McKinsey Quarterly

Getting what you pay for with stock options

| Commentary

Executives can no longer think of stock options as a free ride. The exodus of investors from equity markets and the accounting scandals that toppled Enron and WorldCom have made scores of blue-chip companies—Coca-Cola, General Electric, and Procter & Gamble among them—announce plans to account explicitly for the cost of the options they use to compensate executives and other employees. In November of 2002, the International Accounting Standards Board published a proposal to require all companies to do the same. In any case, rather than burying options as a footnote in financial reports, more and more companies will now report these payouts in the same way they do office rents, salaries, and other business expenses. Such accounting changes are unlikely to harm stock prices, and over time this healthy standard of disclosure should spread throughout the economy, thereby providing investors with clearer and more complete information.

The change, by itself, won’t make it easier for executives and boards to manage compensation. For a start, treating options as expenses opens up another arcane accounting debate: how to calculate their real cost. Moreover, managers must continue to evaluate the desired mix of cash, restricted stock, shadow stock, options, and other such mechanisms, the strategic implications of these mechanisms, and their effect on an organization’s ability to attract executive talent. As the income statements of many companies begin to reflect, for the first time, the true cost of options, senior executives and boards should take the opportunity to rethink this approach to compensation in light of five principles that would help them align more closely the role of options as managerial incentives with the interests of the shareholders.

1. Explicitly tie compensation to individual value creation

In case after case, investors have seen executives reap extraordinary rewards tied to share price increases that had little to do with management and everything to do with factors beyond its control, such as interest rate movements and changes in macroeconomic conditions.

Since standard stock options don’t differentiate between value created by external factors and individual performance, investors may be shortchanged and CEOs may be rewarded regardless of merit—as happened during the stock market run-up of the late 1990s—and top-performing CEOs may be penalized if their tenure coincides with a bear market. Indeed, McKinsey research shows that from 1991 to 2000, market and industry factors drove about 70 percent of the returns of individual companies, company-specific factors only about 30 percent.

One way to home in on the unique value an individual creates is to strip out the effect of factors outside the control of executives as well as the return on equity expected by shareholders. What remains—reflecting improvements in performance or changes in expectations for which the executives were themselves responsible—should be compared with the achievements of their peers. In general, executives ought to be held accountable for their ability to meet the shareholders’ expectations as defined by the cost of equity. In addition, they should (and, presumably, would wish to) be rewarded for any individual value creation and penalized for any individual value destruction.

Indexed options can be a useful tool here. Unlike standard options, indexed ones make it possible to benchmark an executive against a set of his or her peers. Of course, making the right selection of peers is crucial: in the few cases in which indexed options have been employed for this purpose, their impact has been diluted by the use of too lenient or broad a definition of the peer group.

2. Minimize incentives to alter the company’s risk profile

Investors have discovered that executives of the companies whose shares they own have ample opportunity to affect share prices by managing in ways that aren’t necessarily in investors’ best interest. Increasing the financial leverage of a company or the degree of business risk it bears are two prime examples.

Consider the situation of a CEO who holds a substantial number of options that are in effect worthless because the share price has fallen significantly below the “strike” price at which he or she can exercise them. If there is little likelihood that the share price will rise sufficiently, the CEO might well consider undertaking risky acquisitions or new projects that could increase the expected volatility of the stock price and restore the options’ value. All approaches to valuing stock options agree that increasing the volatility of the underlying stock price boosts an option’s value—because as share price movements increase, so does the probability that the stock price will exceed the option’s strike price at some time during the option’s life.

The CEO faces a limited downside; the options were worthless to begin with, and no matter how far the stock might plunge, they can’t become any more so. He or she has nothing to lose and everything to gain from greater volatility—which, however, increases the potential magnitude of downward share price movements and may therefore introduce a degree of risk that many investors would neither anticipate nor welcome. To guard against such circumstances, the board’s best response might be to reduce the weight of stock options in the CEO’s compensation.

3. Favor the grant of restricted stock over stock options

As noted, indexed stock options offer one way to distinguish between value created by external forces and value arising from individual performance. But this solution is only partial. Indexed options can still motivate executives to pursue interests that are unlikely to maximize shareholder value.

One answer would be to replace stock options with restricted stock, granted under conditions relating to executive tenure and performance. By requiring executives to invest some minimum proportion of their wealth or multiple of their salaries in the stock of the companies they run, boards can ensure that they will care about a sustained drop in share prices. Many companies, including Citigroup and Bank One, have introduced such rules.

4. Restrict the timing of stock sales

Boards can also restrict the sale of a significant portion of a CEO’s stock awards for a period of, say, two years beyond the end of his or her tenure. This would ensure that CEOs focus on the creation of long-term value and not on short-lived bumps in stock prices. It would also deter CEOs from leaving unpleasant surprises for their successors and give them more incentive to orchestrate or facilitate their replacement by strong ones.

5. Limit the potential for hedging strategies

Senior executives have many ways to hedge their holdings in the shares of their own companies. From the executives’ perspective, doing so might seem to be a sensible way of diversifying a portfolio. But this course poses a danger because it can, without the shareholders’ knowledge, limit the real exposure of these executives to the consequences of their own decision making. They could, for example, hedge by taking short positions in other companies in the same sector, thus offsetting part of their holdings.

Since there are many ways to hedge, it is difficult to make it impossible for executives to do so against the possibility of a drop in the value of the stock of their own companies. To provide the greatest transparency, boards might consider asking executives to make regular disclosures of their holdings in the industry—or indeed all of their investment activity—as a deterrent to egregious hedging practices.

Recent accounting scandals have given companies an opportunity to rethink stock options and their ideal role in aligning the interests of management and shareholders. The principles described here are not a comprehensive solution to the questions surrounding the use of stock options, but as a point of departure from earlier practices they might help balance the interests of executives with those of the companies and the investors they serve.

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