This chapter also deals with the problems and

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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, 2000). 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 extent. • Options provide an opportunity to reduce executives’ base pay. This balances the great differences between the salaries of executives and other employees. • 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 ( 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...
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This document was uploaded on 10/31/2013.

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