Academic journal article Chicago Fed Letter

Common Sense about Executive Stock Options

Academic journal article Chicago Fed Letter

Common Sense about Executive Stock Options

Article excerpt

How do employee stock options affect the economic value of firms and the welfare of the general stockholders? This article explains how these instruments work and why shareholders should have better information about them.

Employee stock options represent a real wealth transfer from the firm to the employees at the expense of other stockholders.

Corporate governance and executive compensation have recently come under increased public and legislative scrutiny. The use of stock options to motivate and reward employees, and executives in particular, has been a major focus of this debate. While executive stock options have gained the most attention, employee stock options are also of concern, since broad-based employee stock option plans may be far larger than executive stock option grants. These concerns have led to demands for greater transparency of employee and executive stock option programs, and to counter-arguments that changes in their accounting treatment are not needed or may be harmful.1

In this Chicago Fed Letter, I explore the impact of employee stock options on the economic value of the firm and the welfare of the general stockholders.2 Viewed from this perspective, employee stock options represent a real wealth transfer from the firm to the employees at the expense of other stockholders. Where the number of outstanding stock options is large, for instance at firms with broadbased employee stock option plans, the value of the wealth transfer can materially impact the stockholders' claims. I argue that this transfer should be made transparent to the stockholders and show how this can be done. For firms with limited executive stock option plans, transparency as to the value of wealth being transferred to executives is critical to stockholder monitoring of executive compensation, even if the aggregate numbers involved are small relative to the total value of the firm. Employee stock options are rights to purchase shares at a specified price, the strike price, on or before a given date. This is termed an American "call option." If the price of the stock rises above the strike price on or before the expiry date, the holder of the call option can purchase the stock at the strike price and resell it at the higher market price, pocketing the difference. Unlike traded options, employee stock options are issued by companies directly to senior management or to key employees. When an employee stock option is exercised, the firm sells shares to the employee at the strike price. These shares can either be newly issued shares or old shares previously repurchased by the firm and held as "treasury stock." The employee can then sell the shares on the market to realize the difference between the stock price and the strike price. A variation on the employee stock option, called a stock appreciation right (SAR), avoids the issuance/sale of stock by paying the employee the difference in value in cash. Employee stock options typically have a vesting period during which the employee may not exercise the options. If he leaves the firm during the vesting period the option is usually forfeited. After the vesting period, the options become American call options and may be exercised whenever the employee finds it advantageous to do so, though again they may be forfeited if the employee leaves the firm, or may expire unexecuted.

The theory behind granting options to employees is that an employee who stands to profit personally when share prices increase will work harder to ensure that this comes about.' At first firms simply gave employees stock or loans with which to buy stock. However, in 1993 Congress passed a law limiting the tax deductibility of compensation to $1 million per executive. Stock grants were included in the applicable forms of compensation. Stock options, however, were not. Options, which give the manager the same upside potential as holding stock (though not the same downside risk), were seen as an ideal substitute, because their accounting impact was much less than outright stock grants, if they were expensed at all. …

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