Seven myths about stock options.

• Author: Booth, Richard A.
• Position: Common misconceptions about stock options

Stock options do more for stockholders than motivate management to keep share prices high indeed, that may be the least of what they do. Here is a collection of some common misconceptions.

FEW TOPICS are more likely to raise the ire of stockholder activists than management compensation. And given that among the largest companies about 80% of compensation is paid in some form of equity, it is not surprising that stock options have come under fire from those who think executives are overpaid. The problem is that critics tend to focus on the managers who win big from stock options without considering why so much pay comes in the form of options and the risk a manager takes by accepting options. This difference in perspective has led to confusion of the issues and to proposals for reform that would do more harm than good. Thus, I have collected some common misconceptions about stock options and some straight responses.

1. Stock options are just a way for executives to take advantage of the bull market at the expense of stockholders.

   The cynical view is that executives began to accept stock and options as compensation because they somehow knew that the bull market was coming and was likely to last. But there is no reason to believe that corporate executives are any better able to predict where the market is going than anyone else is (assuming, of course, that insider trading is illegal). Rather, increased reliance on stock and options can be traced to increased focus on stock price as a result of the hostile takeovers of the 1980s, which itself can be traced to the availability of junk bond financing and the growth of institutional investors.

   One early reaction to the threat of hostile takeover was the golden parachute, an attractive severance package designed to compensate ousted management for their lost jobs. Many commentators saw golden parachutes as just another abuse, but a few of us noted, even at the time, that a properly tailored golden parachute could well allow management to coolly consider the merits of a takeover bid from the point of view of the stockholders. Stock options do that, too. And much more.

   To be sure, hostile takeovers are less common than they were in the 1980s. And many commentators bemoan the loss of management discipline that the threat of hostile takeover supposedly induced. But the market for corporate control is even more active today than it was in the 1980s. Of course, the reasons for mergers have changed somewhat. Consolidation and going global are major motivations. Nevertheless, the process of deconglomeration that began with the bust-up takeover of the 1980s is alive and well. Witness the boom in spinoffs and tracking stock.

   In short, the takeover is not dead. It has just gone in-house. Part of the reason may be that potential target managers hope to preempt a hostile takeover. But takeover defenses have become virtually impenetrable. So, why does management so often choose to sell? The simple answer may be stock options and the increased equity stake that so many executives have in their companies.

   The bottom line is that stock options do more for stockholders than motivate management to keep share prices high. Indeed, that may be the least of what they do.

2. Stock options make managers think like stockholders.

   Wrong. Stock options make managers think like owners. There is a difference. And it matters.

   Even if management could be compensated exclusively with stock, perfect alignment of interests would be impossible. Management interest always will diverge from stockholder interest because stockholders are free to diversify. With diversification, an investor can eliminate the risk that some companies in a portfolio will underperform the market. For every company that underperforms, there will be another that exceeds expectations. You win some and you lose some. Only the average really matters.

   A diversified...