WFU Law School
Law & Valuation
4.4.2 Basic Option Valuation

4.4.3 Option Applications


Executive Compensation. Perhaps the area where stock options are most pervasive is executive compensation. Frequently, companies will award key executives or board members lucrative stock options in addition to their base compensation. A frequently-stated purpose of such awards is to align the interests of the executive (maximization of personal wealth) with those of the company's owners (maximization of shareholder wealth).

The story of executive compensation in the United States is an interesting one:

In the 1990's commentators and consultants urged corporations to attempt to align executives' interests with the interests of shareholders by offering executives highly contingent, long-term incentive compensation tied to the price of their corporation's stock. Boards of directors responded by authorizing, or urging shareholders to authorize, generous stock option plans that in many instances constituted 75% of the total compensation package. When coupled with the rapid rise in stock prices in the mid 1990s, the stock option plans led to sharp increases in the compensation paid to corporate executives, and, in particular, to chief executive officers. Business Week reported in 2000, the average compensation for CEOs was $13.1 million and that the twenty highest paid CEOs earned an average of $117.6 million. Executive Pay, Business Week(Apr. 16, 2001).

The theory for stock options is that they create incentives for managers to make business decisions that would increase the value of the shares for all shareholders. But has the theory worked in practice? The evidence is unclear. Many critics assert that stock options have failed to align the CEO’s interests with that of the corporation. Instead, stock options have became a short term "inducement for greed -- for CEOs to find a way to run up the share price, then sell their stock before it fell.” Michael Hoffman, Executive Director, Bentley College Center for Business Ethics, CEO Pay Tomorrow: Same as Today, Business Week (Aug. 21, 2002). Two other scholars observe that "high powered incentive contracts * * * create enormous opportunities for self dealing for the managers, especially if these contracts are negotiated with poorly motivated boards of directors * * *." Andrei Shleifer & Robert W. Vishny, A Survey of Corporate Governance 14 (NBER Working Paper 5554, April 1996). They note a recent research paper that found managers often receive stock option grants shortly before good news is announced and delay such grants until after bad news is announced. They suggest "that options are often not so much an incentive device as a somewhat covert mechanism of self-dealing." Id.

What do these high priced compensation packages get the company? Professors Bebchuck, Fried and Walker propose that in practice, executive compensation is determined not by an optimal contracting process but by the “managerial power approach,” which incorporates the executives’ ability to influence the compensation scheme. The executives are able to extract rents (a level of compensation that exceeds the compensation plan optimal for shareholders) because three mechanisms are absent: (1) the board, acting at arm's length, selects the compensation arrangement that maximizes shareholder value; (2) although the board acts under the influence of management, executives are constrained by market forces to select the compensation arrangement that best serves shareholder interests; or (3) shareholders can use their rights under corporate law to block pay arrangements that are not optimal for shareholders, which forces executives to adopt arrangements that maximize shareholder value.” Lucian Arye Bebchuk, Jesse M. Fried, David I. Walker, Managerial Power and Rent Extraction in the Design of Executive Compensation, University of Chicago Law Review, 69 U. Chi. L. Rev. 751, 767 (2002). See also Marianne Bertrand and Sendhil Mullainathan, “Do CEOs Set Their Own Pay? The Ones Without Principals Do,” Working Paper 7604, National Bureau of Economic Research (2000), finding that when the CEO “captures” the pay process, she or he receives greater compensation ceteris paribus for the firms performance that due to exogenous forces outside the CEO’s control (“luck”).

Bauman, Weiss & Palmiter, Corporations (West Group 2003).


When shareholders approve a stock-option plan, must the proxy disclosures include a Black-Scholes valuation of the plan options? In Resnik v. Swartz, 303 F.3d 147 (2d Cir. 2002), the court held that under SEC rules a company can provide either "potential realizable value" or "grant date present value" of options to executives. That the company chose not to provide grant date present value under Black-Scholes did not render the rpxy statement misleading.

Armed with basic information on an option plan, shareholders must undertake the valuation task themselves. Companies have no duty to disclose this!


Calvin Harsha Johnson, "Why Stock and Stock-Option Compensation are Such a Terrible Idea" SSRN 474362

Stock options have grown over the last decade to take up an increasing percentage of the increasing compensation of top management. Stock options worth millions of dollars are reported to public investors as if they were free, and that allows top management to schnooker more salary from shareholders than they would otherwise get. The popularity of options is best understood as arising from deceptive accounting. But for the opportunity to understate compensation cost, stock compensation is a terrible idea. Take away the accounting advantage and compensatory stock and stock options would undoubtedly die off on their own.

First, stock options give management truly perverse incentives to invest in projects with too much downside risk. Option holders participate in gains but not loses, so an option holder will rationally send the company into risks that would scare the flesh off of shareholders who do bear the losses.

Second, stock and stock options carry an unnecessarily high discount rate. The high discount rate means the executive gets the least current value per dollar to be paid or requires the highest future cash payment per dollar of current value or both. Stock carries a high discount rate because of unwelcome volatility in the price of the stock and because of market paranoia about management plans about retained earnings, and neither the volatility nor the paranoia is a necessary virtue of any compensation plan. Better management of the discount rate would avoid stock.

Third, stock compensation, gives employees capital gains, but compensation would almost always be more efficient if employee capital gains were avoided. Deferred compensation is almost always better for the executive because it delays the tax bite on their capital. Even if there is no upfront tax on capital at stake, employee capital gain is usually inferior tax planning because it loses the employer deduction.

This is an edited version of Stock and Stock-Option Compensation: A Bad Idea, 51 Canadian Tax J. No. 3, (Oct. 2003) with the special Canadian concerns deleted out.


Example

Michael Ovitz, a Hollywood mogul, was hired as President of the Walt Disney Company in 1995. Within a year, after a tenure marked by discord and failure, he left Disney with $140 million in executive compensation. Was his compensation justifiable?

A major component of Ovitz's compensation package came in the form of stock options:

Selected Terms of the Ovitz Package (Agreed to Oct 1, 1995)
Base Salary $1 million annually
Set A Stock Options 3 million shares
Set B Stock Options 2 million shares
Discretionary Bonus To be determined
If employment ends by non-fault termination...

...Ovitz entitled to:

  • PV of remaining salary payments under original agreement
  • $10 million severance payment
  • Additional $7.5 million for each fiscal year remaining on contract
  • All Set A Options, which vest immediately
If employment ends by good cause termination... ...Ovitz entitled to no additional compensation

How was this package approved? Did anyone notice that Ovitz was better off terminating his employment rather than continuing? Evenutally, the Delaware courts would consider a shareholder challenge to the Ovitz pay deal. At first, the Delaware judiciary at first seemed reluctant to intervene. (More>>)

FASB BACKS EXPENSING STOCK OPTIONS AT FAIR VALUE

The Financial Accounting Standards Board takes its first steps toward adopting standards that companies should recognize stock-based compensation as an expense in their income statements. The proposed model calls for measuring the value of the options as of grant date. Many companies have already shifted to expensing stock-based compensation to rebuild investor confidence. . . .

http://pubs.bna.com/ip/BNA/car.nsf/is/a0a6t6e3w1


DIRECTORS SEEN NEEDING SOPHISTICATION AS EXECUTIVE PAY GETS MORE COMPLEX

As investors focus on curbing excessive executive pay packages, corporate practices are changing to give directors more detailed information on compensation programs as well as more time to understand the information and its implications, experts in executive compensation tell BNA. Compensation committees at larger companies are often sophisticated and are asking more questions themselves about pay plans, while committees at many smaller companies tend to rely more heavily on consultants to lay out the issues for them, one attorney says. . . .

http://pubs.bna.com/ip/BNA/car.nsf/is/a0a8g6p5z0



Why some cowardly companies still won't count stock options as expenses. Slate By Daniel Gross

Shareholders of software company PeopleSoft yesterday voted to recommend that management declare a loss instead of a profit. That's because some 53 percent of the votes cast in its annual shareholders elections favored a proposal to treat stock options as an expense. Doing so, as the Wall Street Journal reported, would have had the effect of turning the company's 2003 profit of $85 million into a loss of $75.5 million.

Have investors suddenly been seized by a fit of irrationality? Of course not. Next week, the Financial Accounting Standards Board is expected to release a final draft of rules that would mandate companies report stock options as expenses. (more>>)


Wall Street Journal - Here Comes Politically Correct Pay (April 12, 2004)

Board members are looking at CEO pay practices through the eyes of angry shareholders, regulators and employees. That already means some big changes.

Welcome to the new world of politically correct pay. Directors increasingly scrutinize their leader's compensation through the eyes of irate shareholders, workers and regulators. Hoping to make the top honcho's pay more palatable to critics, some are embracing innovative equity plans with steep performance hurdles, ceilings on option windfalls and lengthy stock-retention requirements. Other boards are dropping the most controversial practices, such as megagrants of restricted stock and options, huge departure packages and "evergreen" employment contracts that renew automatically.

"More companies get the message: The old rules don't apply anymore," says Richard L. Trumka, secretary-treasurer of the AFL-CIO in Washington. But in the name of better optics, he cautions, "there's a lot of smoke and mirrors." (More>>)

 

Merger stock lockups

A common component of negotiated corporate acquisitions is the granting by the acquired company of stock options (a stock lockup) to the acquiring company. The options serve to cement the deal, making the acquired company more expensive for rival suitors and gives the acquiring company a consolation prize if an interloper succeeds or the deal otherwise goes awry.

Smith, Thomas A. Real options and takeovers. 52 Emory L.J. 1815-1845 (2003). [L][W]

... In Unocal Corp. v. Mesa Petroleum Co., the Delaware Supreme Court ruled that takeover targets could adopt defensive tactics, so long as they were proportional to the threat posed by a hostile tender offer. ... Real option theory helps explain how certain features of corporate democracy and shareholder voting give shareholders important powers, and how some well-intentioned "reforms" might have unintended and undesirable consequences. ... Suppose a call option gives one the right to buy one hundred shares of Microsoft anytime in the next thirty days for $ 75 per share, and that Microsoft is currently selling at $ 70 per share. ... This data, plugged into option pricing models, should provide some idea of whether a bidder could plausibly claim that its tender offer exceeded the target's trigger price. ... Real option theory is also very different from DPV theory in the way it deals with the history of target stock price. ... If some legal rule forces the owner to sell, and get only the DPV of the asset, he has been deprived of its option value. ... Also, the Revlon rule, which under certain circumstances compels the target corporation to sell itself to the highest bidder, would appear to extinguish the real option value inherent in the power to time the sale of the target - a cost that is not taken into account in the legal doctrine. ...

Smith v. Van Gorkom

A famous corporate law case -- Smith v. Van Gorkom -- raises questions about the usefulness of stock option valuation in resolving fairness issues in a negotiated merger. In the case a corporate acquirer demanded a stock option as consideration for buying a business.

Why would somebody planning to buy a business want an option to buy additional stock in the business? What was the value of the stock option - to the acquirer and to the company? When a shareholder claimed the board had negligently sold the company too cheap, should the reviewing court have paid attention to the option's value? (More>>)

 

4.4.2 Basic Option Valuation

©2003 Professor Alan R. Palmiter

This page was last updated on: October 20, 2004