The theory behind stock options is quite sound. That is, options are a form of de facto stock ownership that should provide managers strong incentive to focus on operating the business in a way that would maximize shareholder value. Unfortunately, in practice stock options suffer from four fundamental flaws that subvert this basic premise:

1. option holders have limited financial risk,
2. options holders often profit from sub-par performance,
3. short vesting periods encourage a short-term business focus, and
4. options are blunt incentive/retention tools.

Close examination of the impact of these structural flaws combined with a dearth of corroborative evidence tying option use to long-term value creation have led us to the conclusion that stock options as they are structured today simply do not work. Therefore, we have reluctantly decided to vote against all stock option plans.  Over the balance of this paper, we discuss the aforementioned fundamental flaws and detail how each works to prevent stock options from fulfilling the promise of enhancing long-term value creation.

FUNDAMENTAL FLAW #1:

Option Holders Have Limited Financial Risk

Stock option proponents passionately argue that options place senior executives in the same financial camp as long-term shareholders. After all, both option holders and shareholders benefit from stock price appreciation and are penalized by declines in the price of the stock…right?  Well, not exactly. While it is true that both option holders and shareholders benefit from stock price appreciation, they are not equally at risk to declines in the price of the stock.

Remember that an option confers the right to purchase stock at a fixed price, a.k.a. the exercise price. However, corporate employees and directors do not pay for this valuable right. Additionally, if the stock declines in value, option holders are not required to exercise their options, i.e. purchase stock. They simply let them expire. Since option holders put no personal capital at risk upfront and there is no future obligation to invest, option holders have no financial downside.

In contrast, shareholders assume significant financial risk when they purchase a company’s stock. Because shareholders exchange cash for their ownership position, they can actually lose money if the stock declines. Ultimately, shareholders only benefit if the total return from holding the stock exceeds the rate of return required to compensate them for the potential loss of principal plus the opportunity cost of foregoing other investments.

The difference in financial risk assumed by option holders and shareholders is evidenced by the change in behavior that occurs after options are exercised. In our experience, the vast majority of option exercises are followed by the immediate sale of all the exercised stock. This behavior suggests that option holders recognize the difference in financial risk between options and direct stock ownership and typically act swiftly to eliminate that risk by converting their holdings to cash.

Some option proponents contend that the lack of financial risk for the option holder is irrelevant, because the issuing company incurs no cost. There is no cash outlay and therefore no cost to the business, so the argument goes. We beg to differ. The company (and by proxy the existing shareholders) incur a clear economic cost when an option is issued. Focusing on the lack of cash outlay from the option grant obfuscates the value transfer that occurs. The issuance of an option clearly confers a valuable right to purchase stock at a fixed cost. This right represents a real claim on the future cash flows of the business.

One final counter argument we often hear regarding the absence of financial risk to options holders relates to options as part of an overall compensation package.  These option proponents contend that option holders do indeed have financial risk, because they are accepting option grants in lieu of additional cash compensation. In other words, option holders have essentially put a portion of their cash compensation at risk by agreeing to substitute options. We give little credence to this argument given there is scant evidence of corporate executives in the United States being under-compensated on a cash basis (salary plus cash bonus). Continue reading →