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The Unintended Consequences of Stock Options

The Unintended Consequences of Stock OptionsStock options are designed to encourage executives to focus on the needs of the shareholder. Giving the CEO a stake in the company's market performance sounds like an elegant and effective way to make sure his or her attention is in the right place. But a study from management professors W. Gerard Sanders and Donald Hambrick highlighted in the New Yorker this week, claims that offering executives stock options may have unintended (and not entirely positive) consequences.

The New Yorker piece is a broad examination of whether performance-pay had something to do with the risky borrowing that led to this summer's sub-prime meltdown. Author James Surowiecki comments:

The problem is that if a company's stock price is below the options' strike price when they expire those options become valueless--and they're just as valueless whether the stock price is a dollar below the strike price or fifteen dollars below it. To a shareholder, the difference between a stock that's at thirty dollars and a stock that's at twenty means a lot. But to a C.E.O. who has a pile of options with a strike price of thirty-one dollars, the difference means much less. As a result, that C.E.O. is likely to embrace projects that promise big rewards, even if they also entail a significant chance of failure.
Surowiecki also digs up some research to support this conjecture. According to co-author Donald Hambrick, the study, which was published in the October/ November issue of the Academy of Management Journal, concludes,
"stock options in large numbers motivate CEOs to "swing for the fences... option-loaded CEOs" strike out much more often than they hit home runs."
The authors noted that the basic purpose of options has been to promote managerial aggressiveness in top executives, even if they sometimes led them "to undertake large-scale risky investments that tended to deliver extreme company performance." What was not envisioned, they wrote, "was that the extreme performance delivered by option-loaded CEOs was more likely to be in the form of big losses than big gains."
So what's the alternative to stock options? Hambrick and Sanders suggest that "a better course would be a widespread supplanting of options by grants of restricted stock -- that is, stock that can only be sold after a certain amount of time passes or a certain goal is achieved."

(Image of big swing by mwlguide, CC 2.0)

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