Stock options are often touted as a good way to align the incentives of management with those of shareholders. Tie executive compensation to the performance of the company that the executive manages, and you will motivate them to produce better results, or so the thinking goes. However, there are reasons to be skeptical of such policies. In his 1985 annual letter to shareholders of Berkshire Hathaway BRK.ABRK.B, Warren Buffett (Trades, Portfolio) outlined his own concerns with stock options.
Different boats
“Ironically, the rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership (I’ll be happy to accept a lottery ticket as a gift - but I’ll never buy one)”.
Granting executives stock options does not make them owners in the same way a purchaser of shares becomes an owner. A purchaser of a business has to consider the opportunity cost of investing, whereas an options recipient does not. Since they have received a piece of the business essentially for free, they do not have to worry about the prospects of that business to the same extent an investor does: they only stand to profit and, in the worst-case scenario, will simply break even.
They may even engage in risky actions that increase the chances of both bigger profits and bigger losses, as they are playing with "house money." Of course, there may be other reasons why an executive is motivated to perform well, but granting stock options is not necessarily one of them.
One size does not fit all
“Stock options are inevitably tied to the overall performance of a corporation. Logically, therefore, they should be awarded only to those managers with overall responsibility. Managers with limited areas of responsibility should have incentives that pay off in relation to results under their control. The .350 hitter expects, and also deserves, a big payoff for his performance - even if he plays for a cellar-dwelling team. And the .150 hitter should get no reward - even if he plays for a pennant winner. Only those with overall responsibility for the team should have their rewards tied to its results”.
Too often stock options are used as a one-size-fits-all strategy to align incentives for managers. Yet it is entirely possible to be mediocre manager and still profit as the company outperforms. For this reason, individuals with limited responsibility should be rewarded with cash bonuses for their good work, rather than stock options. Indeed, Buffett goes on to say Berkshire does not cap bonuses paid out to outstanding managers of its individual units, and that bonuses are paid out without regard to the conglomerate’s overall performance - so that a well-performing manager at Geico will be richly rewarded even if the company as a whole does poorly in a given period.
Summary
Corporate governance is an important component of company value, so diligent investors must always be on the lookout for compensation packages that are overly generous and do not align the incentives of management with those of shareholders. When such packages are present, this usually signifies there may be other inefficiencies that are not being addressed. Accordingly, investors should keep their eyes open for such warning signs.
Disclosure: The author owns no stocks mentioned.
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