10, but enough to offset the chance of a quick $10 million jackpot?

Eliminating the downside
The incentives become even more perverse when one considers what often happens when a company's stock price falls. This is a genuine dilemma for companies that rely heavily on options as a part of their compensation package since many employee options will be "under water" (e.g., the stock price is lower than the option's strike price), and thus the company risks low morale and high turnover. In this scenario, companies will typically issue more options (with strike price at the lower stock price, of course) or simply reprice the existing options.

If Company A's management does the deal, there's a one-third chance it will get a $10 million windfall and a two-thirds chance that the stock gets cut in half -- but in this case management would get a million more options priced at $10 or the existing million options would be repriced at $10. It's a heads-I-win, tails-I-don't-lose situation, so it's not surprising that management teams are increasingly swinging for the fences.

Increase in options = increase in debt?
Acquisitions are only one of many ways in which companies can take on risk in the hopes of a big payoff. They can also do so, for example, by taking on high levels of debt to expand into new lines of business, grow their existing operations, repurchase shares, etc. Over the past 5 to 10 years, net corporate debt has doubled -- with ugly results for an increasing number of companies. Over roughly the same period, the 200 largest companies in America have doubled the percentage of their outstanding shares that are allocated for options. Is this purely coincidence, or did companies take on excessive amounts of debt in reckless pursuit of rapid growth, driven in part by stock-option-created incentives for management to swing for the fences? It's hard to know for sure, but I'd bet on the latter.

Incentives to pump and dump
Let's say the management of Company A has two choices: a) grow the business steadily over five years such that the stock rises 15% annually and doubles to $40; or b) promote the heck out of the stock by investing heavily in speculative new technologies, creating false expectations and so forth, such that the stock triples to $60 in the first year and then declines steadily to $30 over the next four years. Obviously, shareholders as a group are better off under scenario a), but management might be better off under scenario b) because they have the opportunity to convert their options to stock and dump it when the stock is at or near its peak.

New stock vs. repricing options
As noted above, when a company's stock falls, it can offset this cost to management and employees by either issuing more options or repricing existing ones. The latter course is clearly better for shareholders, as there is no additional dilution, yet companies often choose the former because of a quirk in accounting rules: Normal options do not have to be expensed on the income statement, but if a company reprices options, it must reduce its profits if the value of the now-repriced options rises over time.

To avoid the possibility that a non-cash compensation expense might have to be recognized on the income statement, some companies choose to issue extra options:For example, two years ago Microsoft, after its stock price collapsed in the wake of its antitrust defeat in court, granted 70 million new options to employees rather than repricing existing ones. Dell did something similar not long thereafter.

There's a third choice as well. A company can effectively reprice options without having to recognize the cost by canceling existing ones and then issuing new ones, but there's a catch -- it has to wait six months before setting the strike price for the new options. Companies like Sprint, Qwest, i2, Inktomi, RealNetworks, Commerce One, and WorldCom have all taken advantage of this, but it creates truly bizarre incentives: If a company expected its stock price to go up in the next six months, would it offer such a plan? It's unlikely, as employees would be furious that they'd been forced to wait rather than take advantage of the current low share price. Worse yet, employees actually have an incentive to keep the share price down until after the new strike price is set.

One more problem
I currently own a stock that has fallen dramatically over the past two years from over $100 to $7 per share. I have little doubt that the company could be sold for $10-$14 per share, and I would be happy to take an immediate 50-100% gain, as would most shareholders. So why doesn't the CEO engineer a sale in this price range? In part because he thinks that the company is worth far more -- and he may be correct. But I also suspect it's because his options all have strike prices around $10, meaning that he has strong incentives to oppose a sale of the company around this price, no matter how good a deal it might be for shareholders.

Possible solutions
I've heard of various ideas to improve stock option programs by, for example, linking the exercise price to a market or peer-group index, but I think the best solution is to move away from options. To that end, an obvious first step is to require companies to expense them. But what about aligning management's incentives with those of shareholders? In place of options, companies could set up a variety of ways to encourage management (and perhaps all employees) to purchase actual stock with their own money -- and therefore have the same capital cost as well as upside and downside as every other shareholder.

For example, last August I highlighted a program by Markel Corp. (NYSE: MKL) in which the company set up a loan program with a local bank that allows employees to borrow money to buy stock at a company-subsidized interest rate of only 3%. More than 70% of Markel's North American employees participate in this program, and they have borrowed more than $10 million through it.

Here's another example: The new management team that has engineered a remarkable turnaround at Moore Corporation (NYSE: MCL) publishes every month a list of how much company stock is held by each senior manager at the company -- a total of a few dozen people. All of them are expected to buy the stock, and peer pressure is the enforcement tool.

Conclusion
Warren Buffett was entirely correct when he wrote in his 1998 annual letter that stock options are "often wildly capricious in their distribution of rewards, inefficient as motivators, and inordinately expensive for shareholders." He continues, "Whatever the merits of options may be, their accounting treatment is outrageous."

It's time to make companies account properly for the true cost of stock options -- a step that will give investors a truer picture of economic reality and encourage companies to replace stock option incentive programs with those that encourage actual stock ownership.

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He did not own shares of any companies mentioned in this article at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.