Stock options best form of executive pay ever devised

EXECUTIVE PAY

Stock options best form of executive pay ever devised

Despite what critics say, share options don’ t encourage business leaders to boost share values in the short term for their own selfish gain. Quite the contrary, writes Brian Hall in a recent edition of Harvard Business Review. They are the best compensation mechanism for getting managers to act in ways that ensure the long-term success of their companies and the well-being of their workers and stockholders.

But misgivings about this type of executive reward are well warranted , admits Hall, an associate professor at Harvard Business School in Boston, USA. They are bafflingly-complex financial instruments. They tend to be poorly understood. And all too many companies end up with counterproductive plans.

For Hall, the lesson is clear: It’ s not enough just to have an option programme you need to have the right programme.

The case against option grants

Stock option grants have rapidly come to dominate executive compensation packages across corporate America. But their impact on business in general is controversial. Simply stated, the main goal in granting stock options is, of course, to forge a link between pay and performance. According to some very vocal critics, option grants have not achieved that goal.

Critics lay three main charges against option grants, says Hall.

The grants:

  • shower ever greater riches on top executives, with little connection to corporate performance

  • appear to offer great upside rewards with little downside risk

  • motivate corporate leaders to pursue short-term moves that provide immediate boosts to stock values rather than build companies that will thrive over the longer run .

But this criticism does not stand up to close examination, says Hall. In his nine-page article for the prestigious US business magazine, he rebuts in turn each of the charges against stock options.

What he has found is that the critics of options are mistaken. Options do not promote a selfish, near-term perspective on the part of business people.

In Hall’ s view, there is a growing body of evidence that shows option grants have dramatically strengthened the link between pay and performance .

What’ s more, stock options are, without doubt, the ultimate forward-looking incentive plan. They measure future cash flows, and through the use of vesting, they measure them in the future as well as the present. They don’ t create managerial myopia they help to cure it.

Rather than scrapping option grants, Hall recommends that if you want to encourage a more far-sighted perspective, you should simply extend their vesting periods.

Hall concludes with a powerful message for the sceptics: While there are many reasons American companies have flourished over the last two decades, it’ s no coincidence that the boom has come in the wake of the shift in executive pay from cash to equity.

Want to know more?

Title: What you need to know about stock options , B Hall, Harvard Business Review, March-April 2000.

Availability: contact Harvard Business School Publishing, 60 Harvard Way, Boston MA 02163, USA, tel: 001 617 4956800.

To discuss Hall’ s article, visit the HBR forum at the Harvard Business Review web site . . . www.hbsp.harvard.edu