Stock Options and Compensation

Abstract

This note is a brief introduction to the logic and practice of using stock options to compensate executives. The Black-Scholes option-pricing model is used to estimate the value of option grants for a company. The note affords the opportunity to apply options valuation in the context of executive compensation, and serves as a companion to introductions to options that expose the reader to the Black-Scholes option-pricing model. A spreadsheet is available for student preparation of the case. Excerpt UVA-F-1521 Rev. Aug. 5, 2015 Stock Options and Compensation One of the major forms of executive compensation has been stock options. Use of stock options has been promoted as a way to help align incentives for shareholders and managers. That alignment is accomplished by linking executive compensation to performance for shareholders, which, in this instance, is reflected in the value of the company's stock. An alternative way to help align incentives is to give managers shares of company stock. Some firms do this, giving managers shares of stock with restrictions on managers' ability to sell the shares. A criticism of this approach is that it is not sufficiently forward-looking. Because the share price reflects the value of assets in place plus the value of future growth, when the manager gets shares, he or she receives the value of past decisions, and future price changes have only a marginal impact on the value of the shares. Moreover, with an option that gives the manager the right in the future to purchase stock at today's price, the manager gains only if the stock price increases over the current price. Generally, stock-option plans take three forms. A fixed-value plan gives a manager some fixed proportion of salary in the form of options. An example would be an executive whose salary is $ 500,000 and who is given a grant of options equal in value to half of the salary each year. A fixed number plan gives a manager a fixed number of options each year. For example, the plan might award the manager 5,000 at-the-money call options each year. Finally, there is the megagrant. Here, the executive receives a large grant of options this year and then none in the future. In all these forms, the intent is to align management incentives with those of shareholders. . . .