This preview shows page 1. Sign up to view the full content.
Unformatted text preview: ed. We are highlighting
the main points of the various rules, in some cases following closely the
wording of the rules themselves. Furthermore, we discuss whether a stockbased compensation plan results in an expense to a company or not. This
chapter also deals with the problems and difficulties in measuring the expense
and recognising the timing of the expense. 3.1 The Concept of Stock-Based Compensation
Stock options are a right to purchase a specified number of shares of a
company's stock at a specified price (called the exercise or strike price) for a
specified period of time (called the option period, or life of the option).
Companies typically grant fixed options, where the exercise price is fixed and
the number of shares can be determined at the grant date. The exercise price
usually is set equal to the market price of the underlying stock at the grant date,
and typically remains fixed over the life of the option, although there are
exceptions. Employee stock options often have a life of 5–10 years and a
vesting period of several years before which the stock options cannot be
exercised (Lynch & Perry, 2003). The vesting period is a “time frame over
which the employee will become eligible to actually own the stock” (Sunkara,
Corporations use stock options as a method of long-term compensation.
Options are more and more often granted to executives and other employees as
an alternative to increases in base pay. Some of the reasons for using stock
options are (Sesil, et al., 2000):
• Options make workers have the same interests as shareholders. Thus,
executives will make decisions that benefit shareholders to a larger
• Options provide an opportunity to reduce executives’ base pay. This
balances the great differences between the salaries of executives and
• Options are also a tax-efficient way to pay employees.
• Options encourage job creation in knowledge-related industries.
• Options help corporations to cope with tight labour markets.
Over the last ten years a shift has been taking place from the exclusive
dependence on a system of fixed wages and benefits to a greater role for equity
21 stakes in companies. While the shift originally began with the rapid growth of
stock option grants to executives, companies also structure remuneration for
broader groups of employees using stock options. While these may not
accom pany w age c uts, t hey m ay s ubstitute f or w age i ncreases
Part of the reason for the rise in stock options in the last decade was the tight
and tightening labour market and the explosion in high technology job creation
and economic growth. Stocks have performed particularly well during that
period and there was an explosion in the growth of technology companies, an
Internet revolution, an Internet start-up boom, and huge run-ups in the stocks of
many of these companies (Sesil, et al., 2000).
The shift toward stock option compensation originally began with the rapid
spread and the rapid growth of stock option grants to executives. Then, it
spread throughout the management and professional ranks of mainly high
technology companies. Gradually, many companies applied portions of future
remuneration for broader groups of employees to stock-based compensation. A
1998 survey of the top 250 corporations in the U.S. found that fifteen
companies had set aside over 25% of their weighted average shares outstanding
for equity incentives for upper management and employees. (Weeden, et al.,
1998). This study found that the average percent of total shares outstanding
allocated for compensation has increased from the 0.3%-0. 5% range in the
1960s to 2% on average in 1998. 3.2 Stock-Based Compensation Effect on Company Performance
There are a variety of theories to predict different effects of stock-based
compensation on company performance. Agency theory predicts incentive
conflicts arise because the interests of senior managers are not aligned with the
interests of shareholders. In order to bring the interests of the two parties into
closer alignment, owners incur cost in the form of incentive contracts (Jensen
& Meckling, 1976).
Other theories suggest that stock options might lower the information costs in a
company because managers’ and employees’ interests become more closely
aligned. This recognises that employees have access to information that may be
valuable to management. The presence of stock-based compensation plans may
result in employees having the necessary incentive to communicate, or act on
their superior information (www.nceo.org/library/optionreport.html).
Additionally, an argument from efficiency wage theory may apply to stock
option plans: the theory says that due to the higher wage rate, employees who
22 work for firms which pay above the market rate may be less likely to quit and
more likely to exert maximum effort. Thus, it is possible that high effortexerting employees are attracted...
View Full Document
This document was uploaded on 10/31/2013.
- Fall '13