Stock options are often defended as financial incentives that encourage company executives to seek out value-creating activities for the firm. The theory is that option grants force CEOs to focus on increasing their company's stock price so that the options will pay off. For example, XYZ, now trading at $20 a share, issues its CEO a bucket of stock options with an exercise price of $25 a share. Eager to profit from the options, the CEO will work tirelessly to increase the share price of stock so he or she can cash in. Unfortunately, most theories remain theories.
In rare instances, issuing options can lead to true value-creating behavior in a firm. Also, options can be a way for new, privately held companies strapped for capital to attract highly talented individuals. In lieu of market-level incomes, those individuals earn less now for the possible bigger payoff in the future. In this case, you don't have some already wealthy executives gambling with the assets of the firm. Companies like Microsoft
My problem with stock options issued to CEOs is that they inherently promote senseless risk-taking because they come naturally imbedded with an asymmetric payoff system. CEOs are presented with this situation: If the coin lands on heads, they win big; if it's tails, they lose nothing. Without anything to lose, how often do you think a CEO will "flip the coin" -- take on projects or make acquisitions -- to get it to land on heads? In the real scenario, however, we are not talking about 50/50 odds as with a simple coin flip. There are an infinite number of projects or acquisitions that companies can engage in to "create shareholder value."
Let's look back to our hypothetical example. The options granted to the CEO of XYZ Inc. cost him or her nothing. If they aren't exercised, the CEO is no worse off. However, he or she gains immensely if the stock price goes above the option grant price. If the CEO has nothing to lose, the motive then becomes to take on any project that appears to create any sort of temporary increase in stock price, regardless of the long-term effect on the firm. The payoff will always be zero or positive, but never negative. It's no coincidence that as the level of stock options dished out has increased, so have the acquisitions that destroy value rather than create it. And when companies aren't expensing the options, the situation can really get of out hand as shareholders are subjected to a double dose of value-destroying activities.
It gets better. Should those who hold options be in a position to cash out and exercise them, shareholders again get hosed by getting diluted. If a company has 10,000 shares outstanding and you hold 1,000, you have a 10% ownership interest in the company. If 1,000 shares are exercised via options, the total share count becomes 11,000, and your 1,000 shares now represent a 9.1% interest. If the same level of dilution occurs for the next nine years, your initial 10% stake would be cut in half, because you would now own 1,000 shares out of 20,000. So, even if the firm actually engaged in value-creating projects and doubled its value, the value of your investment will have stayed the same because of the dilution caused by the options being issued.
In the end, you are no better off than you started. Be careful of businesses that continually issue boatloads of options. Occasionally, they can be sensible if properly accounted for and issued with prudence.
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Fool contributor Sham Gad is managing partner of the Gad Partners Fund, a value-centric private investment partnership modeled after the original Buffett Partnerships. He has no stakes in the companies mentioned. The Fool has a disclosure policy.