What Role Do Stock Options Play in Executive Compensation?

by Lisa Bigelow

Stock options are a form of incentive compensation that many publicly traded companies use to encourage and retain talent. A certain number of options are awarded to an employee at a certain price, and they vest after a certain period of time. Only after the vesting period ends, can the employee sell the options if the price of the stock exceeds the option exercise price. For top executives, this perk can reap millions.

Maximizing Performance

Stock options, especially when they're awarded in quantity to top executives, should encourage top management to act in the best interest of the shareholders. Options are often granted based on pay for performance, meaning that as the company's management guides it toward greater success, the options become more valuable. Anecdotal tales of astronomical executive pay is largely a result of these executives exercising their valuable options. Executives at a company that's underperforming won't make any money on unexercisable options; this means the share price is trading below the option exercise price.

Income Statements Need Not Apply

Although stock options are costly for companies to issue, their calculations aren't included on the income statement. The price of exercised options is included as a footnote in a company's annual report. If the value was included on the income statement as part of salary, the company's earnings could potentially be reduced by millions of dollars. Shareholder activists who complain can affect future compensation packages for top executives.

Rewarding Success but Ignoring Failure

A key complaint of shareholder activists is that stock options often disproportionally reward success, while not penalizing executives for poor performance. To quell shareholder anxiety, many public companies have instituted clawback provisions. The clawback provision forces executives to repay money earned through stock options if the company fails to perform in the future. In addition, many companies have staggered the options so that management can't sell options all at once, but over a period of time. These protections don't lower executive pay in times of success, but it does ensure that top management will continue to act in the company's best interest.

No Pay for Hard Work

Stock options also have the unfortunate reality of failing top executives who are working hard and attempting to build company and shareholder value by restructuring operations. Not only is top management unable to sell stock because the share price is low, they must also deal with key employee defections who are tired of not getting their fair share. For example, in the 1990s, Apple Computer spent years restructuring and found it difficult to retain talent. While there's no doubt that Apple's executives have been richly rewarded for their success, the years they spent toiling with little results were most likely poorly compensated.

About the Author

Lisa Bigelow is an independent writer with prior professional experience in the finance and fitness industries. She also writes a well-regarded political commentary column published in Fairfield, New Haven and Westchester counties in the New York City metro area.

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