Work hard, not smart : stock options as compensation

This paper examines the optimal compensation package for executives, in particular the optimal mix of stock options and stock grants, for an agent deciding whether to adopt or reject a plan of uncertain value. The compensation structure in such a setting affects not only an executive's efforts to improve the precision of signals regarding the true value of proposed plans but also the choice of a reservation signal that determines the likelihood a proposed plan is adopted. While stock options can bias an executive’s decision criteria away from first-best, we show that the leverage they provide to motivate an executive to undertake more extensive plan evaluation makes options the preferred form of equity compensation if the exercise price is freely chosen. However, there is a role for restricted stock in realigning the interests of the executive with shareholders if the firm is constrained in the choice of the exercise price, which we argue may sometimes be the case. Using extensive data on top-executive compensation, we report evidence on this tradeoff that is consistent with the theoretical predictions. We also find that the extent of option compensation among top executives at a firm is associated with an increase in the likelihood of extreme returns in subsequent periods. A central thesis of the extensive principal-agent literature is the incentive effect on an agent's effort that derives from linking compensation to a measure of the agent's output, albeit at the expense of exposing a risk-averse agent to uncertain compensation. More recently, the literature has considered multiple dimensions to the actions taken by agents depending on the circumstances. When agents are executives, expanding the characterization of the activities of the agent is particularly important. For instance, Murphy (1999) writes that “although the [executive’s] ‘action space’ is typically defined as one-dimensional effort, it is widely acknowledged that the fundamental shareholder-manager agency problem is not getting the [executive] to work harder, but rather getting him to choose actions that increase rather than decrease shareholder value. [In part], increasing shareholder wealth involves investing in positive net present value plans” (p.28). 1 Garen (1994) is one of the first papers to develop and test predictions of the standard principal-agent model with respect to executive compensation. 2 The classic paper introducing multiple activities of agents is Holmström and Milgrom (1991), where the additional activity can be actions such as quality control or maintenance of capital assets. Other examples include Milgrom (1988), where the additional activity involves actions to influence task assignments; Lazear (1989), where the additional activity involves the sabotage coworkers’ contribution to output; Drago and Garvey (1998), where the additional activity is helping others perform their tasks; and Wulf (1999, 2001), where additional activities are influence actions and the distortion of subjective information about investment opportunities. 1 The paper is organized as follows. Section 1 introduces a model in which a risk-neutral executive must choose to adopt or reject a proposed plan of uncertain outcome based on an imperfect signal of the plan’s value. The executive also chooses a level of effort to invest in the process of evaluation – an investment that affects the informativeness of the signal of the plan's value. The purpose of the model is to evaluate the use in executive compensation packages of two forms of equity-based compensation: restricted stock grants and stock options, as well as to explore the potential link between the use of stock options and the performance of firms. In the model, option-based equity compensation moves effort toward first best, but distorts executive decision making away from first best. Thus, in contrast to the common adage for managers to “work smart, not hard,” we find that stock options encourage a “work hard, not smart” approach relative to restricted stock. To illustrate the potential effect of stock grants versus stock options on executives’ actions, Section 2 considers how the substitution between stock grants and stock options influences the behavior of executives and shows that if the firm is unconstrained in its choice of the exercise price on options awarded to an executive, the optimal equity compensation package consists only of options. In other words, the optimal exercise price allows the principal to limit the decisiondistortion consequences associated with options while taking advantage of the capacity of options to encourage effort through leverage. There are two important features of our theory. First, unlike Hall and Murphy (2000), risk aversion on the part of executives is not necessary for a finite optimal exercise value in our model. This result arises from an expansion of the executive’s problem to a project-selection setting in which options can distort executive decision making, and increasingly so as the exercise price 3 This view follows Barron and Waddell (2003) Other papers that consider a project-selection decision include: Lambert (1986), Holmström and Ricart-i-Costa (1986), Campbell, Chan and Marino (1989), Smith and Watts (1992), Hirshliefer and Suh (1992), and Bizjak, Brickley and Coles (1993). 4 Hall and Murphy (2000) suggest that “. if [risk neutral] managers valued stock options at their Black-Scholes value, the optimal granting policy would be to grant an infinite number of options at an infinite exercise price. ” 2 increases. A second important feature of our analysis is that the model yields a “knife-edge” result whereby optimal equity-based compensation package switches from almost all restricted stock to all stock options if the exercise price falls below a critical level. As all-options equity awards are common in practice, identifying conditions under which all-option equity awards are optimal is an appealing aspect of the theory. Section 3 provides a systematic examination of the composition of equity-based compensation among top executives. Although the use of options rather than restricted stock is widespread, there remain instances when the compensation packages of top executives include restricted stock. To explain the use of restricted stock over options in our setting, we explore the implications of restrictions on the setting of the exercise value. We start by noting that our evidence for topexecutive stock-option compensation confirms Hall and Murphy’s (2000) observation that the “exercise price is nearly always set equal to the current stock price” (p. 209). We explore reasons why firms may follow a simple rule of thumb in setting the exercise price equal to the grant-date market price (i.e., “at the money”) and the consequences of such a rule. Simulations are used to show that the firm will introduce restricted stock into the executive’s compensation if such a rule of thumb results in the exercise price being too high. In such cases, the restricted stock component of equity compensation acts to increase the executive’s concern for accepting bad projects and moves the agent’s decision rule toward first-best, although typically at the expense of less effort. Section 4 develops hypotheses based on the simulations presented in Section 3 and reports the results of empirical tests of these hypotheses using an extensive collection of data recorded directly from the proxy statements of over 1,400 publicly traded US companies over 1992-2000. The 5 Note also that in our setting, options can be the preferred means of compensation. This contrasts with Jenter (2001), who finds options to be an inferior means of inducing managerial effort incentives. Jenter's result relies on a risk-averse manager's undervaluation of option awards relative to the market and a downplaying of the leverage role for options in inducing effort. 6 Our focus is on stock option compensation for top executives. For discussions of various rationales supporting a more broad-based use of options, see Hall and Murphy (2003) and Oyer and Schaefer (2003). Hall and Murphy focus on the misperception of boards and managers regarding the cost of options, while Oyer and Schaefer focus on the roles of retention and sorting. 3 analysis identifies variables that can increase the likelihood an at-the-money exercise price is higher than optimal for the alignment of incentives, and thus should lead to a reduced use of options as a proportion of an executive’s equity-based compensation. Consistent with the predictions of the model, we find a systematic tendency to use stock options over restricted stock in research-intensive environments, in smaller firms, and in firms that do not have a policy of paying dividends. Interestingly, we also find evidence that, for both pooled and fixed-effect specifications, higherranking executives are less likely to have a given dollar of equity compensation awarded in the form of stock options. This provides strong support for the idea that as one moves up the ranks of top executives, the distortion effects of stock options become more important, and thus options play a less important role in equity compensation. Section 5 explores the link between the use of option-based compensation among the top executives of a firm and the subsequent pattern of firm returns. Our analysis indicates that executives are more likely to choose an uncertain plan that is either better or worse than the status quo if options are substituted for restricted stock. This suggests that, other things equal, returns should be more extreme when compensation is weighted toward options. The empirical analysis finds support for this prediction. Namely, a firm’s subsequent three-year return is more likely to be extreme (in the top or bottom 20 percent of returns) if the option proportion of total compensation among top executives at the firm is higher. Section 6 contains concluding remarks and