Why Stock Option Compensation Will Kill Your Company - 9 Feb 2009

Why Stock Option Compensation Will Kill Your Company

Posted by: siliconalleyinsider in Silicon Alley Insider

Anne-Marie Fink is the author of “The Moneymakers: How Extraordinary Managers Win in a World Turned Upside Down” and runs the Money Makers site. Here’s an excerpt from the book:

Paying as many employees as possible in stock is an article of faith
to both corporate leaders and people in the investing community. I risk
being branded as a heretic, therefore, when I say:

Don’t pay employees in stock except those at the highest levels.

Investors advocate paying in stock, because we want employees to
share our pain when their stocks are not doing well. A shareholder
revolt ousted CEO Bob Nardelli from The Home Depot in 2007 due to his
indifference to the stock price, which had been stagnant for years.
Those at the most senior levels of an organization, the top five to ten
folks, certainly need to be responsive to shareholders, and receiving a
large piece of their compensation in stock or options ensures that they
will pay attention when the stock isn’t doing well.

However, to pay anyone else in the organization in stock or options
separates pay from performance. Over the long term, stock prices are
determined by the earnings and returns that employees generate, but in
the short and intermediate terms stocks can move for reasons entirely
unrelated to a company’s perfor -
mance. Nothing makes investors
cringe more than when a CEO or CFO predicts how high a company’s stock
price is going. As people paid to forecast where stocks are going to
go, we know how inherently unpredictable the stock price for any one
company is; too many exogenous factors influence prices.

These influences disconnect pay from performance. Throughout the
1990s, many CEOs and other option holders enjoyed huge increases in
their compensation despite mediocre or poor performance. They benefited
as the stock market rose more than fourfold over the course of the
decade. As interest rates fell and risk tolerance rose, investors paid
higher price/earnings multiples for stocks. This rising tide lifted all
stock prices, even those of poor performers. In 2007-08 executives have
seen the reverse impact as the global credit crisis has taken down all
stock prices, even for those companies with no exposure to the subprime
mortgage market meltdown that precipitated the crisis.

Changes in market conditions decouple the performance of stocks from
underlying companies’ earnings and return results. For employees below
the upper echelon, the disconnection between stock price and individual
performance is even larger. These folks not only don’t impact the
multiple of earnings that
their stock trades at, they don’t impact
the overall earnings. Just as rewarding employees on companywide
metrics doesn’t work because most employees can’t impact the whole, so
too rewarding employees with stock is in effective.

The United Airlines debacle with its employee stock ownership plan
should serve as a warning to any corporate executive who thinks freely
awarded options or ownership will align the interests of his or her
employees. In 1994, UAL Corporation, the parent of United Airlines,
signed a historic deal with its pilots’
and mechanics’ unions,
giving them majority ownership in the company in exchange for wage and
work- rule concessions. United represented the perfect test case of
aligning employees’ and shareholders’ interests through stock ownership.

Instead, they proved to be woefully misaligned. The original deal
had the pi lots, mechanics, and some nonunion employees taking an
average 15 percent cut in wages for six years in exchange for a 55
percent stake in the holding company. The deal enabled UAL to stave off
bankruptcy and expand at a time
when other major carriers were
saddled with higher costs. The deal worked reasonably well until the
wage snapback approached. Then it became clear that as owners of the
airline, pilots and mechanics felt they could set their pay as high as
they wanted. They demonstrated little concern for other shareholders.
The results were disastrous. When senior management didn’t immediately
accede to their wage demands, the pi lots staged a disruptive, but
effective, work slowdown in the summer of 2000. Management caved and
the pi lots received significant pay increases just as the industry
went into a cyclical downturn. With higher costs, customers annoyed by
the job actions, and less revenue, UAL filed for bankruptcy protection
in 2002. It was a tragedy not only for the in de pen dent shareholders
but also for the pi lots and mechanics,
who saw the value of their stock wiped out.

There’s another flaw in employee stock ownership plans:

Reward people with stock, and you’ll hurt long- term productivity.

This may seem counterintuitive; after all, stock ownership would
seem to give employees a reason to work harder and better than ever
before, but it has other effects that negate this owner mentality. When
employees have much of their net worth tied up in a company’s

more...http://financegeek.com/why-stock-option-compensation-will-kill-your-company/