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Management Research NewsVol. 32 No. 8, 2009pp. 762-766# Emerald Group Publishing Limited0140-9174DOI 10.1108/01409170910977979

A brief overview of executivestock options in reducing theagency problem of excessive

risk aversionKevin J. Sigler

Department of Economics and Finance, Cameron School of Business,University of North Carolina, Wilmington, North Carolina, USA

AbstractPurpose The purpose of this paper is to discuss how executive stock options help in reducingagency costs in the firm and to address problems experienced by the firm when stock options areused as incentives.

Design/methodology/approach The paper initially discusses types of agency problems causedby company managers and then explains why stock options can reduce the problem of excessive riskaversion displayed by some managers. It then addresses the problems that may occur with theintroduction of executive stock options by the firm and finally offers methods to reduce theseproblems.Findings The paper explains the methods available to reduce the problems caused by executivestock options such as indexing the stock options to the S&P 500 index and structuring the Board of Directors in a manner that helps ensure the stock options are used appropriately.Originality/value This paper is valuable to firms using executive stock options as incentives tomanagers. It outlines the problems stock options can help solve and the problems which may occurby their use. In addition, the ways to reduce the problems produced by executive stock options in thefirm are discussed.Keywords Risk analysis, Stock options, Boards of directors

Paper typeResearch paper

IntroductionAgency problems in firms have been a concern for many years. Managers of firm whoact as agents to the firms shareholders have a duty to make all efforts to maximizeshareholders wealth by working in the best interests of the firms owners.Nevertheless, managers are also concerned with their own wealth creation and self-interest, which may at times be at odds with working in the best interests of theshareholders. Conflict of this type produces agency problems in many financialsettings, where intermediaries act as the agents of investors. This paper discusses howexecutive stock options can help in reducing agency costs and addresses problems

experienced by firms that use stock options as an incentive.Agency problemsManagers as agents are very interested in maximizing their utility of wealth. Theyachieve this end through their salaries, bonuses, perquisite consumption andenhancing their own careers as paths to better paying jobs. Managers can also utilizetheir positions to benefit themselves in other subtle ways. For example, managers whoengage in empire building by not distributing excess cash but invest it when the firmdoes not have a profitable project available, reinforce their positions ( Jensen, 1976; Jensen and Murphy, 1990). Managers can also entrench themselves within their

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positions, which makes it difficult to remove them for poor performance (Shleifer andVishny, 1989).

A major problem for managers who progress through their firms career paths andbuild their career profile is a lack of diversification. This is because most of the current

wealth, future wealth and human capital of such managers are tied directly to theirfirm. This amalgamation may cause managers to become overly risk averse, passingup positive net present value projects simply because they are afraid that a pooroutcome will hurt the firms profitability and subsequently, their own security. Thisbehavior is certainly detrimental to the firms shareholders, who have employed themanagers precisely to take such risks in order to increase their wealth. Stock optionsare offered to the employees of firms as an incentive for managers to take calculatedbusiness risks.

Stock optionsAccording to many studies, executive stock options appear to reduce excessiveaversions to risk by giving managers incentives to increase firm risk instead of avoiding it (see Hirshleifer and Suh, 1992). Other studies in the literature indicate thatstock price volatility increases after the approval of company stock option plans(Defusco et al., 1990; Guay, 1999). According to the Black Scholes Option Model (seeBlack and Scholes, 1973), the important factors determining the value of the call optionare stock price, exercise price, time, risk-free rate and variance of stock returns. Thefactor that influences the option value for the manager and the one a manager caninfluence is the variance of the companys stock returns. The volatility of returns candrive the price of the stock either higher (above the exercise price) or lower (below theexercise price). Given that the options cannot be worth less than zero and thatthe executive did not pay for these stock options, it is in managers interest to increasethe volatility of the stock returns or risk to maximize the value of the stock option. Oneway to increase risk is to take on risky project and the other is to increase a companysfinancial advantage, which means increasing the amount of debt financing incomparison to equity financing.

Including stock options as a portion of an executives compensation package is verycommon in the corporate world of North America. Stock options are usually issued toexecutives with the exercise price about the same as the actual stock price. The optionsmust be exercised by a certain date, three years following from the issuing date, forexample. In order for a manager to profit from the options, the stock price mustincrease above the exercise price. For example, assume 1,000 stock options are issuedat an exercise price equal to the current stock price of $40 per share and three yearslater the stock is trading at $100 per share. The executive could realize a gain of $6million by exercising the option to buy and purchase the shares from the company for

$4 million (1,000 options to buy 100 shares per option at $40 exercise price). Theexecutive could sell immediately 100,000 shares for $100 per share on the open marketfor $10 million, realizing a $6 million profit.

Firms issue both qualified incentive stock options (ISOs) and non-qualified stockoptions as types of equity compensation for employees. The amount the stock priceexceeds the exercise price on non-qualified stock must be reported as taxable income atthe time the non-qualified options are exercised. This income is taxed as compensationand not as a long-term capital gain. Nevertheless, ISOs avoid this disadvantage sincethere are only income tax consequences when the stock is sold after exercising.Qualified options can qualify for long-term capital gain treatment for the entire

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appreciation above the exercise price if the shares are held for a minimum period afterexercising (see Internal Revenue Code Section 423).

Problems with stock optionsStock options produce problems for firms when used as an incentive to reduce amanagers aversion to risk. First, in seeking to encourage managers to take risk,shareholders are buoyant about using stock options in rewarding managers. Topmanagement can harness this enthusiasm to deliver stock option pay withoutsurrendering an equal amount in cash compensation. This results in overpaying themanager. A second problem that ensues from using stock options, as part of amanagers compensation package, is that the payoff from the option includes the firmsstock price increases due to industry and general market trends. These are not relatedto a managers overall performance. Therefore, managers become wealthy simply bybeing in the right place at the right time and not by the merits of their performance.This could actually work as a disincentive to work harder if the stock price rises

regardless of ones efforts. A third problem occurs if the stock price declines afterexecutive stock options are issued with the result of the options being way out of themoney. With option so far out of the money, it may not provide a manager with theincentives necessary to exert more effort to move the stock price in a positive direction.A solution used by many firms is to re-price the options by lowering the exercise priceor issuing more options at a lower exercise price. This step again aligns the interests of the executive with the shareholders but it may also send a negative signal. That is, if the stock price goes up, the manager wins when it goes down, there will beadjustments so the manager can also prosper.

A fourth problem with using stock option as a component of pay is that managershave the freedom to unload their options and shares whenever they choose. Whenmanagers exercise their options and sell their shares, the pay-performance incentive isgone. This forces the firm to issue more options or to find other means to entice theirmanagers to take risk. Finally, the firm also faces dilution of stock ownership when themanagers do exercise their rights.

Addressing the problems of executive optionsFirms address the problems associated with issuing stock options to managers inmany ways. Sometimes, firms buy back shares at the going market price to offset thedilution of shares from exercised executive stock options. To insure that the managerspayoff from a firms stock options is tied directly to ones efforts and not to themovement of the market, the exercise price of the options is adjusted for market forcesby indexing the options to the S&P 500 Index. For example, if the executive stock

options are issued with an exercise price of $40 and the S&P 500 increasesby 20 per centafter the options are issued, the exercise price would also increase 20 per cent. Thisindexing takes the overall forces experienced by the entire market out of the optionpayoff. Indexing can also stop a poor performing market from hindering the incentiveeffect on a managers stock options. In this instance, if the price of the S&P 500 Indexfell 20 per cent after issuing the options, the exercise price would be adjusted downfrom $40 to $32 (Booth, 2003).

Restricting the time when the executive stock options may be exercised can be amethod to control when managers can unload their options and shares. Being able toanticipate when shares are sold in the public market can allow the firm to plan when

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another stock option issue will best serve the company and continue to providemanagers with incentives to perform.

Ensuring that the appropriate total compensation, including stock options, comprisesthe executives pay package is the responsibility of the Board of Directors of the firm.

The board is installed to oversee the activities of top management by monitoring workprocesses to ensure that the activities of executives are aligned with the expectations of the firms owners. Their duties include the need to make sure that the stock options givento managers are structured properly with appropriate incentives.

Board of directorsThe public has recognized overpayment of top management compensation in the USA.Today, the public increasingly questions the effectiveness of the Board of Directors incontrolling the pay of executives. Boards have been suspected of granting automaticpay increases, regardless of how well the top management performs. However, theranks of management usually offer up candidates for directors on a firms board.Dissenting stockholders can propose their own candidates but that is not a commonoccurrence. Therefore, management often has their people placed on the board, sincethey are the only directors offered up at the time.

The key to procuring a directors position is to be placed on the managements groupof candidates, which means one must appeal to the top management. Since theinfluence of top management over the board gives it significant influence over theelection process, directors have an incentive to go with the flow concerning the payarrangement for managers, as long as the pay package remains within a range that canbe defended and justified. People aspiring to a directorship will normally shy awayfrom developing a reputation of picking apart management compensation packagessince this would hurt their chances of joining a board (Booth, 2003).

Increasing the role of the Board of DirectorsThere has been increased scrutiny on the role of the Board of Directors, especiallyconsidering the excesses of Enron and other players in corporate America. Since thepassage of the Sarbanes-Oxley Act 2002 , there is an increased risk of litigation andcriminal charges for members of boards. Firms, therefore, are now more concerned aboutthe roles and composition of a Board of Directors. In this light, many firms take care toinclude external directors on their boards. An outsider is a director who has neverworked at the firm, is not related to any of the key employees and has not worked for amajor supplier or customer. However, it appears the definition of independent outsidersis at times misapplied. Retired chief executive officers (CEOs) or relatives have beenrecognized as outsiders when they are actually insiders with clearconflicts of interest.

Board members comprise the compensation committee that is responsible for

setting the pay for top executives in a firm. However, there are firms where the CEOsits on the compensation committee. The compensations committee annual meetingevaluates the pay packages of top management, which in many cases are designed bythe top executives themselves. Due to the increased risk for directors because of theSarbanesOxley Act , firms are moving away from having the CEO on thecompensation committee and take more care dealing with their top management.

ConclusionIssuing stock options to the managers of firms is one method to reduce the agencyproblem of excessive risk aversion. However, problems arising for the firm using

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executive stock options can be addressed by using an adjustable exercise price andhaving a suitably qualified and motivated Board of Directors. According to Bebchukand Fried (2003), increased research on executive compensation schemes will reducethe agency problem in publicly traded firms. Therefore, future research of this type is

strongly encouraged.

ReferencesBebchuk, L.A. and Fried, J.M. (2003), Executive compensation as an agency problem,Journal of

Economic Perspectives , Vol. 17 No. 3, pp. 71-92.Black, F. and Scholes, M. (1973), Pricing of options and corporate liabilities,Journal of Political

Economy, Vol. 7, pp. 637-54.Booth, L. (2003), What to do with executive stock options,Canadian Investment Review ,

Summer, pp. 12-18.Defusco, R.A., Johnson, R. and Zorn, T. (1990), The effect of executive stock option plans on

stockholders and bondholders, Journal of Finance , Vol. 45 No. 2, pp. 617-28.

Guay, W.R. (1999), The sensitivity of CEO wealth to equity risk: an analysis of the magnitudeand determinants, Journal of Financial Economics , Vol. 53 No. 1, pp. 43-71.Hirshleifer, D. and Suh, R. (1992), Risk, managerial effort, and project choice,Journal of

Financial Intermediation , Vol. 2, pp. 308-45. Jensen, M.C. and Meckling, W. (1976), Theory of the firm: managerial behavior, agency costs and

ownership structure, Journal of Financial Economics , Vol. 3 No. 4, pp. 305-60. Jensen, M.C. and Murphy, K.J. (1990), Performance pay and top management incentives, Journal

of Political Economics , Vol. 98 No. 2, pp. 225-64.Shleifer, A. and Vishny, R.W. (1989), Management entrenchment: the case of manager-specific

investments, Journal of Financial Economics , Vol. 25, pp. 123-39.

About the author

Kevin J. Sigler is a Professor of Finance in the Cameron School of Business at the University of North Carolina. He received a PhD in finance from the University of Nebraska. Kevin J. Sigler canbe contacted at: siglerk@uncw.edu

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