Friday, September 26, 2008

Share Based Compensation and Incentives

There are many different ways to compensate company employees. Share based compensation is intended to align employees' interests with those of the existing shareholders, but it doesn't always work out this way. In general, the more responsibility you have in a company the more potential you have of receiving significant amounts of share based compensation. Different forms of share based compensation have different benefits and drawbacks and this post will examine a few of them.

Some of the different types of share based compensation schemes include:

1) stock grants
2) stock options
3) stock appreciation rights

Stock grants are company shares that are granted to employees and often are contingent upon achieving specific company performance goals. Achieving performance goals is often measured through various accounting metrics. One of the drawbacks to stock grants that are dependent upon accounting numbers, is that managers often have influence over company accounting and this could lead, however unintended, to accounting manipulation (a few names certainly come to mind).

One of the problems in awarding stock options, is that they have significant upside potential without the downside risk. This imbalance between risk and reward may lead to overly risky employee behaviour, as discussed in Security Analysis. Stock options are worth more when the market price of the company stock moves higher, and so employees, especially executives, may act imprudently (examples here) by rushing to take on risky projects in an attempt to make their option holdings more valuable.

Both stock grants and stock options can lead to ownership of the company's shares by employees. One of the advantages of having share ownership is purportedly that employees will think and act more like shareholders. One of the criticisms against employee company share ownership, is that they may behave too conservatively in an attempt to protect their stock capital. Personally, I have a hard time with that argument, especially if I measure the statement against Warren Buffett, who as the largest shareholder of Berkshire Hathaway does not seem to have suffered in his management style due to significant share ownership.

Nevertheless, one way to circumvent potentially cautious employee behaviour due to share ownership, is through stock appreciation rights of SARs. With SARs, the employees' share compensation depends on the movement in the stock price and does not depend on having ownership of the stock. In addition, SARs do not cause ownership dilution amongst existing shareholder's but they do require a cash outflow from the company if they are paid out.


Reyer Barel said...

Consider the following entrepreneurs and ask yourself if you feel that share ownership caused them to act too conservatively:

Sam Walton - Walmart
Larry Ellison - Oracle
Bill Gates - Microsoft
Marc Andreeson - Netscape, Opsware
Dave Packard - Hewlett and Packard

These are just a few of business owners that come to mind and I wouldn't classify any of them as overly conservative managers.

If you made a list of every manager with substantial share ownership that you knew of, how many of those managers would you classify as acting overly conservative because of their level of stock ownership? I suggest that the list would be far outweighed by the managers that acted appropriately or perhaps even a tad agressively in order to maximize the value of their shares!

I referenced Warren Buffet in my post because I believe him to be the quintessential counter example to the argument that increased levels of share ownership can cause managers to act overly conservatively. Of course Warren is an exceptional manager, but there are many other managers I can think of that acted in a shareholder friendly manner, precisely because they had significant share ownership (the cause of dual class shares notwithstanding)!


Bike Crashes UK said...

Why is stock-based compensation added to net income? I understand the equation but not the reasoning. Is it because it needs to be added to operating expenses in order to determine operating income?

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