Employees' stock options from a shareholder's perspective.

ABSTRACT

Although employee stock options (ESO) have existed for some time now, corporate watchdogs are becoming increasingly wary about potential abuse of ESO and have seriously challenged the value of such compensation schemes. Undoubtedly, this renewed scrutiny, being fueled by the recent corporate scandals, is not without justification. Indeed, many boardrooms have automatically acquiesced management requests for excessive and unwarranted amounts of ESO without engaging in due diligence and without questioning the financial impacts of such compensation schemes on the existing shareholders. This study draws on 34 survey results and six structured interviews with experienced individuals who have served in the compensation committees of the board of directors for many years and who have been extensively exposed to ESO issues to sort out between the myths and realities of such compensation schemes. From the shareholders' perspective, the utilization of ESO could reduce agency costs provided that there is an appropriate mechanism of self-imposed discipline at the level of corporate governance and a more independent and autonomous boardroom configuration.

1. INTRODUCTION

ESO are financial contracts that give the employees the right to purchase the company's stock at the predetermined price known as the exercise price (or the strike price) between the vesting date and the expiration date of the options. In other words, an employee cannot exercise the call option immediately upon its issue. Instead, the employee has to wait for the vesting period to be over to be able to exercise the option. The utilization of ESO would dilute the economic and voting power of existing shareholders via a reallocation of ownership. In effect, the existing shareholders are giving part of the value of the company to the employees who are now the new owners. The value of the ESO increases with the stock price, the expected life of the option, the volatility of the underlying stock and the risk-free interest rate, whereas it decreases with the exercise price and the issuance of dividends to the shareholders. Table 1 illustrates how some of the ESO characteristics impact on shareholders' wealth and employees' wealth.

Over the past decade alone, the use of ESO has expanded dramatically. As it is shown in Figure 1, the number of employees receiving ESO grew almost ten times from the early 1990's to the year 2002. Presently, it is estimated that more than 10 million employees hold some form of ESO. The use of ESO has spanned beyond top executives to also include a broader class of employees (Core and Guay 2001). The use of ESO has long been considered as a judicious scheme of aligning the interests of the employees with those of the shareholders, while not immediately granting the employees with voting power until the ESO are exercised (Hall 2000). The reasoning behind tying a fraction of employees' compensation to measures of company performance (such as stock price) is to strike a balance between risk and incentives. The fundamental economic theory is based on the assumption that management could pursue its own interests at the detriment of the shareholders. Since shareholders, or more practically their representatives on the board of directors, cannot keep a vigilant eye all the time on management actions, management compensation is made contingent upon shareholder wealth. It is presumed that by tying employees' performance to the stock price (i.e., making them part owners of the firm), they would become more engaged, more vigilant, and more active participants in corporate affairs. Such a situation would also prompt them to think strategically and to be proactive in averting crises from hitting the firm in the first place.

[FIGURE 1 OMITTED]

Nonetheless, there is a prevailing perception by shareholder activists that many corporations have indulged in the issuance of unreasonably high and unwarranted ESO plans. In 2001, the SEC has required that companies disclose (at least annually) the number of securities to be issued upon the exercise of outstanding options, warrants or grants, and the number of securities available for future exercise (Security and Exchange Commission, 2001). In light of the recent events in the marketplace, the intent of this paper is to assess whether ESO alleviate agency costs (i.e., monitoring and controlling costs) and to determine whether the boardrooms have operated under an environment in which erroneous myths have impaired their business judgment and common sense by indulging in the issuance of large and unwarranted number of ESO. Finally, control mechanisms are recommended to avert against ESO abuses.

2. RESEARCH METHODOLOGY

The surveys have targeted individuals who have acquired significant experience by virtue of their experience in corporate governance (and particularly in the compensation committees of the board of directors) and who have acquired significant expertise in ESO either in academic or industrial settings. In contacting the potential respondents, the purpose of the surveys was explained, along with a request for participation. The individuals selected were provided with a cover page of the survey that explained the rationale behind the study. A biographical sketch of the individuals was then requested. The idea was to locate the most senior and knowledgeable people with the right mix of expertise to complete the surveys. Often, the individuals who would first be contacted would forward the survey request to another individual or recommend another person who would be more knowledgeable on the subject matter. Many of the respondents indicated have made some serious efforts to answer the questions by requesting further information and clarification. Of the 34 individuals who completed the surveys, six were further selected for a structured interview. These individuals have an average of 17 years of experience in the compensation committees of the board of directors. The directors' anonymity has been purposely protected to allow them to discuss freely information regarding corporate governance without the wariness of putting their companies under the spotlight.

3. STRUCTURAL LIMITATIONS OF ESO VALUATION MODELS

According to the survey results shown in Tables 2 and 3, there is a strong consensus among survey respondents that current valuation methods available for expensing stock options are not ideal. There are many option valuation techniques and it is true that they all have some structural limitations. The most notable valuation model are the Black & Scholes Nobel winning formula (Black and Scholes 1973; Black and Scholes 1972; Merton 1973) and the binomial method using multiple discrete time periods of option prices (Cox et al. 1979; Rendleman and Bartter 1979; Breen 1991; Brennan 1979; Stapelton and Subrahmanyam 1984; Hsia 1983; Nawalkha and Chambers 1995). One structural limitation of option pricing models is that there is considerable leeway regarding the assumptions used in the option-pricing model as it relates to the expected life of the option, the stock price volatility, the dividend yield, and the risk-free rate. The two most intricate assumptions are the risk free rate and the stock price volatility. Obviously, interest rates are in constant state of flux and never remain constant over an extended period of time. Fortunately, however, it turns out that differing interest rate assumptions have limited impact on the price of the option. The more troublesome assumption, however, is the constant volatility assumption of the stock price (Chou 1998). The estimated volatility of the stock is based on historical price data. The use of historical data to predict future volatility on the stock price can be misleading because companies may undergo major transformation, management changes, or business portfolio redesign. Obviously, managers would be tempted to use assumptions that would lead to minimum valuations of the cost of ESO. As it is shown in Figure 2, the value of a call with a life of 5 years may vary dramatically should arbitrary assumptions of volatility be used regardless as to whether the ESO is in-the-money, out-of-the-money and at-the-money.

[FIGURE 2 OMITTED]

Furthermore, the prevailing option models they have been created for market stock options (MSO) and not for ESO (Aboody 1996). As it is shown in Table 4, ESO and MSO have different characteristics. Probably the most important disadvantage of the ESO is the vesting restriction. Should the employees leave their companies before the vesting period is over, then they would have to forfeit their ESO. Of course, such restriction does not exist for MSO. The inalienability of the ESO is another disadvantage in the case where the employee might prefer to early exercise their options before maturity (thus foregoing a substantial portion of the time value) due to psychological reasons or risk aversion (Huddart 1996, 1994). Risk aversion is probably the most compelling reason for early exercise. By paying its employees with ESO, a company forces them to hold non-diversified financial portfolios. To avoid this risk factor, employees would exercise their ESO and diversify their portfolios. In doing so, the ESO holders would only earn the intrinsic value of the option but would have to forego its time value (which might be significant). Conversely, the MSO holders do not need to exercise the option before maturity should they need liquidity. Rather, it would be more advantageous to them to sell the option in the market place rather than exercising it early. In this respect, they have a significant advantage over ESO holders: They would earn both the intrinsic value and the time value of the option. However, ESO holders also have important advantages over MSO by virtue of the fact that they possess inside information that outside investors are obviously not privy to under antitrust regulations.

4. AGENCY COSTS

4.1 Imperfect Incentive Scheme

ESO are viewed as providing incentives for employees to work and increase the company's value and as means of retaining and attracting talent, particularly in a competitive labor market environment. As such, ESO are viewed as improving the cash liquidity of the firm, and it indulges into an effective laissez-faire approach while holding the managers and the employees accountable for their actions by relying on stock prices (a forward-looking measure of performance). However, it is well known that fluctuations in stock prices may be due to factors that are beyond the control of management. In such cases, the use of ESO could be viewed as an inappropriate form of rewards or penalties. As shown in Tables 2 and 3, the majority of survey respondents agree that ESO are often ineffective compensation schemes. The syntactic nature of earning definitions and the flexibility under GAAP rules have all contributed to an atmosphere propitious to what has been labeled "management of earnings" in which ESO value is artificially inflated either through aggressive accounting practices or disingenuous manipulations of financial statements. Consequently, the shareholders have been consistently fooled by the false impression that value has been created through legitimate means when in fact no value has been created in actuality but instead fraudulent accounting practices have artificially created value only "on paper". The ultimate result has been the unjust enrichment of the employees at the expense of the shareholders. Public outcry is precisely the reason why the Sarbanes-Oxley Act has been passed into law. The issue of re-pricing out-of-the money ESO is another highly controversial situation. Some companies have decided to issue new ESO and keep the previous ones that are out-of-the money. With time, they may switch from being out-of-the money ESO to being in- the money after some favorable movements of the stock price. The employee could then be doubly rewarded at the expense of the shareholders. Firms justify re-pricing by claiming that failure to do so would result with unmotivated employees and an undesirable employee turnover. Previous research has shown that firms with greater agency problems and insider-dominated boards are more likely to re-price (Chance et al. 2000).

4.2 Conflicts of Interest

Quite often, the interests of the shareholders are incongruent with those of the managers due to the use of ESO. According to the NYSE, a conflict of interest occurs "when an individual's private interest interferes in any way--or even appears to interfere--with the interests of the corporation as a whole". Specifically, the use of ESO may prompt employees to unduly favor risky projects. The value of an ESO increases with risk because of the asymmetry between potential losses and potential gains. Thus, employees have a lot to gain and little to loose in the presence of uncertainty and volatility. Conversely, the shareholders and the bondholders have an aversion for risk due the symmetrical profit and loss structure under stock price fluctuations. Unless they are properly compensated by additional returns, the shareholders and the bondholders would be risk averse, particularly that risky projects would increase the cost of funds of the firm, thus further eroding shareholder value. Moreover, ESO plans create an environment non-conducive to the issuance of dividends (Arnold and Gillenkirch 2001). When a company declares dividends, the stock price tends to fall by the amount of the dividend on the ex-dividend date. Accordingly, the call price also drops, but by a smaller amount than the stock price. Since companies issue ESO plans that are not dividend protected, it mean that employees holding ESO would not be compensated for any dividend payout due to the prevailing accounting rules. Accordingly, the CEO would have no incentive in recommending the issuance of dividends.

4.3 Financing Cost

ESO have long been considered as a creative method of financing the business while at the same time rewarding the employees for their performance. This practice is particularly prevalent in the technology arena where start-up companies have the potential for future growth, but are basically short on cash. A company using ESO would not have to use its cash reserve to retain talent or lure talent away from competition. Instead, it would issue new shares that are sold at a discount to the employee. As shown in Tables 2 and 3, there is a consensus among the interview respondents that ESO are not necessarily an inexpensive form of financing. In fact, ESO represent a missed opportunity cost for the existing shareholders that the corporation has decided to forego in favor of its employees. As noted by one interviewee, "should the options have been sold in the open market, the corporation could have increased its liquidity. Instead, the firm has decided to give them for free for the employees". Another way to look according to another interviewee is "in the absence of ESO, the corporation could have issued new shares to the public at the prevailing market price (and not at a discounted price), thus gaining more value than issuing ESO at the exercise price". In effect, by issuing ESO, a significant value is being transferred from the corporation to the employees because the existing shareholders might indirectly sell some of their equity at a discount to the employees who are now the new owners particularly if the underlying stock price is volatile and the time to maturity is long.

5. CORPORATE GOVERNANCE MYTH

As the steward of corporate governance, the board of directors should be an effective watchdog against controversial ESO decisions. It is indeed the board of directors who reviews and approves ESO plans. However, there are documented cases, not the least being the Enron's scandal, in which the board of directors has repeatedly failed to exercise the most fundamental duty of loyalty and care by granting excessive ESO plans. Not once did Enron's corporate board voice an objection to any of management's ESO practices (Rebeiz 2002). The Enron's scandal is not an isolated case. Many boards have indeed operated under an environment in which erroneous myths have impaired their business judgment and common sense. Specifically, and as shown in Tables 2 and 3, there is a consensus among the survey respondents that the boardrooms have falsely considered that out-of-the-money ESO are free when in fact they are not free.

The value of the ESO depends on two factors: (1) The intrinsic value of the option; and (2) The time value of the option. The intrinsic value is defined as the asset price minus the exercise price of the option. The intrinsic value of a call option is never less than zero because the holder of the call has the right not to exercise the option. If the asset price exceeds the exercise price (in-the-money call options), then the intrinsic value is greater than zero. If the asset price diminishes below the exercise price (out-of-the money call options), then the intrinsic value is zero. Even when the ESO is out-of-the-money (the stock price being less than the exercise price), the option still has value because of the time value of the option. The time value of the option could be subdivided into two components: The virtues of patience and the discounting power of money. The virtues of patience are a reflection of the benefit of a wait and see strategy before exercising an option too precipitously. Since call options have limited loss and unlimited gains (asymmetry between profits and losses), the longer one would wait before exercising the option, the more it would be advantageous for the option holder because it maximizes the expected return on the investment (not much to loose, but a lot to gain particularly if the underlying asset is very volatile). The second component of the time value, the discounted power of money, indicates that the further away in time one has to secure fund to exercise an option, the more advantageous it is for the option holder due to the lower discounted present value of the exercise price. The time value is an important component of the ESO value and should not be ignored in making ESO decisions. As pointed out by an interviewee, "the fact that many boardrooms have decided to solely concentrate on the intrinsic value of ESO and superbly ignore its time value is an aberration that defies option valuation logic".

6. CONTROL MECHANISMS

There has been a distinguished tradition among institutional investors, and particularly public pension funds, of favoring shareholders' proxy vote as a control mechanism to protect shareholders' rights against excessive equity compensation plans. It is indeed the institutional investors that forced the relaxation of the 1992 SEC proxy rules, thus permitting communication among shareholders prior to the proxy vote. The institutional investors were also behind the 1997 SEC shareholder proposal amendment rule allowing shareholders to introduce their own resolutions in the proxy statement for matters dealing with issues of significant importance. All these shareholder activisms have been instrumental in increasing shareholder activism power especially when it relates to the proxy vote (Securities and Exchange Commission 1997, 1992). As one interviewee puts it, "institutional investors are now able to concert their efforts, to coordinate their actions and to vote in unison".

Furthermore, the NYSE has approved corporate governance rule proposals on August 1, 2002 reflecting recommendation from the NYSE Corporate Accountability and Listing Standards Committee that would require shareholders approvals for all stock option plans and that would prohibit brokerage firms from voting on behalf of their customers. There is evidence that brokerage proxy votes are significant in number (often 10-15% of shares outstanding) and that they almost go invariably in support of management decisions, a practice that has been referred to as "ballot stuffing" (Gillan 2001). On August 10, 2002, NASDAQ also has proposed new rules that would require shareholders approvals for all stock option plans but the NASDAQ recommendations are less stringent than the NYSE proposal; they do not require a shareholders' vote when a company assigns lower exercise prices on previously granted options or when the company decides to replace out-of-the-money ESO with new options with lower exercise prices. Now the task is incumbent on to the SEC to harmonize the NYSE and NASDAQ proposals and turn them into regulation, in the meantime, many companies have rushed to issue new ESO plans before the SEC rule goes into effect in the new proxy season. For example, Texas Instrument has issued ESO that would equal 240 million shares (14% of the shares outstanding at the company) should the options be exercised (The New York Times 2003).

However, regulation is not a panacea for an endemic problem. As Alan Greenspan puts it, "regulation has, over the years, proven only partially successful" (Remarks by Chairman Alan Greenspan 2002). In the words of one interviewee, "more regulation is not warranted. Instead, what is needed is more self-imposed discipline at the level of corporate governance". Indeed, despite shareholder activism and additional regulation, shareholders still have a limited influence on the issue of ESO issuance and approval. As it is shown in Tables 2 and 3, there is a consensus among interviewees as to the fact that shareholders have limited influence on ESO plans through their proxy votes. As pointed out by one interviewee, "one has to keep in mind that ESO and other equity compensation resolutions are made within the confines of the boardroom and away from the public eye. These decisions are then imposed to uniformed shareholders on a fait-accompli basis with little room to maneuver". The following is an example on how the proxy statement for the shareholders may read:

   "We will vote on a new ESO plan. Your board of directors recommends
    a vote for the endorsement of the ESO and ratification and
    recommends a vote against each of the shareholder proposals. We
    will also report on the activities of the company, and you will
    have an opportunity to submit questions or comments on matters of
    interest to shareholders generally".

According to the vast majority of survey respondents, the most meaningful ESO improvement strategies are most likely to emerge internally within the firm at the level of corporate governance through better directors' self discipline rather than being pushed by external forces in the form of regulations (Tables 2 and 3). Undoubtedly, a more independent corporate governance configuration is a first line of defense against excessive, controversial and unwarranted ESO compensation plans. An independent configuration in corporate governance also spans beyond structural considerations (e.g., independent directors, separation of the roles of CEO and Chairmanship of the board) to also include psychological ties with management. For a too long period of time, the board has operated under unwritten and unspoken norms where it is taboo to criticize the CEO within the confines of the boardroom or meet outside the presence of the CEO. When it is the CEO who invites individuals to join the board, as it is often the case, the newly appointed directors may have a misguided sense of loyalty and indebtedness towards the CEO who extended the invitation to them at the expense of their fiduciary relationship to the shareholders (Rebeiz 2001). This deeply entrenched culture of rubber-stamping managerial decisions has contributed to the recent corporate scandals that have reverberated across the entire market place and into the public arena.

The concept of independence also applies to external consultants. As one interviewee puts it, "external consultants, whether they are working for the compensation, the audit, the nominating or other committees, should be completely dissociated from the sphere of managerial influence". Along the same lines of thought, external consultants should not engage in consulting activities that span beyond the realm of jurisdiction mandated by the board of directors and that might impair their independence to management; they should be hired by the board, they should be reporting to the board and they should be accountable only to the board. At the very least, such practices would enhance the image of the board from a rubber-stamping entity to a legitimate, conscientious and independent entity.

7. CONCLUSIONS

Although ESO could be viewed as a win-win situation between the shareholders and the employees, there are many instances in which the use of ESO would result in a zero-sum gain between these two constituencies. Misuses of ESO have been well documented in the marketplace, not the least being the one involving the Enron's scandal. The root cause of this endemic problem is not the concept of ESO per say, but the misuse of such plans at the corporate governance level. The lack of structural independence of the board, coupled with psychological ties with the management team, is probably the reason why the boardrooms have failed to avert the many ESO abuses. For too long, the board of directors has operated under the myths that ESO are free and that they are an inexpensive form of financing. The time is ripe for the boardrooms to re-examine their ESO practices and to take remedial solutions that are fair and acceptable to all the constituencies. The unequivocal determination of ESO theoretical fair values and the establishment of autonomous boardroom configuration would be first good steps in providing an improved system of checks and balances against controversial ESO plans. As one interviewee puts it, "a self-imposed discipline at the level of corporate governance is more effective in averting ESO abuses than any piece of legislation enacted".

TABLE 1. IMPACT OF ESO PARAMETERS
ON SHAREHOLDERS / EMPLOYEES' WEALTH

Parameters                           Shareholders'   Employees'
                                     Wealth          Wealth

Increase in stock price              Increase        Increase
Increase in stock price volatility   Decrease        Increase
Increase in exercise price           Increase        Decrease
Increase in expiration time          Decrease        Increase
Increase in vesting time             Increase        Decrease

TABLE 2. SURVEY RESULTS

                           Strongly
                             Agree         Agree        Neutral
                          (Frequency)   (Frequency)   (Frequency)

Current valuation
methods available for
expensing stock
options are not ideal         14            11             5

ESO are often
ineffective
compensation schemes           8            10             7

ESO are not necessarily
an inexpensive form of
financing                      9            10             6

The boardrooms have
falsely considered
that out-of-the-money
ESO are free                   5            13             9

The shareholders have
limited influence on
ESO plans through
their proxy votes              8            11             7

The most meaningful ESO
improvement strategies
are most likely to
emerge internally
within the firm at the
level of corporate
governance                     9             9             8

                                         Strongly
                           Disagree      Disagree
                          (Frequency)   (Frequency)

Current valuation
methods available for
expensing stock
options are not ideal          3             1

ESO are often
ineffective
compensation schemes           6             3

ESO are not necessarily
an inexpensive form of
financing                      5             4

The boardrooms have
falsely considered
that out-of-the-money
ESO are free                   5             2

The shareholders have
limited influence on
ESO plans through
their proxy votes              5             3

The most meaningful ESO
improvement strategies
are most likely to
emerge internally
within the firm at the
level of corporate
governance                     6             2

TABLES 3. SURVEY STATISTICS

                                        Standard    Standard
                                        Deviation   Error on
                          Average (a)      (a)      the mean

Current valuation
methods available for
expensing stock
options are not ideal        1.00         1.10        0.19

ESO are often
ineffective
compensation schemes         0.41         1.28        0.22

ESO are not necessarily
an inexpensive form of
financing                    0.44         1.35        0.24

The boardrooms have
falsely considered
that out-of-the-money
ESO are free                 0.41         1.10        0.19

The shareholders have
limited influence on
ESO plans through
their proxy votes            0.47         1.26        0.22

The most meaningful ESO
improvement strategies
are most likely to
emerge internally
within the firm at the
level of corporate
governance                   0.50         1.24        0.22

                          Computed
                          t value    [t.sub.0.05]

Current valuation
methods available for
expensing stock
options are not ideal       5.22         1.69

ESO are often
ineffective
compensation schemes        1.85         1.69

ESO are not necessarily
an inexpensive form of
financing                   1.87         1.69

The boardrooms have
falsely considered
that out-of-the-money
ESO are free                2.14         1.69

The shareholders have
limited influence on
ESO plans through
their proxy votes           2.14         1.69

The most meaningful ESO
improvement strategies
are most likely to
emerge internally
within the firm at the
level of corporate
governance                  2.32         1.69

(a) The following conversion scores were used:
Strongly agree = 2; Agree = 1; Neutral = 0;
Disagree = -1; Strongly Disagree = -2

TABLE 4. DIFFERENCE BETWEEN MSO AND ESO

Features                        MSO                 ESO

Issuer of the option            Exchange            Company
Holder of the option            Investors           Employees
Maturity                        Three months        Up to 10 years
Liquidity and transferability   Yes                 No
Vesting restriction             No                  Yes
Categories                      Mostly European     American
Types of instrument             Calls/puts/others   Calls only
Types of transactions           Long/short          Long only
Method of disposal              Selling/buying      Exercising only
Initial capital requirement     Relatively small    Relatively large
Inside information              No                  Yes

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Authoe Profile

Dr. Karim S. Rebeiz earned his Ph.D. from the University of Texas at Austin in 1991. He has many years of working experience in Finance at Ford Motor Company. He is currently an Assistant Professor in the School of Business (Finance) at the American University of Beirut.