What You Need to Know About Stock Options

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Author: Brian J. Hall
Date: Mar. 2000
From: Harvard Business Review(Vol. 78, Issue 2)
Publisher: Harvard Business School Press
Document Type: Article
Length: 5,532 words

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Despite what critics say, stock option grants are the best form of executive compensation ever devised. But just having an option plan isn't enough. You have to have the right plan.

TWENTY YEARS AGO, the biggest component of executive compensation was cash, in the form of salaries and bonuses. Stock options were just a footnote. Now the reverse is true. With astounding speed, stock option grants have come to dominate the pay -- and often the wealth -- of top executives throughout the United States. Last year, Jack Welch's unexercised GE options were valued at more than $260 million. Intel CEO Craig Barrett's were worth more than $100 million. Michael Eisner exercised 22 million options on Disney stock in 1998 alone, netting more than a half-billion dollars. In total, U.S. executives hold unexercised options worth tens of billions of dollars.

It would be difficult to exaggerate how much the options explosion has changed corporate America. But has the change been for the better or for the worse? Certainly, option grants have improved the fortunes of many individual executives, entrepreneurs, software engineers, and investors. Their long-term impact on business in general remains much less clear, however. Even some of the people who have profited most from the trend express a deep discomfort about their companies' growing dependence on options. Do we really know what we're doing? they ask. Are the incentives we're creating in line with our business goals? What's going to happen when the bull market ends?

Option grants are even more controversial for many outside observers. The grants seem to shower ever greater riches on top executives, with little connection to corporate performance. They appear to offer great upside rewards with little downside risk. And, according to some very vocal critics,, they motivate corporate leaders to pursue short-term moves that provide immediate boosts to stock values rather than build companies that will thrive over the long run. As the use of stock options has begun to expand internationally, such concerns have spread from the United States to the business centers of Europe and Asia.

I have been studying the use of option grants for a number of years now, modeling how their values change under different circumstances, evaluating how they interact with other forms of compensation, and examining how the various programs support or undermine companies' business goals. What I've found is that the critics of options are mistaken. Options do not promote a selfish, near-term perspective on the part of businesspeople. Quite the contrary. Options are the best compensation mechanism we have 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 I've also found that the general nervousness about options is well warranted. Stock options are bafflingly complex financial instruments. (See the sidebar "A Short Course on Options and Their Valuation.") They tend to be poorly understood by both those who grant them and those who receive them. As a result, companies often...

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Gale Document Number: GALE|A60471889