Stock Options' Perverse Incentives
By Whitney Tilson
, I presented an overview of stock options, highlighted their good qualities, and began my critique
by underscoring the insane accounting for them. Today, I'd like to continue my critique by analyzing the incentives
-- often perverse -- that stock options create.
The differences between stock and stock options
A stock option is the right to buy a stock, for a certain time, at a certain price. While the value of an option is
certainly tied to the value of the underlying stock, they are by no means identical. An option is essentially a
leveraged way to own a stock: If the stock price rises, the option's value rises faster, and vice versa. For example,
let's say an employee has an option with a strike price of $15 and the stock is at $20. Assuming the option has
vested, the employee can convert the option into a share of stock by paying the strike price, then sell the stock and
pocket the $5 gain.
Now let's consider what happens if the stock price rises 25% to $25: The option increases in value by 100% to
$10. Conversely, if the stock falls 25% to $15, the option's immediate realizable value falls 100% to zero (assuming
it can't be sold, which is the case with almost all employee stock options). Most importantly, if the stock continues
to fall below $15, stockholders lose more money, while the option holder isn't affected very much, as the option
was already worthless (though as the stock price falls further below the strike price of the option, the chances that
the stock ever rises above the strike price in the future diminish).
Option holders benefit and suffer disproportionately as the stock price rises and falls -- as long as the stock price is
above the option strike price -- but are less affected by stock price movements below the strike price.
Swing for the fences
Why does this matter? Because management teams are constantly presented with various opportunities to make
acquisitions, invest to expand the business, issue debt, and so forth. Each decision has a certain risk-reward
equation: Shareholder value can be enhanced, but it can also be destroyed, so making the right call is critical. At a
bare minimum, as a shareholder I want to make sure that management has the same incentives I do: They profit if