Executive Stock Options

Abstract

The author discusses the flaws in the current structure of executive stock options that creates a moral hazard, by forcing a fundamental conflict of interest between the management and the shareholders of a company. However, eliminating stock options and replacing them with restricted stock in employee compensation packages is a mistake with far-reaching and long-term consequences. The author argues that executive stock options are part of the basic building blocks of efficient markets in that they create risk-sharing between employees and shareholders, with incentives for out-performance and penalties for under-performance. As a solution to this dilemma, the article proposes a simple yet fundamental change in the structure of executive options. The main thrust of this change involves basing the payout of the option on the long-term average of the stock price over the life of the option. The implementation of this change would address the moral hazard issue, preserve the value of options to corporations and employees, and, at the same time, result in a true alignment of management and long-term shareholder interests. The proposed changes also facilitate stability in the pre-retirement capital accumulation and post-retirement capital depletion life cycles of individual investors. Issues related to the expensing of options are addressed. Furthermore, this solution is shown to be robust against backdating manipulations.

TOPICS: Wealth management, security analysis and valuation, performance measurement