Option compensation can be a double-edged sword
Options are viewed by most corporations as an essential component in an
executive compensation package. They have the potential to provide a major
windfall to their holder - not just a small performance bonus. However, they
have their darker side, too.
options are supposed to be a form of incentive compensation. If the holder of
options works hard and is a team player, she will be handsomely rewarded when
the market bids up the company's share price. Unfortunately, though, a company's
share price often bears no resemblance to its underlying financial performance,
let alone the performance of any one individual. Hence, a new hire, lured by the
sizzle of stock options, can become discouraged if they don't meet her
an investor's perspective, there's a huge downside to options, namely dilution.
Companies, especially the Silicon Valley variety, typically have between 20% and
30% of their shares under option. As these options are exercised, investors who
have paid market price for their holdings can be substantially diluted. Not only
that, but those shares purchased under option by an optionee are likely to be
sold into the market for a profit, rather than be held by the employee as a
loyal co-owner of the enterprise.
routine granting and subsequent exercising of options can quickly compound the
outstanding share balance. This gives rise to "market capitalization
creep" - a steady rise in value of the company attributable to an increased
stock float. Theoretically, share prices should fall slightly as new shares are
issued. However, these new shares conveniently get absorbed, especially in hot
markets. I've seen companies double their stock base in less than two years!
belief that options are better than company bonuses because the cash comes from
the market, rather than from corporate cash flows, is nonsense. The long term
dilutive effect is far greater, not to mention the negative impact on earnings
bullish market sessions, options can indeed provide huge benefits to their
holders. However, as we've seen recently, stock prices can drop mercilessly.
When they do, employees with deep out-of-the-money options can become
discouraged by feeling that something has been taken away from them. Instead of
doing their work, they become obsessed with watching stock prices.
has been used to describe lucky option holders with highly appreciated options.
As these optionaires become real millionaires, corporate managers must ask
themselves if their payouts are really justified. Why should a secretary earn a
half million dollar bonus just because she had 10,000 "token" options?
What did she risk? And what about those instantly rich millionaire managers who
decide to make a lifestyle change and quit their jobs?
return for being a director of a junior public company, options may be one's
only compensation. A colleague of mine was given an option to buy 50,000 shares
at $.40 per share, good for five years. For three years, the stock languished,
trading under $.50. In the early 1998 run-up in prices (just like we're seeing
now), the shares jumped up to $2.00. At this price, it made a lot of sense to
exercise these options but he was asked by the CEO to hold off on the basis that
the company was planning a financing and it wouldn't look good for directors to
be selling stock. By mid-summer, the market slumped and the financing was
cancelled. He finally exercised the options in the fifth year - just before
their expiry - when the stock was trading at around $.60. Needless to say, he
did not reap any huge windfall for his commitment to the company.
way I see it, as much as stock options can be a great carrot in attracting
talent, they may not be the panacea which we'd like them to be. Less aggressive
stock option plans would be less punitive to shareholders yet still offer
incentives to key employees.