Do Underwater Executive Stock Options Still Align Incentives? The Effect of Stock Price Movements on Managerial Incentive-Alignment

Abstract

The concern that out-of-the-money stock options are not an effective way to motivate managers has led boards of directors to consider measures such as lowering the exercise price of underwater options, or issuing new option grants, to restore the incentive managers have to increase shareholder value. This paper explores whether such measures are needed: do out-of-the-money options lose their power to align incentives? We address this question by estimating how the incentive-alignment power of options changed over the course of the year 2000, a year that for many firms marked the derailment of the long-running bull stock market. Examining the sensitivity in the value of the manager's stock option to changes in the firm's stock price (one metric for incentive-alignment power), we find that in general the ability of options to align incentives remained remarkably intact. This resilience in incentive-alignment power stems from the long maturity of executive stock options, the relatively high stock price volatility of firms that experienced stock price declines, and to a lesser extent, the increase in volatility levels that accompanied weakening stock prices. We test the robustness of these results to the metric of incentive-alignment power, replacing market values with the value that managers place on their stock and option holdings, adjusting for managers' inability to fully diversify their portfolios. We also test how sensitive our results are to volatility assumptions. We conclude that even a steep decline in stock price can leave incentive levels intact, so restoring incentive-alignment is seldom a good justification for resetting the stock price or issuing new option grants. Before rejecting such measures, however, boards must examine whether the ability of stock and option holdings to retain key managerial talent deteriorated as the stock price declined, for our findings suggest that in selected firms or industries, the value of those holdings declined substantially.