A Thought on Options for Executive Compensation

October 13, 2004

The use of stock options as a source of free money (from an accounting perspective) appears to have run its course, since most firms that could have used this as a stimulus have either suffered the consequences or captured the benefits (SRi Media). American accounting laws allow firms to not treat stock options as an expense; the FASB is proposing to change the rules so firms must, but the US Congress is considering a bill to prevent the BASB from doing so (Thomas.gov). Let us assume Congress passes the law and, as a consequence, nothing changes. Since stock options tend to negatively impact the value of stocks if exercised, the costs of them are, over time, transferred from investors to the firms that use them (since the firm must assure higher returns to raise the same finance capital as before). Eventually, the benefits of springing this tactic on investors is used up, investors incorporate this into their expectations of what the firm will do, and the whole enterprise serves as a revenue transfer from other asset markets (like land and labor) to management.

Put another way, let's say that companies that use stock options as an incentive for investment are called O-firms; firms that don't, are called NO-firms. There are two possibilities: either all firms are perceived as potential O-firms, in which case all firms have a strong incentive to become O-firms, or it is possible for investors to make a confident distinction. If they can, then O-firm stocks have to outperform NO-firms by some small amount to attract the same price for public offerings; we could call this the "optional discount." If not, then here is what happens: the discount is universal, so firm management knows they must issue public offerings with a higher projected future return. If there is a systemic reason to require this of public offerings, then very slightly fewer public offerings will be made, since fewer ventures will offer the higher rate of return. This will affect employment and fixed capital outlays at the margin. Hence, the median income will decline slightly, as will the prices of machinery, real estate, and plant fixtures.

This can only occur one time, however; if the firm issues more stock options, then the options become an expense whether they are accounted as such or not. There is no further benefit to be had from surprising the markets, since they already discount your stock on the assumption that you will issue stock options. For this reason, the compensatory option wave has passed its peak.