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Stock Options: Compensation or Something Else?

Any shareholder knows that all other things being equal, management stock options are "bad" for shareholders. A shareholder will often tolerate such stock options with the expectation that an equal or greater good will come out of it, at least in "incentivizing" management.

How do such incentives work? They aren't like cash compensation, with remunerates managements for coming to work and going through managerial processes. Instead, they reward managements for results. In this regard, they aren't like ordinary compensation expenses, even though well-regarded investors like Warren Buffett seem to think so.

Stock options are particularly useful in start-up situations, which are operating at a break even, or even more precarious level. Paying "full price" (in cash) for needed talent, could break many a fledgling company. Instead, the company will offer a cut-rate cash salary, and a generous package of "call" options. In effect, the company is saying, "we're asking you to take less of today's economic 'pie' (in the form of a lower salary), so that there WILL be a pie today. In return, we will offer you a larger slice of tomorrow's pie, provided there IS a pie tomorrow." A good deal for the company, whose survival chances have soared.  A good deal for the executive if the chances of prosperity are high enough.

As far as we're concerned, stock options DON'T affect earnings. What they do affect is earnings PER SHARE. Either a smaller earnings base or a larger share base could adversely affect outside shareholders. But it ought to be made clear which. What we would like to see in this situation is a fully diluted share calculation, which reflects how much of the future prosperity the outside shareholder has sacrificed, in exchange for a greater likelihood of survival today.

There is an important difference between the two compensation sche... Managers that are paid in cash and own little or no stock tend to perform mainly managerial functions. They come to work, per... "work," and get paid, whether or not they produce results. You don't want to compensate management of a new company like this, because then they have no reason to try to get it off "dead center."

Managers that are paid in stock options are typically more aggresive, because it's in their interest to be so. They will, at least, seize opportunity. But it's possible for management to be "too motivated." Bear Stearns, for instance, had about one-third of its stock "owned" by employees. So did many other Wall St. firms. Why is that?

Unlike outside stockholders, who have to pay full price for stock, managers are typically compensated by options that pay off above a certain strike price. Thus, such managers have an incentive to get the market price as far above the strike price as possible. Then they exercise the option, buy the stock at the strike price, and sell it a a higher market price. That's a good thing.

The problem arises by the fact that management has no "resposibility" for the stock below the stirke price. They can walk away. But outside shareholders lose.  Management usually wins in such situations. But when they do lose, they lose spectacularly, because they have no penalties for losing, and therefore take too many risks.  Heads, managemeent wins, tails, they "tie."

So pick your poison. Compensation as "expense" might not incentiize management enough. Compensation as assets (shares) might incentivize management too much. But know the difference, and don't confuse one with the other.