Can Stock Options Discourage Opportunism?

A recent study (“Should You Reward Your CEO with Stock Options?”) looks at whether stock options can motivate executives to deploy excess company resources to increase investor returns.

The Study

Academics Michael Greiner of Oakland University in Michigan and Scott Julian of the Mike Ilitch School of Business at Wayne State University, also in Michigan, undertook the study to test the following hypothesis:

Stock options and other interventions only help a firm’s performance when its managers might otherwise misuse firm resources—activities known as opportunism.

 

The Sample Size

The study analyzed 1,815 public companies from 341 industries, using financial data from 2010 to 2015.

Study Mechanics

The authors assessed company performance using Tobin’s Q, which divides a company’s total market value by its total asset replacement cost. Essentially this measure looks at what the company is worth vs. what it would cost to replace the company. It is frequently used as a measure of company performance in academic studies.

The authors also evaluated the potential for executives to misuse resources for their own benefit. This requires both of the following to exist at the company:

1. Excess resources. For executives to be able to misuse resources, there have to be some excess resources available to them. For this measure, the authors relied on “absorbed slack,” which they describe as a measure of excess costs available to management. If you have a few hours and enjoy parsing academic-speak, here is a study that explains what absorbed slack is with all the fancy words you could want.
2. Executive discretion. Executives also can’t misuse resources unless they have the discretion/authority to do so. The authors considered how much managerial discretion the executives of each firm had (it isn’t clear how they assessed this). In addition, they treated CEOs who serve on the board of directors as having more discretion, citing research that has shown that CEOs who sit on the board are more powerful.

Finally, the authors considered the company’s debt ratio, under the theory that companies with high debt ratio have to allocate most of their unused resources to paying down the debt, lending agreements often restrict executive discretion, and companies with a lot of debt are usually under more scrutiny from lenders.

Findings

The results of the study support the authors’ initial hypothesis. In their words:

We found that where firms had a higher potential for opportunism on any of the three measures, stock options were indeed associated with higher returns for shareholders. But where managers had little potential to behave opportunistically, such options actually hurt performance.

 

Takeaways

The authors believe that stock options “can be a useful tool to align top managers’ interests with those of their bosses, the firm’s shareholders,” but only where those managers have resources available to them that they could otherwise misuse.

They recommend that, before granting stock options, directors first assess whether there is a substantial risk that managers will misuse resources. Based on this assessment, they offer the following advice to directors:

• Issue stock options only if there is high absorbed slack combined with either high managerial discretion or the CEO serving on the board of directors.
• Don’t issue stock options if there is a low debt ratio.
• Don’t avoid stock options just because they are expensive. (They might be well worth it.)
• Don’t issue stock options just because they are popular. (They might be an expensive and harmful waste of money.)
• Regularly check to see if opportunism risk has shifted since the last stock options decision. (Slack, discretion, debt and board membership can all change.)