Stories
Stories
Underwater Options May Not Sink Incentives
Topics: Finance-Stock OptionsResearch-Research and DevelopmentHuman Resources-Compensation and BenefitsDuring the bull market of the 1990s, stock grants and options formed increasingly large components of executive compensation. Now, however, with many options "underwater" as share values have declined well below the strike price, boards of directors are perplexed. Can a manager really remain motivated when payoff requires such a daunting climb?
A clear temptation, and a path pursued by many firms, is to reduce strike prices or award new options reflecting lower stock values. But, as HBS associate professor Lisa Meulbroek notes, this gesture is problematic. "If you restrike the options every time the stock price dips, you've set up a situation where managers can never lose. What kind of incentive is that?" Meulbroek asks.
In fact, the assumption that underwater options dramatically weaken managerial incentives may itself be invalid, according to a working paper titled "Do Underwater Executive Stock Options Still Align Incentives?" by Meulbroek and HBS assistant professor Li Jin. Their study uses the option delta, which measures how a single option's value is affected by a change in the stock price. Calculating this delta for firms in January 2000 and again in December of that year, when substantial stock price shifts had occurred, they found the effect on the delta, and thus the effect on incentive alignment, to be surprisingly low. For example, although Nasdaq stocks dropped an average of 19 percent in value over the year, the average delta declined only 5 percent.
Reasons for this include the ten-year maturity of typical option awards, which allows a long window for value recovery, plus the relatively high volatility of many stocks with significant price drops, making a similar rebound less far-fetched.
"I'm not convinced the answer is you never have to do a restrike," says Meulbroek. "You just need to take a harder look to make sure the impact on incentives warrants it."
- Laura Singleton (MBA '88)
Post a Comment
Related Stories
-
- 15 Jun 2021
- HBS Alumni Bulletin
Keeping Hourly Workers Focused on the Stock, Not the Clock
Re: Peter Stavros (MBA 2002); Dave Bangert (MBA 2005); Ben Perl (MBA 2007); Michael Kramer (MBA 1999); Shary Aziz (MBA 1976); By: April White