Business Strategy

Debunking the Dangerous Myth About CEO Stock Options

CEO Stock options Photo by Yiorgos Ntrahas on Unsplash

It is common practice for American CEOs to receive stock options as part of their payment packages. In fact, stock options are a major contributing factor to the increase in CEO remuneration, which increased from $3 million in 1992 to $12 million in 2016. 

The logic behind stock options is to encourage CEOs to take more strategic risks to drive up stock prices

However, scholars suggest that CEO stock options don’t have an impact on shareholders’ dividends. In fact, this strategy may be dangerous for shareholders, as CEOs with stock options have an exit strategy that they don’t if company stock prices fall. 

Why don’t stock options impact stakeholders’ shares?

The answer: because of the nature of stock options. 

According to two Australian finance professors, “A stock option is a financial contract that basically allows someone the right but not the obligation to buy a certain number of company shares in the future, at today’s market price. Thus, stock options allow CEOs to benefit if the company’s stock price rises, but not lose out if the stock price falls. Because in the latter case CEOs simply walk away from the transaction as the contract is not binding.”

What’s more, the professors found that stock options for CEOs often didn’t impact companies’ strategic planning. In their research, they considered the 1,500 largest American companies from 1992 to 2016, including those firms that granted CEOs stock options and those that did not.

Ultimately, their research determined that CEO stock options didn’t impact dividends. They uncovered this result by considering a 2005 regulation that forced companies to include their CEOs’ stock option payments in their financial statements.  

Thus, as the professors explain, “If stock options drive cash holdings then firms most affected by this US regulatory change should have experienced a bigger change in cash balances than firms least affected.”

How has this study impacted CEO stock options?

Not significantly. Though the professors published their study in 2017, American firms continue to increase their CEOs’ stock options. In 2019, the average CEO payment package increased by 14 percent to $21.3 million including stock options that may or may not have been exercised. 

When Boeing CEO Dennis Muilenburg was fired for his bungling of the 737 Max crisis, he left with $18.5 million in stock options, while the company’s shareholders lost 25 percent of their holdings. 

How Can Companies Offer Stock Options Safely to CEOs?

Harvard Business Review studied nearly 2,000 companies to consider “opportunism,” or when CEOs may aim to benefit themselves “rather than to help shareholders achieve a higher return on investment.” Here are a few ways to mitigate the negative impact CEO stock options can have on shareholders:

Consider limiting “absorbed slack” and CEO spending discretion.

HBR defines “absorbed slack” as the amount of money available to managers that the shareholders may not be able to track. CEOs, then, may spend this money at their discretion with little oversight from shareholders. 

So, if CEOs are both able to spend this money as they wish and the amount of absorbed slack is high, opportunism is more likely, as well. Thus, shareholders should worry more about CEOs who are presented with this situation. 

Opportunism decreases if the CEO doesn’t have a seat on the board.

If a CEO has a seat on the board, they’re more likely to engage in opportunism. Specifically, if the board no longer has a chance to oversee the CEO, then the CEO has more chances to behave in a way that doesn’t benefit shareholders. So, HBR recommends that CEOs should not hold board membership. 

The lower a company’s debt load, the fewer opportunities a CEO has for opportunism.

The less debt a company has, the more likely a CEO is to engage in opportunism. The higher the debt, in turn, the more scrutiny the CEO is likely to face. This is because the company has less discretionary funding at the CEO’s disposal, and if money has been borrowed, the CEO has even less chance to spend it as they wish. Finally, borrowed money also means that the lender is monitoring CEO’s actions more closely. 

CEOs and Stock Options

Years of examples and research has proven that paying CEOs in stock options doesn’t always pay off for shareholders. CEOs can become opportunistic, meaning that they make choices for themselves, while failing to provide increased dividends for shareholders. 

If companies still want to pay CEOs in stock options, they can mitigate the likelihood of managerial opportunism. Strategies include limiting managerial discretion, keeping the CEO off of the board, and carrying a higher debt load. 

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