Stock options may be the gas that Silicon Valley runs on, but two years of falling stock prices left a lot of tanks on empty last year. Yet as it heads into a new decade, the valley’s options culture remains surprisingly resilient.
The answer for some companies in 2009, including Google, Intel and eBay, was to hit the reset button by exchanging options that became worthless (or were “underwater”) because of the falling stock market for ones that reflected the new, lower share prices.
Options give workers the right to buy company stock at a preset price, offering them the opportunity to profit if those shares increase in value.
For companies that did not do an exchange, the improving economy and rising share prices helped take care of the problem, lifting many options near or above the water line.
A study by Equilar, a Redwood City compensation consulting firm, shows options of top officers at 140 valley companies gradually surfacing above water during the last half of the year.
There is an aspect to this debate, however, that deserves greater scrutiny: the freedom of executives to pick the moment when they can cash out on their equity-based incentives. Standard pay arrangements give executives broad discretion over when they sell shares and exercise options that have been awarded to them. Such discretion is both unnecessary and undesirable.
The freedom to time the moment they cash out enables executives to use the special knowledge they have about their companies to sell before a stock-price decline. Although insider-trading laws supposedly prevent executives from using “hard” material information, executives usually also have “soft” information at their fingertips which gives them an advantage over the market. Indeed, it is a well documented fact that executives make considerable “abnormal” profits – that is, above-market returns – when trading in their own firms’ stock.
There are troubling aspects to this situation.
Even as Washington tries to rein in Wall Street pay, bankers are likely to make unusually large gains on the stock grants and options they received after shares in their companies fell sharply during the financial meltdown.
As banks cut bonuses last year, they shifted more pay into stock and options from cash. Within months, the financial system began to mend — partly with the help of billions of dollars in government aid — and that stock began surging in value. Some of it can be cashed in starting in just a few months.
And so the bonuses Wall Street received last year, billed as paltry at the time, are turning out to be among the most lucrative payouts ever.
Hoping to encourage bankers and managers to stay, Citigroup began dispensing several million stock options this week to more than a quarter of its workers in a way that could result in a sizable gain for them.
Many Citigroup employees saw their nest eggs vanish after the bank’s share price plummeted to about $4 now from about $56 a few years ago.
As an extra incentive to stay and help with the turnaround, Citigroup said it would grant one stock option at just above the current market price for each unvested share employees had accumulated. If the share price rebounds, as it has at Goldman Sachs and JPMorgan Chase, Citigroup employees could see a sharp increase in their 2009 compensation.
What in the world was Marvel’s Board thinking? Have they been reading the popular press? Don’t they know that actions like this will attract “lightning rod like” criticism, even outside the banking business?
Marvel Entertainment Inc. Chief Executive Isaac “Ike” Perlmutter was granted stock options for more than a million shares in the weeks after a subordinate opened discussions with Walt Disney Co. that ultimately led to a merger agreement, according to a filing Disney submitted to the Securities and Exchange Commission.
The baby or the bath water?
No doubt stock based compensation has been widely used and sometimes misused as part of executive compensation programs. Corporate America overdosed on stock options, which were the sole or primary compensation vehicle at many companies during this most recent chapter in economic history. But we say let’s not throw the baby out with the bathwater. The goal of executive compensation programs is to drive risk appropriate behaviors that result in enhanced shareholder value and wealth creation. One of the best, and maybe the only true measure of shareholder value creation is long-term growth in stock price. Thus, risk should not be avoided, but managed appropriately.
While we believe options can have a proper role in a well designed compensation scheme, we do not generally endorse stock option only programs where vast sums on wealth can be accumulated solely as a result of a “rising tide” lifting all boats – where executives profit from stock price increases that are not even relatively superior than the market “norm”. It is incremental performance above the norm that truly benefits shareholders, and the delivery of above average performance consistently over long-term business cycles should be rewarded handsomely.
Grahall’s executive compensation designs show how stock can be used appropriately based on rigorous scientific methods reflecting business strategy and risk considerations. For example, Grahall’s Performance Based Wealth Accumulation and Retention Program” (gPB-Warp), is a plan that links an executive’s long-term wealth accumulation first to the accomplishment of long-term strategic goals approved by the Board of Directors, and secondly to the long-term stock performance above the average of the company’s direct competitors, a stock index or both of these.
Unlike Roger Martin’s recommendation, which excludes all stock incentives, gPB-Warp incorporates company stock as an incentive upon the accomplishment of the strategic goals. Stock incentives tying the executive’s wealth to the company’s performance have long been considered the key link between the executive’s and the shareholders’ interests. This provides the executive with a direct attachment to the company’s long-term sustainable performance. But too much stock can sometimes tempt an executive, especially one nearing retirement, to avoid taking even acceptable risks. So, gPB-WARP also includes maximum predetermined exposures and the ability to diversify as the executive nears retirement.
We urge companies to consider all aspects of total rewards when developing executive compensation programs: the money (how much), the mix (what components are used) and the messages (how the money and mix drive behaviors). Taking this holistic approach, company stock can be effectively incorporated into executive compensation programs. Critiquing the use of company stock in an executive reward strategy is like the proverbial carpenter with a hammer, hoping to find some nails. Where only cash is used to reward executives, shareholders had better hope that the directors set the correct goals.