The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options

Abstract

Finance theory has long recognized that the incentive-alignment benefits from equity-linked compensation plans are inevitably tempered by certain deadweight costs to the firm, but relatively little empirical work has been devoted to identifying and measuring those costs. Boards and their compensation advisors attempt to measure the value of the compensation packages they award, rarely studying the real cost of such plans, measured as the difference between the market value of the instruments granted and the value managers place on those instruments. This value difference arises because incentive plans compel managers to hold sub-optimal portfolios. Sub-optimality occurs when managers prefer to hold a contingent claim on the firm's stock that differs from the one the compensation plan forces them to hold; financial engineering can, in principle, mitigate this cost. Sub-optimality also results from the manager's loss of full portfolio diversification. This latter source of sub-optimality is an unavoidable deadweight cost: to align incentives, the firm's managers must have concentrated exposures to that firm's specific risks, but this forced concentrated exposure prevents the manager from optimal portfolio diversification. As a consequence, undiversified managers value stock or options at less than their market price, for equilibrium market returns, determined by well-diversified investment strategies, do not fully compensate managers for their exposure to the firm's total stock price volatility. The firm, therefore, always faces a tradeoff between the benefit of aligning managerial incentives, and the cost of paying managers with instruments that the firm could otherwise issue at a higher price in the market. This paper derives a method to measure the deadweight cost associated with inefficient diversification, and then estimates its magnitude for a broad spectrum of firms. Empirically, this deadweight cost is quite large, particularly in rapidly growing, entrepreneurial-based firms. For Internet firms, the estimated value of stock options to undiversified managers is only 53% of their cost to the firm, prompting questions of whether compensation plans in such firms are weighted too heavily towards incentive-alignment to be cost effective. This result also has a further implication for those who interpret insider sales as signals of firm overvaluation: namely, managers can believe that their firm's stock is substantially undervalued by the market, and still prefer to sell stock, whenever they are not restricted from doing so.

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