Cited in the research is evidence that CEOs who receive substantial option-based compensation are taking high-risk bets with firm capital and are not necessarily betting well.
Differences in performance when the CEOs are paid with in-the-money options or compensation with lock-up periods as opposed to at-the-money or out-of-the-money stock option grants should be expected. The latter tend to incent more risk-taking, but not necessarily smarter risk taking as only upside is rewarded, with downside being relatively painless.
Consider this research applicable to all highly compensated employees, sales people, executives, traders, etc. Entrepreneurs, out of the box, have relatively little at stake save their reputation and start-up capital. The entrepreneurs situation is one where disproprortionate upside reward is warranted, as little curent value exists. The downside is relatively limited for them, creating a return profile similar to an out-of-the-money call option. Entrepreneurs are risk-takers. Their high failure rate suggests that objectively measured, they are collectively not good risk takers. But, those that do take the good risks are highly compensated. From this research, it appears that stock option grants tend to make CEOs behave more like entreprenuers.
Within an established corporation, though, only a small number of highly compensated employees are in roles that parallel that of the entrepreneur. Rather, the majority of highly compensated employees likely fall into a category more like that of the established business owner and should have upside reward and downside risks like an established business owner.
Establshed businesses are more attractive to capital providers and they are expected to have nowhere near the overall failure rates experienced by entrepreneurs. Bad risk-taking will result in a loss of value to the business owners, as good risk-taking will result in increased value to the business owners. Bad risk-taking that eliminates the firm is to be avoided with high probabilty, Again, this is quite different from the entrepreneur. Aligning the risks and rewards for most highly compensated with those of business owners is warranted, and the research seems to confirm this logic.
Among the findings of the research cited in the New York Times article, are:
- stock options encourage CEOs to take relatively large bets, not necessary relatively good bets.
- stock options tend to bring about relatively large outcomes, good or bad. In other words, they increase the volatilty of expected outcomes.
- the heavy use of options brings about more large losses than large gains.
You can download the paper here.
