Microsoft was one of the first companies to grant stock options to all employees. Later it was estimated that thanks to this decision, more than 10,000 employees became millionaires.

Stock-based compensation is still actively used today. It used to be even more popular because it helped attract valuable employees without appearing as an expense on the income statement. However, under today’s accounting standards, recognizing this compensation as an expense is mandatory.

We are talking about a call option, which gives the right to buy a share at a specific price. Therefore, the employee is motivated to see the share price (the value of the organization) rise as much as possible.

Such options usually come with restrictions:

  • Vesting period – the option can be exercised only after a certain period, typically measured in years.
  • If the employee leaves the company before the vesting period (voluntarily or otherwise), they lose the right to the option.
  • If the employee leaves after vesting, they must exercise the options that are in the money; those that are out of the money are forfeited.
  • Employees do not have the right to sell the option itself.
  • When an employee exercises the option, the company issues new shares and sells them to the employee at the option’s strike price (causing dilution).

How effective are options in motivating employees? And what temptations do they create?

First of all, they are very useful for startups. Options attract superstar talent. If the company goes public successfully, everyone benefits; if it fails, investors do not have to pay for the failure.

But why do options represent such a large portion of compensation for managers of already-listed companies? Because they push management toward more risk-taking (sometimes excessively). Option compensation is not proportional to shareholder compensation. If things go well, the option holder earns a reward; if things go poorly, the holder loses nothing—unlike the owners of the firm.

In addition, the presence of options creates temptations for financial “alchemy.” For example, management may time positive news releases to coincide with option-exercising periods, or spread negative news when options are being granted. There have also been many scandals related to backdating—manipulating option-grant dates through false declarations. Some people even ended up behind bars because of this.

As for valuing the option, different methods are used. The simplest is to apply the Black-Scholes-Merton model, while for greater accuracy, binomial or trinomial trees are also constructed.

Adapted from:
Options, Futures & Other Derivatives, John C. Hull

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CEO and Executive Compensation Practices in the Russell 3000 and S&P 500, – Posted by Matteo Tonello, The Conference Board, and Olivia Tay, Semler Brossy Consulting Group, on Thursday, October 7, 2021