One of the more intriguing changes in executive and employee compensation is the increase in the use of stock options. Although much of the discussion about stock options has focused on “new economy” companies, there has been a corresponding increase in stock options grants for more traditional firms as well. The typical explanation for the use of stock options is that these compensation vehicles enable companies to attract and retain the best employees and also provide superior incentives for employees to increase shareholder value. While these explanations seem reasonable on the surface, they hinge on the assumption that employees understand how stock options work. Yet according to recent research by Wharton professors
One of the more intriguing changes in executive and employee compensation is the increase in the use of stock options. Although much of the discussion about stock options has focused on “new economy” companies, there has been a corresponding increase in stock options grants for more traditional firms as well. The typical explanation for the use of stock options is that these compensation vehicles enable companies to attract and retain the best employees and also provide superior incentives for employees to increase shareholder value.
While these explanations seem reasonable on the surface, they hinge on the assumption that employees understand how stock options work. Yet according to recent research by Wharton professorsDavid F. Larcker and Richard A. Lambert, employees, in fact, tend not to understand the basic economics of stock options – a finding that has important implications for employees, employers, boards of directors and management consultants.
Larcker’s and Lambert’s research, based on a survey of 122 Knowledge@Wharton readers conducted in March 2001, looked at what stock options cost the firm and at what value employees place on them. “For example, we found that some employees harbor unrealistic expectations as to what will happen to the stock price,” says Larcker. “In other words, the employees value their options more than they are theoretically worth, which can cause human resource problems as well as raise certain ethical issues.”
An earlier survey, this one conducted in May 2000 by OppenheimerFunds Inc., came up with some of the same conclusions although its scope was more limited. The survey, based on 107 respondents who owned stock options, found, for example, that 39% of option holders said they knew “little” or “nothing” about their options and another 35% said they knew only “something.” As a strong indication of serious knowledge limitations, 11% of the respondents had allowed “in the money” options to expire, essentially rendering them worthless. Finally, 52% said they knew “little” or “nothing” about the tax implications of exercising options.
A Primer on Stock Options
Stock options are deceptively simple compensation contracts. When an option is exercised, its payoff rises by one dollar for each dollar the stock price is above the exercise (or strike) price. If the stock price is below the exercise price when the option matures, the option is left unexercised and its payoff is zero.
What stock prices will be five to ten years in the future are, of course, unknown at the grant date. As a result, many firms rely on a valuation model to determine the cost of granting an option. One common valuation methodology is the Black-Scholes approach, which is easy to compute with widely available programs and provides a reasonable indication of the expected cost to the firm of granting a stock option. For a typical company, the Black-Scholes value of an executive stock option granted at the money – where the grant price is the same as the stock price on that date – is 30% to 50% of the current stock price.
Although the cost to the firm can be reasonably estimated, the value of the stock option to an employee is not simply the Black-Scholes value. This is because the wealth of employees is much more highly tied to the value of the firm than is the wealth of well-diversified outside investors. Employees, who are contractually forbidden from selling their options to outside investors, therefore have less ability to hedge the risk associated with holding options, and they are more likely to exercise options early for both liquidity and risk reduction reasons.
In general, the value of a stock option to a risk-averse employee can be substantially below the firm’s cost of granting the stock option. Thus, the value of a stock option to an employee should not exceed the Black-Scholes value of the option.
Black-Scholes and other similar models provide theoretical figures for the cost of the option to the firm or the upper bound to the value of the option to the employee. However, almost nothing is known about how employees actually value their stock options. The key issue is, “What do employees perceive an option to be worth?” Providing an answer to that question has profound implications for designing compensation programs.
It was also one of the questions asked by the Larcker and Lambert survey, conducted with iQuantic Inc. The survey participants were managers or top-level executives from 98 different firms. The typical respondent was 36 years of age, had been employed by his or her company for five years, earned cash compensation of $135,000 and held equity in their company of $50,000. The typical respondent had been granted options three times by his current firm and had exercised options once.
Given the timing of the survey, it is not surprising that stock prices of many of the respondents’ firms had fallen during the previous year; the average one-year stock price return (volatility) preceding the survey went down 50%, and the average volatility was 98%. However, the respondents thought that their firm’s stock price during the next year would increase by an average of 96%. So, despite poor recent stock price performance and high volatility, the respondents appeared very optimistic about the future.
The survey asked the respondents to provide an answer to the question, “How much cash would your company have to offer you per option to return a fully vested stock option with seven years life remaining”? In other words, “what is that option worth to you?” Five different scenarios of exercise price and current stock price were examined (in decreasing level of value): stock options that are in the money by 100% (i.e. the current stock price is double the option’s exercise price), in the money by 10%, at the money (i.e. the grant price is the same as the stock price at that date), out of the money by 10%, and out of the money by 50% (i.e. the current stock price is half of the option’s exercise price).
The results, shown in a graph, revealed that managers value their options substantially above the Black-Scholes value. For example, at-the-money options are valued at 50% higher than the Black-Scholes value and options that are out-of-the-money by 50% are valued at more than double the Black-Scholes value. These results, says Lambert, “indicate that managers do not fully understand the value of stock options or possibly their associated incentive effects.”
Further analysis revealed that younger employees at low managerial positions have the most upward bias in the perceived values. In addition, employees who exercised options during the past year and have higher expectations for future stock price performance place higher values on their stock options. Consistent with traditional economics, employees who are highly risk averse (or have a strong dislike of volatility in their wealth) place a much higher value on in-the-money stock options and a much lower value on out-of-the-money stock options. Finally, says Larcker, there is some preliminary evidence that men do a slightly better job valuing stock options than women.
In several instances multiple employees from the same firm responded to the survey. The results for a firm engaged in software development and consulting are presented as are the results for a firm engaged in computer hardware manufacturing. With some exceptions, the respondents valued their options above the upper bound computed from Black-Scholes. Moreover, these figures revealed that employees generally do understand how the value of a stock option decreases as the option falls further out of the money. The figures also demonstrated that there is substantial variation in the perceived value within managers of the same company. “The extent of this heterogeneity is problematic for understanding whether stock options provide the same incentives across the organization,” says Lambert.
Implications for Firms
It is difficult to believe that stock options have the desired effect on employee behavior if employees do not understand the basic economics of stock options. Clearly employers need to develop more sophisticated training programs, the researchers suggest. For example, firms need to educate employees about the expected range of value for stock options and perhaps point out that the expected value is probably less than the Black-Scholes estimate.
Moreover, the training program needs to be tailored to the bias associated with specific employee characteristics. For example, younger employees in technical areas may have a different set of problems understanding stock options than senior-level managers in marketing.
Then there is what Larcker calls “more devious behavior – the idea that firms can cut back the number of options granted to employees in order to satisfy wage requirements.” For example, assume that the expected economic value of a stock option is $20, but the employee overvalues the same stock option at (say) $40. In addition, assume that the employee requires stock option value of $10,000 per year. How many options would satisfy the employee: $10,000/$40 = 250? Clearly, the firm is using the bias of the employee in order to pay him or her less (the employee should demand $10,000/$20 = 500 options, and not 250 options).
The goal of this research is to understand how employees value stock options and to identify the factors that cause employees to over-value or under-value their options. If you are interested in surveying a broad cross-section of your employees about how they value their options, please contact David Larcker (firstname.lastname@example.org) or Richard Lambert (email@example.com).
To get an idea about the survey, click here:
To see a sample report from this survey (best viewed using the Internet Explorer browser) click here.