He saw that a lot of managers in U.S. corporations applied a double standard to options. The extreme case would be the ten-year fixed-price options on all or a portion of the business granted to management. It was unthinkable for the manager to grand long-term options on the business that added more money on its capital base regularly. “Managers regularly engineer 10-year, fixed-price options for themselves and associates that, first, totally ignore the fact that retained earnings automatically build value, and, second, ignore the carrying cost of capital. As a result, these managers end up profiting much as they would have had they had an option on the savings account that was automatically building up in value.”
The stock option is often thought of as a reward so that the management and the shareholders are in the same financial boat, and to let the managers “truly walk in the shoes of the owners.” However, according to Buffett, those financial boats were far different. The stock option has two main advantages for the managers that the shareholders of the business can’t have. The first is the capital cost; no owner can escape from the burden of capital cost, whereas a holder of fixed-price option bears no capital costs at all. The second is the downsize risk. Shareholders have to bear the downsize risk, but the managers don’t. “In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership," Buffett wrote. For Buffett, it is like a lottery ticket: He would feel happy to accept the lottery ticket as a gift, but he would never buy one.
The manager who receives the fixed-price option would prefer to retain all of the earnings and pay no dividend at all, as he could use the capital of the firm at no cost. In contrast, the owner would lean toward the total payout because he can prevent the manager from sharing in the company’s retained earnings.
Nevertheless, Buffett said that options can be quite appropriate under some circumstances. He emphasized three main points: First, stock options could be tied to overall performance of a corporation. He mentioned that the option should be awarded only to those managers with overall responsibility.
Second, they should be structured very carefully. Options need to have a retained-earnings or carrying-cost factor, meaning that any retained earnings would have to come at a cost. And as important, it should be priced realistically. Buffett mentioned: “When managers are faced with offers for their companies, they unfailingly point out how unrealistic market prices can be as an index of real value. But why, then, should these same depressed prices be the valuations at which managers sell portions of their businesses to themselves?” Then he added: “The obvious conclusion: Options should be priced at true business value.”
Third, some managers that Buffett admired a great deal disagreed with him regarding fixed-price options. However, those people built the corporate cultures that work, and fixed-price options have been a very helpful tool for them. “By their leadership and example, and by the use of options as incentives, these managers have taught their colleagues to think like owners. Such a culture is rare and when it exists should perhaps be left intact – despite inefficiencies and inequities that may infest the option program. 'If it ain’t broke, don’t fix it' is preferable to 'purity at any price.'"
For practice at Berkshire Hathaway, Buffett use an incentive compensation that rewards key managers for achieving their own targets in their own businesses. [i]“If See’s does well, that does not produce incentive compensation at the News — or vice versa. Neither do we look at the price of Berkshire stock when we write bonus check.”
For Buffett, performance is defined in the underlying economics of the business itself. In some businesses the managers enjoy the great tailwinds that they do not themselves create, but in other businesses, they fight vigorously for the headwinds.
In his opinion, all Berkshire managers can use their own money (either it comes from salary or bonus money) to buy Berkshire’s stock in the stock market. “By accepting both the risks and the carrying costs that go with outright purchases, these managers truly walk in the shoes of owners.”
Interested readers can read more in Warren Buffett’s discussion below:
The Worst Enemy Is Ourselves: Lesson from Buffett's Purchase of Berkshire Hathaway
Return on Reinvested Earnings at the Parent Level
Earnings Should Be Retained or Distributed as Dividends?
Business Valuation Approach to Bonds and Operating Businesses