Why Stock and Stock-Option Compensation are Such a Terrible Idea

Abstract

Stock options have grown over the last decade to take up an increasing percentage of the increasing compensation of top management. Stock options worth millions of dollars are reported to public investors as if they were free, and that allows top management to schnooker more salary from shareholders than they would otherwise get. The popularity of options is best understood as arising from deceptive accounting. But for the opportunity to understate compensation cost, stock compensation is a terrible idea. Take away the accounting advantage and compensatory stock and stock options would undoubtedly die off on their own.

First, stock options give management truly perverse incentives to invest in projects with too much downside risk. Option holders participate in gains but not loses, so an option holder will rationally send the company into risks that would scare the flesh off of shareholders who do bear the losses.

Second, stock and stock options carry an unnecessarily high discount rate. The high discount rate means the executive gets the least current value per dollar to be paid or requires the highest future cash payment per dollar of current value or both. Stock carries a high discount rate because of unwelcome volatility in the price of the stock and because of market paranoia about management plans about retained earnings, and neither the volatility nor the paranoia is a necessary virtue of any compensation plan. Better management of the discount rate would avoid stock.

Third, stock compensation, gives employees capital gains, but compensation would almost always be more efficient if employee capital gains were avoided. Deferred compensation is almost always better for the executive because it delays the tax bite on their capital. Even if there is no upfront tax on capital at stake, employee capital gain is usually inferior tax planning because it loses the employer deduction.

This is an edited version of Stock and Stock-Option Compensation: A Bad Idea, 51 Canadian Tax J. No. 3, (Oct. 2003) with the special Canadian concerns deleted out.