(Nov 6): Much has been made of the benefits of long-term incentive plans such as stock options.

The Center on Executive Compensation in the US argues that long-term incentives encourage the achievement of a company’s strategic objectives to enhance value. This is because these incentives ensure alignment with shareholder interests. In the US, long-term incentives such as stock options often form the largest component of executives’ compensation.

This widely held view is often promoted by management consultants to earn their fees and company’s management to further their compensation. Indeed, many regulatory authorities similarly promote long-term incentive plans as part of “good governance”.

But is this widely held conventional view accurate? What are the associated risks?

To be fair, academics and consultants do put caveats to their recommendations. One of them is that the granting of stock options must be appropriately balanced. They should be structured to encourage executives to make decisions that benefit the company over the long run. But how can this be achieved, especially when stock options are usually exercisable two to five years after being granted?

Stock-based compensation is widely adopted by the largest companies in the US. Of the Dow Jones Industrial Average’s 30 component stocks, 28 had granted stock options.

Using data from Bloomberg, the relative sizes of these options were computed using the five-year average of stock-based compensation expenses to revenue ratio (see Chart 1).

https://edgemarkets.s3-ap-southeast-1.amazonaws.com/s3fs-public/Chart%201.JPG

The smallest was 0.1% a year for Wal-Mart Stores and General Electric. Goldman Sachs was highest at 6% a year, and the average for the 28 companies was 1.1% a year.

Next, we looked at the returns of these companies relative to the Dow (see Chart 2), that is, their relative performances. There was no clear relationship between the size of stock-based compensation and relative stock-price performance.

https://edgemarkets.s3-ap-southeast-1.amazonaws.com/s3fs-public/Chart%202.JPG

Finally, we looked at the compound annual growth rate of the pre-tax profit for these 28 companies before and after the granting of these stock options (see Chart 3).

Yet again, there was no clear relationship. Some companies notably recorded negative earnings growth.

https://edgemarkets.s3-ap-southeast-1.amazonaws.com/s3fs-public/Chart%203.JPG

A major question that should be addressed is whether company earnings are sustainably enhanced after the granting of stock options to executives. We did not do this test, as it is time-consuming, requiring rigorous data collection and testing over a longer time horizon. Academic research papers are better suited for this purpose, and we are far from trying to pretend to present a definitive conclusion.

We accept that the results above are only preliminary, but we think it is sufficient for the purpose of this article. It does indeed raise the question of whether stock-based compensation does lead to superior shareholder returns. For now, the evidence is mixed at best.

On whether stock-based compensation raises the leverage or risk of companies that grant stock options, the results are much stronger in support. The leverage ratios (measured by net debt-to-shareholders’ equity) of 19 of the 28 companies were higher in FY2016 than in FY2011.

Research has shown that these risk-encouraging pay packages have often resulted in executives’ favouring large new investments in concentrated projects. Their company’s balance sheet is also leveraged up to enhance returns on shareholders’ equity, which generally supports higher stock prices.

Put it this way: If you give someone who has the authority to make investment and operational decisions an option to exercise if the stock price goes up, and there is no penalty if the company fails, would this person not take excessive risks? It is encouraging a one-way bet for executives, at shareholders’ expense. Worse still, stock options are often granted at a discount to market price.

I am raising the issues above not because I think stock options are necessarily bad. They can be positive if properly administered with strong board oversight. But I think the absence of doubt and lack of consideration for the risks associated are a mistake. Conventional beliefs are too often left unquestioned, and challenging them may offend many.

I am a firm believer of aligning management’s interests with those of shareholders. But stock options do not achieve this at the moment. It is time to consider alternative ideas or drastically change current long-term incentive plans.

• Exercise period only from five to 10 years after granting, instead of two to five years. This is more consistent with creating long-term shareholder value, rather than a means for executives to cash out. As the exercise entitlement could be after the executives are no longer in the company, executives will also focus on attracting, retaining and developing talents for succession. More often than not, a great leader often leaves behind a weak successor;

• Consider adjusting the exercise price to reflect a company’s performance relative to the overall market. In a booming stock-market cycle in which the index is up 30% for the year and your company’s stock price is up 15%, has management performed?

• Alternatively, tie the award of stock options not to stock prices but to the realisation of operational cash flows and profitability (excluding extraordinary items);

• It is also necessary to adjust the targets to be achieved by considering the balance sheet of the company. Executives can leverage up the balance sheet to take on higher risks to achieve superior returns. For this reason, a company’s valuation does not just take earnings into account, but sustainable earnings — that is, it considers risks. One approach is to assign risk-weighted required internal rates of return for new investments; and

• More controversially, executives should be held accountable for bad decisions and bad outcomes, just as they would benefit from the positive ones. Instead of stock “options”, where the executives can choose whether to exercise, depending on whether the stock prices are up or down, these stocks are “exercised or bought” by the executives, where payments from them are deferred. These deferred payments are accrued over the time of the exercise period, but they are due and must be paid back to the company. The executives become personally liable, and if they make bad decisions, they pay the same price as shareholders. Of course, executives can choose not to participate, but they cannot have their cake and eat it too.

I am not an HR or a management consultant and do not profess to be knowledgeable in the field or to have considered all effects and consequences. But I am an analyst and I understand the one-sided, risk-encouraging impact of current long-term incentive plans.

So, the next time you are asked to vote for an executive long-term incentive plan, a type of stock-based compensation or another, you should ask questions and hopefully get responses that are more thoughtful than the standard template replies.

Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore

Are employee stock options good for shareholders?

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