Does giving stock options to employees help a company succeed? And if a company does decide to award options, what happens when its stock plummets? Is repricing necessary to protect workers from a collapsing stock market, or is it an unnecessary burden on shareholders?
Options give rise to emotional questions — questions that are likely to stay in the public eye because the state of the stock market makes an increasing number of companies likely to reprice their options. Opponents of stock options argue that by giving them out, firms slice the pie more thinly, benefiting executives while diluting the value of shares held by outside investors. The Securities and Exchange Commission is proposing to tighten the rules so that companies planning to reprice options will have to release more information.
Supporters of stock options for managers can take heart from two academic studies of new-economy firms, which are due to be published in the next few months. One study supports the practice of granting options to key employees, while another study concluded that the practice of repricing options was used to retain key employees.
Repricing generally occurs when a stock price drops enough so that the options to buy the stock become worthless, because they give someone the right to buy a stock at a price higher than its market price. A company occasionally will reprice its options so that holders can exercise them at a lower price, giving employees the opportunity to make money off their options.
One study — conducted by Christopher D. Ittner, Richard A. Lambert and David F. Larcker, professors at the University of Pennsylvania's (dossier) Wharton School of Business — concludes that firms that give options have higher annual stock returns than comparable companies that don't. A 20 percent increase in the ratio of equity grant value to manager salaries results in a 4.7 percent increase in the following year's stock market returns, the study found.
Equally important is the question of who gets the options. Companies that do better are those where larger grants are given to managers and technical employees, the study found.
"Don't expect performance improvements if you give options to secretaries, but do expect improvements if you give options to people who really matter, like the R&D guys," Larcker said in an interview.
The second study looked at 253 firms that repriced options in 1998. Most of the companies suffered from internal problems, rather than being victims of a stock-market downturn. The professors, Mary Ellen Carter of Columbia Business School and Luann J. Lynch of the Darden Graduate School of Business at the University of Virginia (dossier), concluded that companies repriced options in an effort to keep executives from bolting to other firms.
"We found that the likelihood of repricing increases as options become more out-of-the-money, and that firms reprice in response to poor firm-specific performance, not poor industry performance," Carter and Lynch wrote.
It might seem that executives of a poorly performing company would be less likely to be recruited by successful firms, and therefore would need fewer incentives to persuade them to stay. But Carter and Lynch suggested that executives at such companies might like to move to a better-performing firm; their firm might need them to stay because it would find it hard to attract talented replacements as long as it is doing poorly. Naturally, a tight labor market would exacerbate this effect.
It's also possible that executives of companies that perform poorly are precisely the type of people who should not be rewarded by repricing. The knowledge that they are protected might remove one incentive that the managers have to do a good job. Carter and Lynch don't address that question in their study, but concede that it is a concern.
"It seems that firms have to trade off the need to retain the executive with the need to create a properly designed incentive contract.
