Risk and reward

I'm going to be very interested to read this series by Marc Andreessen, but I rather strenuously disagree with this:

Overt sexism aside, from an incentive standpoint the result of shifting from stock options to restricted stock should be obvious: current employees will be incented to preserve value instead of creating value. And new hires will by definition be people who are conservative and change-averse, as the people who want to swing for the fences and get rewarded for creating something new will go somewhere else, where they will receive stock options -- in typically greater volume than anyone will ever grant restricted stock -- and have greater upside.

And sure enough, in the wake of shifting towards restricted stock and away from stock options, Microsoft's stock has been flat as a pancake. The incentive works.

Now, against that, it is true that stock options, particularly for public companies, have an often-destructive random component: they tend to increase in value in rising stock market environments and decrease in value (potentially to zero) in falling stock market environments, regardless of whether value is being created inside your particular company.

For that reason, in the long run it probably makes sense for some new approach to stock-based compensation to be developed that both preserves the motivation to create as opposed to preserve value, but factors out the environmental swings of rising and falling stock markets. Some form of indexing against market averages would probably do the trick. This has been tried from time to time, and I expect it to be tried more in the future, at least for public companies.

This is not the major problem with stock options. The major problem with stock options is twofold: out of the money options encourage managers to take excess risk, because they get nothing if they preserve value, so even a remote chance of boosting the stock price that carries a hefty risk of failure is a good idea for the managers--but a terrible idea for the shareholders.

The other problem is that they encourage short-term misinformation about a company's prospects in order to boost the price long enough to excercise your options and sell the stock. The time of option excercise is one of the few times when an executive can sell his own company's stock without triggering a market reaction.

You will notice that while Microsoft's stock price may not have done much, it also didn't go the way of Pets.com, or even Sun. No compensation system is perfect, but stock options have big problems.

Comments

This is not the major problem with stock options. The major problem with stock options is twofold: out of the money options encourage managers to take excess risk, because they get nothing if they preserve value...

He makes this point...

Posted by bobvis | March 28, 2008 12:07 PM

I worked at Activision, a large video game making company, a few years ago. They were using stock options for all their employees.

I know this is just an anecdote, but there were (from the ground floor view) some severe problems from retaining tons of frustrated, miserable, or generally disaffected employees (who were still politically savvy enough to avoid being fired) who, because the stock was doing well and because we had fairly long term vestment schedules, were tied to the company LONG past when they wanted to be there, and it showed. Realistically, it wasn't like any particular one of them, by working harder, could have elevated the stock price all that much (Activision stock was primarily buoyed by Tony Hawk games during this window of time, I think).

I guess I shouldn't complain, as I did benefit from said options, but it was clear options in that case were doing far more damage than good (given that many of the angriest people were also the most senior, and would actively poison newer people coming in).

Responses about management failure and the notoriously lousy quality of life issues in the game industry are valid, of course, but, without those options, most of the problems would have sorted themselves out organically.

I have no idea if that's a common problem or more of an edge case, though - games are funny in that, at their best, the act of making good ones can be a very powerful incentive in and of itself for some people.

Posted by Nathan McKenzie | March 28, 2008 12:47 PM

The major problem with stock options is twofold: out of the money options encourage managers to take excess risk, because they get nothing if they preserve value, so even a remote chance of boosting the stock price that carries a hefty risk of failure is a good idea for the managers--but a terrible idea for the shareholders.

I'd qualify this a little bit -- with the exception of the people at the very top of the corporate pyramid, managers depend on their jobs, both as a source of immediate income and as a basis for obtaining future career opportunities hopefully based on a record of success in prior employment. So they have good reason to be conservative. Stock options can help counteract that inclination.

Posted by alkali | March 28, 2008 12:59 PM

I would also rather strenuously contest the notion that outside of small companyes, stock options for anyone other than senior management can affect performance. Give all the stock options you want to ordinary workers, but I favor stock grants for senior managers.

Posted by Megan McArdle | March 28, 2008 1:07 PM

The other problem is that they encourage short-term misinformation about a company's prospects in order to boost the price long enough to excercise your options and sell the stock. The time of option excercise is one of the few times when an executive can sell his own company's stock without triggering a market reaction.

How is the same not true for restricted stock which offers value to the holder on some date during which the senior management could, presumably, put out misinformation to inflate its value?

Posted by Topper Headon | March 28, 2008 1:38 PM

My major complaint is the use of "incented".

Orwell is rotating his grave at that sort of ghastly evisceration of decent English.

(Note that I do not say "proper English" or claim that it's "not a word".

I think it's brutal and ghastly in a completely unjustified way, and is neither more efficient, more clear, nor more precise than - for instance - "motivated".)

Posted by Sigivald | March 28, 2008 1:47 PM

I suppose it depends on the restrictions put upon the stock grants Topper.

Posted by Nelson | March 28, 2008 1:48 PM

In my personal experience, most senior execs these days sell stock options through a 10b5-1 plan, which takes the timing of exercise out of the hands of the option holder, and thus mostly eliminates the incentive for short-term manipulation of earnings (and more to the point, lessens the risk of shareholder suits).

Microsoft's stock is flat because MS has huge market share in slowly growing markets. They have plenty of new business initiatives, but they're all dwarfed in the revenue/profit picture by Office, Windows, et al.

Posted by MahlerFreak | March 28, 2008 3:00 PM

"Incented" does "feel wrong," but it's apparently standard usage.

If being "motivated" is the act of being given motivation, why isn't being "incented" the act of being given incentive?

On the other hand, as the Pope walks down the aisle with his censer spreading incense, does that mean the congregation has been incensed?

Posted by liberalrob | March 28, 2008 3:18 PM

"The time of option excercise is one of the few times when an executive can sell his own company's stock without triggering a market reaction."

This is incorrect. Anytime an executive sells stock (and, an exercise is not a sale) it must be reported of Form 4 to the SEC and gets spashed over Yahoo and the like. The market does not discriminate between the sale of stock incident to an option exercise and other sales by an executive.

Posted by wwren | March 28, 2008 3:21 PM

In my personal experience, most senior execs these days sell stock options through a 10b5-1 plan, which takes the timing of exercise out of the hands of the option holder

"After Rule 10b5-1 was enacted, the SEC staff publicly took the position that canceling a planned trade made under the safe harbor does not constitute insider trading, even if the person was aware of the inside information when canceling the trade." - from the Wikipedia

Posted by Nelson | March 28, 2008 5:30 PM

You said:

No compensation system is perfect, but stock options have big problems. (emphasis mine)

Marc said:

it is true that stock options, particularly for public companies, have an often-destructive random component... For that reason, in the long run it probably makes sense for some new approach to stock-based compensation

Where are you disagreeing with him?

BTW Pets.com failed because it was a sucky idea, not because of compensation issues.

And FWIW Level 3 used to index their options to the S&P 500. They were praised for it back in the last 90s, but I haven't heard much about it lately.

Posted by Derek Scruggs | March 28, 2008 6:37 PM

Options reward volatility.

They have been used as a money pump (from investors to employees). Someone should analyze (near) relative lows at award to option vesting highs for signs of gaming the system.

Posted by Ari Tai | March 28, 2008 7:11 PM

Most corporate incentive plans today grant both restricted shares and options. This is a straw-man debate.

Posted by jult52` | March 28, 2008 7:36 PM

Derek, you wrote that Marc was making the same point as Megan when he wrote: "it is true that stock options, particularly for public companies, have an often-destructive random component." But that's not true.

Megan is arguing, correctly, that stock options make managers go long volatility. In other words, they have every incentive to embrace strategies that have a reasonable chance of sending the stock price soaring -- even if those same strategies also have a good chance of demolishing the stock price. That's because an option is no more valueless if the stock is $20 below the strike price than it is if the stock is $1 below the stock price. But obviously if you're a shareholder, you care quite a bit whether the stock is at $30 or at $11. So stock options give managers the wrong incentives.

Andreesen doesn't seem to recognize this. The problem he identifies with stock options is a different one, and actually isn't specific to options (it's also true of restricted stock), which is that any stock grant will often end up rewarding people for stock-price gains that are driven by market, rather than company-specific, factors. That's a totally different point.

Andreesen is writing as if shareholders have no interest in preserving value. But that's obviously false. Don't you think Microsoft shareholders are a lot happier with their company's performance than, say, Bear Stearns shareholders or Countrywide shareholders are?

Posted by K. Williams | March 28, 2008 11:47 PM

Seems to me a simple compromise solution, would be grants of in-the-money stock options, i.e., options at an exercise price below the current share price. You adjust the exercise price according to how much value-preservation vs value-growth the company wants.

A practical problem with them though, is the tax treatment relative to on-the-money options is punishing.

They also suffer from a PR problem, because of the confusion with backdated options.

Or you could give people *both* stock and options in some determined proportion. It's not an either/or choice, after all.

Posted by gek | March 29, 2008 4:37 PM

A point almost expressed, is that someone granted calls can turn them into synthetic puts and make money if the stock tanks.

Give somebody options and they benefit from volatility, not necessarily rising stock prices.

Posted by M. Furlan | March 30, 2008 11:54 PM