Thursday, September 4, 2008

From Buffett's Basket: Options and Executive Pay

Buffett warns that company granted options can rise in value simply because management holds onto retained earnings (keeping them from the shareholders) in a company rather than due to any exceptional management skills. Think of a savings account that allows interest to accumulate. A manager would have to do nothing other than retain the earnings to see the profits grow and the value of the account rise. This however, does not imply the management has done anything exceptional with the retained capital.

Managers with long term, fixed price options have time on their side to allow retained earnings to appreciate the value of their options. This is an all too common occurrence in corporations where retained earnings are withheld from owners, increasing the value of options to the benefit of managers. For this reason, Buffett advises that long term fixed price options should reflect a cost of capital charge and a hurdle that needs to be overcome before allowing managers to benefit from the options. In this way, the options structure can be fair to the existing shareholders.

Another problem with options is that they often result in selling a piece of the business at under fair value. Think of yourself as an owner of a company, would you ever want to sell pieces of their business to outsiders at less than its real worth? Yet, this is exactly what happens when options are issued at market prices that happen to be below the actual business value. For the good of all company shareholders, Buffett counsels that options should be priced at the true business value of a company.

Lastly, company options should only be awarded to managers with overall responsibility in a company. Buffett gives the example that if See's Candy does well, the managers at See's will benefit from that but will not get bonuses based on how Berskhire Hathaway performs. In the same way, managers at See's would not have their bonuses reduced if Berkshire Hathaway performed poorly but See's performed well. Buffett believes that a manager should be rewarded on what is in their control to affect.

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