Option-based Compensation: Panacea or Pandora's Box?

Abstract

During the past decade, investors have become increasingly concerned about the proliferation and size of stock option plans. Shareholder concerns center on four main issues. First, the cost of option-based compensation may exceed the associated benefits, resulting in excessive transfers of wealth from shareholders to optionholders. Second, the current accounting for and disclosure of option-based compensation may not be adequate for valuation purposes. Third, although many companies submit option plans to a shareholder vote, it appears that some companies may use exchange and market rules to avoid the shareholder approval process. Given the potential for stock option plans to transfer large amounts of wealth from shareholders to optionholders, the ability of shareholders to vote on option plans is seen as a critical corporate governance issue. Fourth and finally, with recent stock-price declines, many employees now hold out-of-the-money or underwater options. In order to retain and motivate employees, some corporations have responded by repricing or replacing underwater options with new grants. This replenishment has raised shareholder concern that the practice effectively rewards employees for failed performance, and that repricing undermines the rationale for using options as incentive compensation in the first place. Although recognizing that there are potential benefits of option-based compensation, the primary focus of the paper is on (1) measuring the 'cost' of option-based compensation, (2) management actions to deal with underwater options, and (3) shareholder concerns about the use of stock options. Shareholder concerns suggest that the use of option-based compensation will continue to be a hot-button corporate governance issue.