Stock Options Aren’t ‘Free’ Compensation : Executive pay: Shareholders may find down the road that undeserving managers own a big chunk of the company.
To the executives who get them as a perk, stock options are an extraordinarily valuable right, especially for risky high-tech or start-up companies. The holder of an option does not risk nor commit any capital to the corporation during the years that the corporation could certainly use the capital, but the holder nonetheless shares in the gains from the corporation’s capital at the same rate as shareholders who did shoulder the risk. A holder of an option gets to buy the stock after the results are in.
Stock options are also popular on the corporate side because under current accounting standards, such options given to executives as compensation are reported on profit-loss statements as if they were cost-free. The Financial Accounting Standards Board, which sets the standards for corporate accounting, is seeking to change that rule and treat the value of the stock options as a cost that reduces the corporation’s reported earnings. But executive compensation would be stingier if management were held accountable for the value of the options that they both give out and get. The accounting board is holding hearings this month in Connecticut and San Jose and can expect plenty of corporate pressure against any changes that would fairly account for the real costs of executive stock options.
The executives of a corporation are supposed to be the faithful servants of the shareholders, who own the business the executives run. The first purpose of accounting, both in history and in importance, is as the vehicle by which managers account to the owners as to how well they have managed the business. It is a feckless and faithless servant, indeed, who fails to mention as a cost in his official account the fraction of the business he has taken for himself. If the company is successful, the original owners will learn that they have lost a significant fraction of their company to their “faithful” managers because of “free” options issued years earlier. What investors would be willing to buy stock in an untried company, knowing that the fruits of their investment will be taken by executives should the company prove a success?
Treating executive stock options as cost-free pushes overall compensation upward. Any resource treated as free is inevitably overused: We have environmental problems in part because businesses have treated our air and our waters as free ways to dispose of wastes; the savings-and-loan industry made a “free” government guarantee program into a $2-trillion expense because neither the managers of the S & Ls nor the depositors considered deposit insurance to be a cost. And executives get too large a share of successful companies because the granting of stock options to the executives is considered free.
Stock options give bad signals to managers. A holder of a stock option tends to revel in risk: The holder can win big when risky projects are successful, without bearing the losses that shareholders bear. Executives with options have a self-serving interest in choosing projects that have too much risk. But when they do win, they often win without merit because of market fluctuations unrelated to the executive’s performance or contribution.
Better forms of compensation, such as outright stock grants, are not used because they must be reported as a cost. Reporting the cost, however, is honest accounting.
