Quản trị kinh doanh - Chapter 12: Pptions and executive pay

Chapter 12: Options and Executive Pay4/8/2013Chapter 12: Options and Executive PayEmployee Stock OptionsStock Options – A Brief OverviewShould Firms Grant Employees Options?Source of Firm Financing Employee Self-SelectionReducing TurnoverOptions as Incentive PayPerformance MeasurePay-Performance RelationshipGranting Options Over TimeOther Incentive Effects of OptionsHow Do Employees Value Options?Executive PayWhat is the Most Important Question?Executive Pay for PerformanceOther Incentives and ControlsDo Executive Incentives Matter?4/8/2013Chapter 12 – Options & Exec PayAfter Today’s Lecture, you will be able to address the following questions:When should a firm use stock options?How should options be structured?What is the best metric to measure executive performance?Who is responsible for stewardship of the corporation?Why are important checks and balances often underutilized/underemphasized? 4/8/2013IntroductionEmployee options differ from traditional optionscan’t tradecan’t hedgeundiversifiedStock = option w/ K = 0restricted stock = employee option w/ K = 0Stock Price (S)Payoff at Exercise (Intrinsic Value)Exercise Price (K)$“Out of the money”“In the money”“Premium”“Discount”If S = issue date stock priceStock Options TermsCall Option: Right to purchase company stock at a predetermined pricePut Option: Right to sell company stock at a predetermined priceStrike Price: Fixed price set for exercising of optionQuestion: What does in the money mean?4/8/2013Employee Stock Options – I Black-Scholes not necessarily useful for valuation of options used as compensationVesting of options is very typicalEmployee holding periodHolding periods legally required for Initial Public Offerings (IPO’s)Other conditions may applyE.g., expiration, contingencies, incentive and purchase plans (ISO’s, NSO’s, ESPP’s) 4/8/2013Employee Stock Options – II Reasons offer for broad use of ESO’sSource of firm financingEmployee commitmentReduced turnoverGeneral incentive valueALL OF THE ABOVE ARE UNSUPPORTED BY ECONOMICS4/8/2013Employee Stock Options – IIIEconomics Point of View Regarding OptionsNot a good source of firm financingMore expensive than most other formsNot an efficient means of generating employee commitment Other means can be used (promotion, bonuses, etc.)Reduced turnoverSame as above, and targeting may be non-optimalGeneral incentive valueFree-rider effect prevails unless the connection between performance and reward is more directRisk-adjustment by the employee is greater than the market’sNONETHELESS, THERE ARE OCCASIONS THAT CALL FOR THE USE OF STOCK OPTIONS4/8/2013Employee Stock Options – IVEconomics Point of View Regarding OptionsOptions are a leveraged investment compared to owning a stockA firm can grant options more cheaply than shares of stock Normal risk adjustment by employee still makes stock options non-optimalOnly advisable for individuals who can boost outcomes and adjust riskOptions are appropriately used as executive compensationQuestion: Is this a form of selling the job?4/8/2013Employee Stock Options – VStrategies for Granting OptionsLump allocation at hireOver time on a set scheduleFixed number or fixed value?Not generally used as a rewardWhy?Note WellOptions increase risk-takingGranting stock is also possibleQuestion: How does this affect risk taking?4/8/2013(Why) Give Employees Options?Financing?Sorting?risk aversion; ability; inside info about likelihood of successRetention?Incentives? See below 4/8/2013Market Value of OptionsPublicly-traded Call options can be valued using Black-Scholes formula:4/8/2013Optimal Policies for Granting ESOsLooking 2 slides back option grants are less costly, the lower is K (lower risk premium required)consider using restricted stock insteadIncentives from options depend on two factorsis the option’s value sensitive to performance: D(option value)/D(S) large?this decreases with K (e.g., see 3 slides above)how many options does the employee have?larger K Þ 1 option is less valuable, so more can be granted for same total pay, strengthening incentivesthese 2 effects work against each other in practice, highest incentives are usually near K = SÞ Most ESO’s are issued at the money4/8/2013Other ImplicationsOptions granted out of the money, & indexed options, require even larger risk premiumse.g., Webscale’s bizarre options Allow early exercise & relatively fast vestingHow should you grant options over time?4/8/2013Granting Options Over TimeOne option: grant all options at once (e.g., at hiring)very strong initial incentivesbut the grant is “fragile” – if stock price falls, all options are underwaterimplies low incentives & high retention risk – the latter b/c expected pay fallsAlternative: grant some each year – grant is less fragilefixed $ value of options each yearlower but consistent incentives from each new grant; lowest retention riskfixed number of options each yearsince the value of at-the-money options rises & falls with S, next year’s grant rewards (or punishes) this year’s performanceincentives are stronger than fixed value grants, but retention risk is higher4/8/2013Managing Option “Fragility”Summarizing the previous slide:Repricing OptionsSuppose a stock price drop puts employee options deep out of the money. Should they be repriced?Yes: or little incentiverefinance at the moneyadjust # of options so zero cost to firmNo: does it really increase incentives?why did the stock price fall?Backdating of OptionsThis year’s corporate scandal: back-dating of optionsWhat are possible explanations?insider tradingfraudrisk aversionoptimal grants (balancing incentives v. risk premium) would be in-the-money, but accounting & tax rules makes favor at-the-money optionsThe practice appears to have been widespread how could that be possible, & who is likely to blame?should the practice be illegal?4/8/2013Some Evidence“Lucky” grants more likely when outside directors were not majoritypotential payoffs from “luck” were higherhad prior “lucky” grantsOther findingsnot just in “new economy” firmsaverage gains exceeded 20% of option grant value43% of grants were given at lowest price of the quarterestimate that perhaps 60+ % of grants were manipulated4/8/2013Last PointsOptions are not for all employeesOptions may cause manipulationvery strong incentives when at-the-money, due to non-linear “shape” & leverage; very weak if too far out of the moneybased on financial #s that may be manipulable in the short termdifficult to “punish” manipulation ex post; by then they have been vested & possibly exercised4/8/2013How do Employees Value Options?BS values traded options, with perfect hedging – investors are effectively risk neutralgood estimate of opportunity cost to shareholders from granting option to employee, instead of selling itpoor estimate of employee value: can’t trade, hedge, or diversifyemployees typically demand large premiums over BS values to give up other pay for optionsNo formula like BS exists for an employee’s option valueneed to adjust for risk aversion, non-tradeability, vesting/turnoverESOs are not “free,” but the most expensive common form of paynot to mention substantial tax & accounting complications4/8/2013Black-Scholes v. Executive’s ValueExecutive’s Value Relative to BS ValueRatio of executive’s value to BS value, as a function of K/S4/8/2013ImplicationsEmployee stock options are not freethe firm incurs an opportunity cost from issuing ESOs (often substantial)Options are the most “expensive” common form of payin terms of risk premium that must be paid to the employeenot to mention substantial tax & accounting complicationsYet one more reason to avoid them except for key employees4/8/2013The Executive Pay Package4/8/2013IntroductionWe now briefly apply these ideas to executive pay packageswe focus on the CEO; most of the principles apply to top management4/8/2013Do Executive Incentives Matter?Yes if designed appropriatelylittle direct evidence (information & stock price; inside trading; signaling)case studies of pathologies (e.g., Circon, General Dynamics, LBOs)Are incentives enough?“income effects” can reduce motivationintrinsic motivation may be strong & not aligned with shareholder interestsThere are 4 other controls over executivesregulation (e.g., Sarbanes-Oxley)product market competitionmarket for corporate control (takeovers, hedge funds, private equity, etc.)Board of Directors4/8/2013Classic Executive Incentive ProblemsInefficient use of resourcesWrong strategypet projectsempire buildingdiversification to cross-subsidize & lower risksurvival instead of shareholder valueEntrenchmenthoarding cash / wasting free cash flowstacking the boardresisting the market for corporate control & outside criticismapplication: golden parachutes4/8/2013Designing the Package: EvaluationAlways work on performance evaluation firstStock price (or a proxy of firm value, for private firms)?does this measure motivate short-term thinking?more generally, does it distort incentives?is it easy to manipulate? your answers depend on your faith in efficient capital marketsAccounting numbers?Other measures?Always use subjective evaluation too perhaps the most important job of the Compensation Committee4/8/2013Tying Performance to RewardsOnce the evaluation method is chosen, focus on how to tie it to payMany CEO pay packages have all sorts of goodies. What’s the point?avoid complexity (compensation consultants, of course, like it!)often, simple equity (perhaps levered up with some options) is enoughif some kind of bonus is contemplated, have a good reasonsome perks may be efficient ... e.g., jet ... ask, do they improve productivity?Monitor potential unwinding of incentivesrequire pre-trading disclosure for insidersprohibit trading in derivatives, esp. related to the firm’s securitiesConsider “clawback” of rewards if relevant #s are later restatedgradual vesting can also help here4/8/2013The Level of PayNext, think about the level of payIn public companies, there can be great controversyfight the urge to give in to outside pressuredesign the package to improve shareholder valueDon’t let the CEO & consultants take over the process ...board pay (esp. comp. committee) correlated w/ CEO payCEO appointed before comp. committee chair  CEO pay 11% higherinterlocked directors (esp. interlocked CEOs)  CEO pay 10% higherIvy Leaguers more interlocked, but not paid moreinterlocked board effects getting smallermore outside directors  more likely CEO dismissal4/8/2013ImplementationThe Board’s job descriptionTask 1: support top managementprovide expertise; “training”; aid decision makingdon’t micro-manage usually let CEO do the job; defer to their judgmentTask 2: support shareholders (oversight)subjective performance evaluation, compensationcut the cord when necessaryStrike a difficult balance between decentralization, advice, & oversight4/8/2013Incentives From Options?For most employees, stock options violate both conditions needed for an effective incentive planperformance measure is uncontrollable “Lottery Ticket”incentive intensity very weak a very poor incentive for almost all employees use options for key employees onlyThese problems apply to many popular incentive plansbroad bonus pools, gain-sharing, employee stock ownership, etc.4/8/2013DiscussionWhy do companies use options or other types of broad profit sharing plans?they don’t understand how to design incentive plans?public relations?such plans feel good?other?How do we explain Lincoln’s successful profit sharing plan?performance measure individual (& carefully done), not co.-wide% shares are small, but dollar values are enormous4/8/2013GovernanceBoard compositionchair should be an outsider, not the CEO or a cronyno insiders (employees) other than CEOconsider limiting outsiders who are also CEOs; may be too sympatheticbe wary of interlocked directorsCompensation Committeeno insiderstake an active role in designing the package; don’t just ratifymonitor compensation consultants for conflicts of interestProcesshold some meetings w/ out the CEOallow board members to contact any employee, obtain any info. or dataCultureeven when your buddy stacks the board by appointing you, stay independentclearly define roles of members & committeestalk within the board about culture, balancing support v. governance, etc.4/8/2013Executive CompensationIf objective is maximizing shareholder value, then the best CEO compensation is the one accomplishing thatMost important issue is strength of pay-for-performance relationshipQuestion: In this context, what is the best metric for the CEO’s performance?Lazear & Gibbs refers to the accidental incentive system – What is this?N.B., what does Lazear & Gibbs say about optimal incentive strength?4/8/2013Exec Compensation – Other ControlsExtrinsic InfluencesOutside advocates/shareholdersMarket competitionHostile takeover threatBoard of DirectorsGroups, including grouped shareholders, tend to distortProduct markets are most importantWhen are hostile takeovers a threat?4/8/2013Exec Compensation – GovernanceCritically importantDifficult to change fundamentallyKey to executive successManage the majorityDole out non-pecuniariesSelect to minimize collaboration Question: Is there moral hazard involved? 4/8/2013Summary – Chapter 12Optimally, firms use stock options for employees who can directly affect firm performance and value – incentive intensityOptions compensation should be used as a motivator, ex-ante, rather than as an ex-post rewardExecutive action can be either strategic or operationalExecutive performance is best measured by stock price, but also responds to extrinsic influencesCorporate boards play an indispensable stewardship role; Enforcer upside is limited4/8/2013