Stock Options Effectiveness for Management Compensation - Literature review Example

Abstract

Stock option is the most effective management compensation. It carries lots of benefits for the company, the mangers and the shareholders. The benefits can also be found in other forms of compensation but in much less values. This study shows that the employees profit the most from this payment scheme, followed by the company then the shareholder. There also a number of demerits related to options. The company is the most disadvantaged with this method of payment, then the shareholders and then workers are the least affected by its negative outcomes. The conditions in which any of these disadvantages can occur is always one: if the company income reduces significantly necessitating a big decline in stock prices. However, most of the demerits of this method can be avoided through strategic planning and expert advice and the advantages be maximized for the benefit of all the parties interested in company performance.

Stock options are effective for management compensation

Introduction

There are several varied views of management experts and researchers concerning the most effective form of staff and management compensation between stock options and other compensations. This paper therefore, disambiguates this contention by relating the values of stock option over other modes of compensation to both the management and the entity they work for. This discussion relies on studies done by other scholars and current expert opinions in the area. Like all other forms of compensation, options have a number of merits and demerits. However, in the interest of all parties involved in the business, the merits outdo the demerits.

Why stock options are effective

According to Booth (2009), there is no better compensation to company executives than stock options. Stock options give the company an opportunity to put the interests of the mangers in line with those of the shareholders. The managers do not only strategize for profit, but also will become more careful about ensuring the company does not incur losses so that stock prices don’t fall. With options, reduction stock prices will mean no compensation while an increase attracts reward for the CEO. Secondly, options give the market an idea of a company with better future prospects because the number of options given is normally dependent on future income. Thirdly, options motivate companies to enter mergers and takeovers and control asset portfolio as deemed necessary. Determination of the quantity of options is however difficult to agree upon. This fact makes some argue that options may make managers overpay themselves without knowledge of the directors. It is also thought that as a motivation, stock options may tempt CEOs to venture into risky management approaches geared at increasing the stock prices. These claims are not true because options have external market control determining the extent of use. E.g. if a company gives out options, it has to buy shares again to manage dilution. Due to cash limitation, a company is limited in its offer of options. Abuse of this mode of payment through backdating and other calculation issues can be avoided by announcing and fixing the due date in advance.

There is a significant relationship between payment through stock options and the performance of workers. Knowing that their stock benefits will be determined by performance of the entity, which dictates the stock prices, employees work harder to ensure good outcome. A study conducted in Technological companies in Taiwan indicated this relationship. For the employees, options have greater effects on the stock benefits than on dilution. Market factors check the possibility of options ending up in dilution. Secondly, stock options induce good performance in the employees as a motivation while possibility of dilution is never a concern that has effect on employee performance. From the gathered evidence, it is provable that stock options as well as stock benefits have a motivational effect on the delivery of company employees. However, the study never ventured into proving whether giving employees this form of compensation dilutes stocks of shareholders (Chen, 2007).

Jensen & Murphy, (2010) say that stock option compensation began to gain popularity as an effective incentive for CEOs in the late 19th century to curb many performance dynamics that fluctuated earnings of the managers. For instance, salaries of CEOs in America have been increasing since the 1980s to match the relative growth in the business industry. They say for the previous 50 years, business and economy had been growing while CEO pays were not changing at the same pace. As percentages of the company capital, it always went down as company income increased. Therefore, having CEOs own some shares, means that they also benefit in terms of income as the company capital increases. It is not only serving as motivation but also as a fair dealing. With options, rewards were meant to encourage good performance but they also carry penalties for poor performance. It was also a shift of attention from achievement-salary justification towards mutually inclusive achievement. Now people don’t work for salary increment but for raising company capital value.

Managers of public and private companies can get stock option without taxation until when they want to sell their shares. Due to the difficulty of selling shares in private companies, employees hardly the benefit tax charged on implementation of the share transfer. This is how with time, managers have become owners of private companies. In countries like Canada, the tax charged on employee benefit is lowered by 50% if the exercise prices exceed the shares and if the worker keeps the shares for at least 2 years before selling them. As they seek to benefit from the financial cushion of keeping the shares for two years, options become incentives to make workers stay with the company. However, once they own shares, the management employees can have the full rights of shareholders like access to company financial reports (Chhabra, 2008)

A feature published in the Forbes Magazine explains that the use of options as incentive for employees has a number of advantages for both private and public companies. The benefits listed in the article have all been discussed in this paper. They include shelving of immediate cost on the employee, being an inducement for value gain in company, offer of tax flexibility and being an avenue to ownership.

On the other hand, for a number of reasons, privately owned companies need to be cautious about using options to add work outcome value. Ownership of shares make the management staff part of the shareholders and they begin to assume watchdog roles alongside their designated duties. They critically analyze the use of finances, distribution of earnings and want to influence important board room decisions. Secondly, it is difficult to sell the entity because keeping your making market enquiry from knowledge of all workers is impossible. Where there are too many holders with small stocks, determination of asset prices is also difficult. Besides, having to include options in accounting reports and deciding the quantity of options to issue brings in complexity in management and operation. Moreover, options bring in deferred compensation which cushions employee benefits attract tax fine on the company. Lastly, if the company does poorly and the stock prices go low, the employees compensated in form of options will be demoralized if they miss incentives after being conditioned to it. ("Forbes Welcome," n.d.)

Other scholars hold that stock option succeeds in the long run. It controls dilution by repurchasing shares of the employees and provides good work incentive. Nevertheless, it can also be an enticement for mangers to unscrupulously raise stock prices at present without caring about the future value of company stock. One of the ways this has been done is through manipulation of accounting income. The managers are also many times tempted to take risks that may be overstretching the interests of stock owners. If such risky investments succeed, the stock benefits increase for shareholder and stock options are huge for the managers. However, if they fail, the managers have no stock option and shareholders’ stock equity suffers great blow. Finally, it only takes a significant decline in stock prices and options are a forgotten story. Hence, workers miss incentive (Whittington, & Delaney, 2011).

The last disadvantage of stock option in management compensation is that they can threaten unity and cooperation in a company. When an employee becomes the shareholder and has conflict of interest between designated roles and auditing role, they become difficult to work with. Again, decisions about options have been a common cause of disharmony between mangers and the directors as well as the shareholders. Sometimes, CEOs are driven by the incentives to secretly make subjective decisions that contravene the interests of the directors as they try to increase stock prices. (Reviews C. T., 2013)

Conclusion

In conclusion, stock options as compensation for management have many advantages for the company, the workers and the shareholders. For the company, it is an incentive for better performance that leads to better capital value of the entity, it gives positive future prospects to the public, it helps retain workers and determines decisions about portfolio of asset. For the worker, it offers income with tax flexibility, a compensation for hard work and an opportunity to own the company. For the share holders, if the stock prices go up due to the incentive, the stock benefits also increase. There are also disadvantages of this compensation method to all the stake holders. Beginning with the company, it makes the employees accessible to sensitive company financial revelations that may affect their cooperation with the company; the company incurs charges of tax from deferred payments and poor control of options can dilute stock equity. For the workers, it can trick them into retention in a company and can be demoralizing some times. For shareholder, it can dilute share prices or make mangers get into affairs that can lead to losses. Nevertheless, options remain the most effective mode of management compensation.