Arnold Kling  

Executive Compensation

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The Case for Price Gouging... Comment of the Week, 2003-09-2...

Two interesting articles in the latest Journal of Economic Perspectives. Lucien A. Bebchuk and Jesse M. Fried focus on the agency problem.


Managers have an interest in compensation schemes that camouflage the extent of their rent extraction or that put less pressure on them to reduce slack. As a result, managerial influence might lead to the adoption of compensation arrangements that provide weak or even perverse incentives. In our view, the reduction in shareholder value caused by these inefficiencies, rather than the excess rents captured by managers, could be the largest cost arising from managers’ ability to influence their compensation.

On the subject of stock options, Brian J. Hall and Kevin J. Murphy write,

When a company grants an option to an employee, it bears an economic cost equal to what an outside investor would pay for the option. But it bears no accounting charge and incurs no outlay of cash. Moreover, when the option is exercised, the company (usually) issues a new share to the executive, and receives a tax deduction for the spread between the stock price and the exercise price. These factors make the “perceived cost” of an option much lower than the economic cost.
...This insight provides a strong case for a requirement that options be expensed. The overall effect of bringing the perceived costs of options more in line with economic costs will be that fewer options will be granted to fewer people: stock options are likely to be reduced and concentrated among those executives and key technical employees who can plausibly affect company stock prices.

For Discussion. When a high-tech company gives stock options to a secretary, is this because the secretary over-values stock options and accepts less compensation otherwise? Or is it because the firm undervalues the options and overcompensates the secretary? Or are options correctly valued by both sides?



TRACKBACKS (3 to date)
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The author at Catallarchy.net in a related article titled Options are not an opportunity cost writes:
    Arnold Kling links to a paper titled "The Trouble with Stock Options" by Brian J. Hall and Kevin J. Murphy, and quotes the following excerpt from it... When a company grants an option to an employee, it bears an economic... [Tracked on September 24, 2003 9:23 AM]
COMMENTS (20 to date)
Brad Hutchings writes:

Arnold, what stage company are you assuming in your secretary query? Clearly, Hall and Murphy are talking about public companies. I agree with the premise that compensation ought to be simple and straightforward and that stock grants are more clear cut than options (i.e. as Microsoft has switched to), I don't agree that secretaries of pre-public high tech startups should not have a stock component to their compensation. By my observation, the stock (or option) does not compensate for lower pay than the market generally provides for those skill levels. But it does provide a long-term incentive to weather the storms and get to pay-dirt. Startups are very risky career moves. Ask anyone who left a traditional industry to work at a dot-com and is now getting back into that industry. If the company is successfully built and sold, everyone who played a part ought to share in the spoils. A secretary slash office manager who puts up with 10 high skill, high ego snots for three years is entitled to a couple hundred g's when they all become millionaires.

-Brad

Jim Glass writes:

With a start-up company -- tech or not -- nobody knows the value of anything.

Hugh Hefner paid $500 for the pictures of Marilyn Monroe that appeared in the first issue of Playboy. The pictures eventually made millions of dollars but neither Monroe nor the photographer go a penny over the $500.

Considering what was known *at the time* did she undervalue them? Or was $500 pretty good for nude pictures for a dubious 1950s start-up dirty magazine that hadn't published at all and whose first issue didn't even have a date on it because the publisher didn't know when he'd be able to get a second issue out. Maybe $500 was a very good price and Hefner just did the equivalent of hitting the lottery. If I recall correctly, Hefner was so short of cash that he paid other people with stock. I wondered how they valued the stock of a company that had no money?

William Shatner was paid in stock for doing his Priceline commercials. Did he/Priceline over/undervalue the stock compared to making a deal in cash? Well, look at the immense range over which the stock traded in a short time -- even in retrospect it's kind of hard to tell, one has to pick a particular moment somehow to judge by.

With a start-up, who can tell *at the time* what the stock is worth? How? I think whether one prefers to be paid by it in stock or cash may much more reflect the risk/reward preferences and cash needs of the parties, than any rational caluclation about what the stock is actually worth.

With more or less established businesses it's another story. But one topic per post so I won't go there (now).

Don Lloyd writes:

"When a company grants an option to an employee, it bears an economic cost equal to what an outside investor would pay for the option."

Although it doesn't specifically say so, this is a claim of an economic opportunity cost.

In fact, neither granted options NOR stocks qualify as economic opportunity costs.

From Economics, A Contemporary Introduction, 3rd Edition, 1994
by William A. McEachern, Professor of Economics, University of Connecticut,
page 30 --

"Because of scarcity, whenever you make a choice, you must pass up other
opportunities; you must incur an opportunity cost. The opportunity cost of
the chosen item or the chosen activity is the benefit expected from the best
alternative that is forgone."

New company stock granted by the company has NO scarcity value to the company itself, as it can create more new fully equivalent shares out of thin air without effective limit or expense.

Even if the stock were scarce, and if grants did prevent a best alternative of a secondary stock sale on the market, ask the shareholders if their expected benefit would be anything close to the sale prooceeds of the secondary offering. While the company itself will reap the cash sale proceeds, the existing shareholders will suffer an ownership dilution of roughly the same order, either plus or minus.

It would be just as correct, and just as wrong, to say that a secondary stock offering has an opportunity cost equal to the expected benefit of an employee stock grant.

In spite of the fact that stock grants ARE currently expensed, the status quo is not an excuse for invalid logic, and options should not be expensed either.

Regards, Don

Kyle Markley writes:

I echo Don's position.

I work for Intel, which has arguably outgrown the usefulness of awarding broad-based stock options, but this year a shareholder vote narrowly prevented the expensing of options.

I've run into the confusion even among my co-workers that somehow stock options cost the company something. They don't. They're a cost to the shareholders, not to the company. Maybe the tax treatment isn't right, but that's another issue.

Are there any pro-option-expensing arguments that don't confuse the company with its shareholders?

Arnold Kling writes:

I do not understand the distinction between "cost to the company" and "cost to shareholders." Imagine if I own all the shares in the company. Then anything I pay out in compensation is a cost to me.

I am not convinced that startups differ from established companies, unless you want to argue that a secretary has more direct impact on company profits for a startup (which might be true). Otherwise, the main difference is that startups are hung up for cash and are willing to take loans from everybody. So a startup would be willing to take a loan from its secretary. The secretary gives the loan in the form of a lower salary or longer working hours, and instead of an IOU the shareholders give the secretary stock options. But there is no reason for the secretary to be investing in a startup. It's like giving the secretary lottery tickets in lieu of a salary.

Don Lloyd writes:

"I do not understand the distinction between "cost to the company" and "cost to shareholders." Imagine if I own all the shares in the company. Then anything I pay out in compensation is a cost to me."

If you grant shares, you no longer own all of the shares, so the case is a bit special, but not really different.

In the general case, the shareholders each own a percentage fraction of the company proper. The economic value of what they own can change due either to changes of value of the company proper OR to changes in the percentage fraction of the company that they own, OR both.

When cash compensation is used, the value of the company proper will be reduced and the shareholders' change in value will follow one for one.

When share compensation is used, the company proper gives up nothing that it can't costlessly replace and the shareholders suffer a loss in the percentage ownership to the compensated employees.

In the case of a secondary stock offering, new stock may be sold to new shareholders, reducing the percentage ownership of the existing shareholders, but roughly offsetting this by the cash added to the company proper, leaving them about as well off. The proponents of expensing say that the company has added cash, which is true, but they entirely ignore the ownership dilution of the existing shareholders.

Does that help?

If you gave away a 50% share in your fully owned company, you would clearly have a 50% reduction in the value of your holdings. If you have given it to an employee, the supporters of expensing want you to say that your company proper suffered an additional 50% value loss as a compensation expense as well.

Regards, Don

Lawrance George Lux writes:

The dilution of Stock by Options or Stock grants is a given. Startup operations find a spread of risk, rather than loss of cash as Wages, to be a non-painful method of avoiding labor obligations. It is much different when Companies have acquired Capitalization. The spread of risk has disappeared, replaced by a loss of Share value for Stockholders. Stockholders lose a real value in their Stock and Dividends.

The Issue is one which should require some Exchange or Federal regulation. Stockholders could make a Case for theft without compensation, because of Company issuance of Stock options or blocks. I could accept a Five-year limitation placed on Corporations of such issuances from the point of incorporation. lgl

Kyle Markley writes:

"I do not understand the distinction between "cost to the company" and "cost to shareholders." Imagine if I own all the shares in the company. Then anything I pay out in compensation is a cost to me."

It's a cost to you in your capacity as a shareholder. It's not a cost to the company as such; the company's assets and bank balances are unaffected. The ownership is redistributed, and that's all.

Daniel Lam writes:

"It's a cost to you in your capacity as a shareholder. It's not a cost to the company as such; the company's assets and bank balances are unaffected. The ownership is redistributed, and that's all."

If this is the logic on which accounting principles are to be based, then indeed stock options, or, for that matter, stock grants should not be expensed.

But this would also imply that when a company issues shares or options for cash, it should book the proceeds as pure profit. After all, the company's bank balance has been boosted by this rearrangement of ownership.

Somehow there is something wrong with this.

Kyle Markley writes:

Daniel,

I don't think the proceeds should be booked as profit (because they aren't a result of product sales) but they definitely increase the cash balance of the company and the accounting should reflect that somehow -- but I'm not an accountant; I don't know what the right category is.

Jim Glass writes:

"...this would also imply that when a company issues shares or options for cash, it should book the proceeds as pure profit ... Somehow there is something wrong with this"

The cash received increases the asset side of the balance sheet, the stock issuance increases the liability side ("equity") so it is a wash for the P&L -- no profit or loss.

Jim Glass writes:

Reagrding valuing options as compensation:

Option valuation can be complex so lets simplify by talking about stock compensation first.

For an established company which is known to investors, the best estimate of its stock's future price is the current price. (Perhaps discounted by the average amount one expects the market to advance annually in the future).

If anyone in the market had solid knowledge that the price would be higher than that in the future, they'd bid the price up now. Similarly, if anyone knew the price would fall in the future they'd sell it or short it now.

This doesn't mean the current price will be the future price, of course. As a best estimate, it just means that any future difference is as likely to be in one direction as the other.

Since the market price is the best estimate of the future price, it's hard to see how either the company or the secretary can systematically misjudge the value of the stock high or low.

(Also, the IRS insists that stock compensation be valued at true market price for employment tax and income tax purposes -- so if someone does arrange to systematically misvalue stock compensation they may have some questions to answer to the government.)

That being the case, and since the value of cash and stock compensation should be the same in current-value terms -- again, the IRS will insist -- the choice seems just to be one of the preferences of the parties in the circumstances. There should be no systematic misvaluation.

Options come in a lot of varieties and can be a lot more complex. In particular they tend to offer upside with no downside, which makes valuing them fun. And there are special tax breaks and tax rules for some kinds, all of which makes it a lot easier for one party with superior knowledge to game the other. But I'm assuming the company and secretary here both act in good faith and wouldn't do that. In that case they still can be fairly valued in principle, formulas exist to do it, and there still shouldn't be any systematic misvaluation.

I suspect any systematic misvaluations that occurred in recent years in option compensation arrangements perhaps had less to do with the nature of options themselves than with the stock market boom leading individuals to form the mistaken judgment that stocks could only go up in value (and fast) -- which in turn gave companies the opportunity to pay apparently high-dollar compensation at no cost in valuable cash-flow dollars by watering their stock.

(And watering the stock is one of he most time-honored traditions in finance, back to the days when the NYSE met literally on "the curb". Nothing new about that.)

But with the boom gone that misjudgment and all are gone too. The end of the boom and the recent 50% drop in stock prices is going to do a heck of a lot more to straighten out abusive option compensation practices than any regulatory reforms will.

Lawrance George Lux writes:

The commentary here does not reflect one aspect of Stock options and block payments of Stock. The future values of Company Profits are diluted amidst a wider spread of Stock. It does not matter, if the Stock dilution provide Profits potential higher than the lost share of equity per Shareholder. It incites loss of Property right for Stockholder, if Profits do not rise to maintain Dividends or expand them.

Current Corporate practice becomes a villian, when Stock Options or Blocks are granted in excess of any realistic Dividend maintenance. This is what must be regulated, or eventually; a sharp reaction from Stockholders will come. lgl

Daniel Lam writes:

"The cash received increases the asset side of the balance sheet, the stock issuance increases the liability side ("equity") so it is a wash for the P&L -- no profit or loss."

Yes, that is the sensible accounting treatment for when a company issues stock (or options) at market price. So when it issues the same stock (or options) for free, it is assuming identical liabilities without the corresponding boost to assets. This constitutes an expense, no?

Don Lloyd writes:

Lawrance,

I think you're on to something, but I would try to express it in a different way.

Assume a high profit, high growth company.

When it makes a secondary offering of stock to sell on the market, the ownership dilution of existing shareholders will be very closely offset by the cash acquired by the company, so that the value of the existing shareholder holdings remains roughly unchanged, IF the market price of a share of stock remains unchanged and the market cap of the company (share count X share price)increases by the amount of the added cash.

However, for this to be true, the added cash must be able to be invested in something that has the same rate of return that the company itself had before the added cash. If this is not the case, either the market share price must fall or the company must become overvalued by whatever criteria it was previously valued under.

If the cash cannot be invested in an equivalent business, then we have a company that consists of a real profitable business with an interest-bearing account bolted on. Since the future interest payments cannot match the future free cash flow of the business itself, the market share price must fall and shareholders will suffer a net injury from the stock sale.

The same thing applies to the cash salary reductions produced by stock and option grants. If this extra cash cannot be put to work effectively enough, the market share price must fall.

Regards, Don

Don Lloyd writes:

"Since the future interest payments cannot match the future free cash flow of the business itself, the market share price must fall and shareholders will suffer a net injury from the stock sale."

Actually, I haven't got this quite correct. Whether shareholders will suffer an injury or not must depend on what the price of the stock is relative to its future free cash flow. A secondary stock sale of a stock whose price exceeds the discounted present value of the future free cash flows will not injure the shareholders. If the holder of a stock will realize a return equal to an interest-bearing account of the same size, then the stock sale will be a wash and the share price should remain unchanged. However, there is no point in holding such a stock when cash itself will give the same return.

Regards, Don

Dave Scruggs writes:

I remember from my old Organizational Psychology that while money isn't a motivator, "inequity" is a demotivator. How much productivity is lost in an organization because employees resent the high compensation of upper executives?

I'd think that the lengths that executives go to in order to obscure their true compensation indicates that they recognize this. Public companies often provide the bulk of executive compensation in stock options, so that salaries appear more reasonable. Corporate benefits and memberships don't appear as salary. HR departments keep compensation plans secret to prevent bad feelings among workers.

This also seems to provide a better explanation for employee stock options. Less inequity is perceived because stock options are generally available. The quality and quantity of the options are secret, so that the majority of the benefits can accrue to the upper level management. In this way, compensation can be made far more uneven while insulating the primary beneficiaries from the repercussions of widespread resentment.

Bernard Yomtov writes:

Jim,

"The cash received increases the asset side of the balance sheet, the stock issuance increases the liability side ("equity") so it is a wash for the P&L -- no profit or loss. "

Yes. But continuing our previous exchange, what entries are made when shares (or options) are exchanged for labor? I've never seen a line on the balance sheet that says "paid-in labor."

Take the case of the secretary who's market wage is $40,000. She gets paid $30,000 cash and $10,000 in stock. Now if you don't record the stock as an expense you are inaccurately showing labor cost of $30,000 instead of $40,000. It seems to me that you should record labor cost of $40,000, with $30,000 coming from cash and $10,000 going to an equity line called "paid-in labor," or something of that nature.

This is roughly what you would do if the company paid with a promissory note instead of cash. It would reflect the fact that the company has obtained something of value, labor, in exchange for a claim on future cash flows. Well, stock is a claim on future cash flows also, so why not treat it the same?

Jim Glass writes:

"... what entries are made when shares (or options) are exchanged for labor? I've never seen a line on the balance sheet that says 'paid-in labor'"

Well, what entry is made on the balance sheet when a corporation issues new shares in a stock split, or when the owner makes a gift of shares to someone, or engages in estate planning by issuing shares to his kids to shift ownership to them for estate planning purposes?

None. There's no new asset obtained and no new liability created.

Issuing stock shares doesn't create any new liability for the company. It just changes who the liability "equity" is payable to.

Why would a mere change of ownership affect the income statement or balance sheet?

"if the company paid with a promissory note instead of cash [there'd be] ... a claim on future cash flows. Well, stock is a claim on future cash flows also"

Not so. Say a company has assets worth $1 million net and issues ...

[] A note >$1 million. This is a claim against it, a new liability, so its net asset postion falls to

Bernard Yomtov writes:

Jim,

"Well, what entry is made on the balance sheet when a corporation issues new shares in a stock split, or when the owner makes a gift of shares to someone, or engages in estate planning by issuing shares to his kids to shift ownership to them for estate planning purposes?"

None in the above cases. Bu when a corporation issues new shares to raise cash for some purpose there is an entry. It goes into something often called "additional paid-in capital" in the equity section. Ther's cash coming in, unlike in your examples, so there has to be an offsetting entry.


"Not so. Say a company has assets worth $1 million net and issues ...

[] A note >$1 million. This is a claim against it, a new liability, so its net asset postion falls to

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