Executive Stock Options and the Incentives
As discussed in chapter 3, the typical executive pay package consists of many elements with disparate effects on the executive’s incentives. Of the various elements of pay, salary, bonus, and so on, the equity portion is the main vehicle through which the firm seeks to give the executive incentives for longterm value maximization. Further, as we have seen, the two principal equity vehicles are restricted stock and executive stock options. Of these, restricted stock is fairly straightforward and familiar in design, with a purely linear payoff structure. By contrast, ESOs are much more complicated. As figure 3.6 showed, the payoff of ESOs has a complex curvilinear shape.
The most salient feature of ESO payoffs is this curvilinear shape, which means that issuing an ESO ultimately costs the firm nothing unless the stock price rises above the exercise price of the option. For stock prices well above the exercise price, these options pay off very handsomely for the executive. This chapter explores the nature of ESOs and their incentive effects more closely, particularly because we have not fully considered some of the complications inherent in ESOs over and above plain vanilla stock options. These additional feature of ESOs—particularly their long lives, the vesting restriction, the possibility of forfeiture if the executive leaves the firm before vesting or while the options are out-of-the-money, and the requirement that any vested and in-the-money options be exercised upon departure.
Effect of Accounting Rules
The development of ESOs as a major component of executive compensation and the development of firm practices surrounding the treatment of ESOs has turned in important ways on the accounting rules that govern the granting of ESOs. In recent years, ESOs have been governed by three distinct accounting regimes. The first was the Accounting Principles Board Opinion APB 25,