Incentives matter, but misaligned incentives matter too. - 8/23/08

2008-08-23

Incentives matter, but misaligned incentives matter too.

Stock options are intended to incentivize employees to create value for shareholders.

Option fail to do this. True, a stock option holder gains when shareholders gains. However, the owner of a call option does not participate in any of the losses shareholders experience when the stock price goes down.

Let's say a stockholder buys a $100 share and awards the CEO 1 call option.

Scenario 1: Stock price rises to $110
Stockholder: +$10
CEO: +$10

Scenario 2: Stock stays at $100
Stockholder: +0
CEO: +0

Scenario 3: Stock price lowers to $90
Stockholder: -$10
CEO: -0

Scenario 4: Stock goes bankrupt
Stockholder: -$100
CEO: -0

So,
we would expect CEOs with a whole bunch of options to try to maximize
the possibility of getting really big gains that he can share in. He
should do this even if this may cause really big losses for
shareholders since this would leave him no worse off than if the stock
price remained flat. (Compare scenarios 2 and 4.)

Surely though,
this is Bob just getting theoretical though. Surely CEOs don't *really*
increase risks for their firm simply to increase thee expected value of
their options. Right?

Um, no. It turns out that the extremely cynical view of managerial behavior presented above is basically true:

We
find that CEO stock options engender high levels of investment outlays
and bring about extreme corporate performance (big gains and
big losses), suggesting that stock options prompt CEOs to make
high-variance bets, not simply larger bets. Finally, we find that
optionloaded CEOs deliver more big losses than big gains.

Oddly
enough, you actually the firms that gave executives back-dated options
were actually doing their shareholders a favor! Options at a lower
strike price allow executives to benefit from *not* losing money for
shareholders.

Reference:
"Swinging for the Fences: The
Effects of CEO Stock Options on Company Risk Taking and Performance," W
M. Gerard Sanders and Donald C. Hambrick, Academy of Management
Journal, Volume 50, Number 5 / 2007, pages 1055 - 1078.