Skip to contentSkip to navigation

The “Dos” and “Don’ts” of Options Grants

(originally published by Booz & Company)

Stock-option compensation plans have been at the center of public debate recently, but most discussions fail to consider a hidden value of options. While much of the attention has focused on how companies account for senior executives’ princely stock-option packages, a more fundamental question is which workers should get options grants and why.

Stock-option grants are an important resource to help companies manage their compensation costs and retain employees at all levels. The classic justification for offering options is that doing so provides incentives that align employee and shareholder interests. For senior executives and employees of startup companies, the economics from stock options can be attractive, and thus serve as effective motivators. But the incentives built into most employee packages appear less than compelling. Indeed, the options held by a typical middle manager of a firm with 1,000 employees might represent a 0.01 percent stake in the company. Suppose those options induce him or her to frequently spend nights or weekends working. If that hard work created (an optimistic total of) $1 million of shareholder value over the course of a year, it would net the manager $100. That’s not much of an incentive.

But just because options grants are unlikely to affect the on-the-job behavior of the rank and file doesn’t mean options should be abandoned. An important and underappreciated benefit of stock options is that they can keep compensation in line with changes in market wages. In the late 1990s, for example, Silicon Valley engineers were in high demand, so their total compensation (in cash and options) rose dramatically. If those engineers had been compensated entirely in cash, their salaries would have been exorbitantly high. But large stock-option grants in a booming industry meant those engineers’ salaries could be kept lower while their options became valuable. When the recession hit the region, engineering jobs became less plentiful. Likewise, the engineers’ options became less valuable, and total compensation dropped. So while the boom and bust made dramatic swings in total compensation necessary, the use of options allowed companies to keep salaries relatively stable. Options fluidly adjust overall compensation, both upward and downward, in connection with the firm’s and the industry’s prospects, and thus can be an efficient mechanism to retain employees.

Which firms can benefit from this natural pay-adjustment process, and to which workers should they be issuing options? The best compensation strategy may be defined differently among different geographic regions, even for the same types of employees.

Consider two software companies — one in Palo Alto and the other in Chicago — each trying to balance cash salaries with stock-option grants for its accountants. Demand for accountants in the Palo Alto area is high when the technology sector is doing well. In this environment, the software firm should offer accountants higher options and lower wages. With stock options becoming more valuable in such boom times, these individuals would be less likely to move to another Silicon Valley firm. And the increasing value of the options gives the firm the flexibility to moderate salary levels and still retain talent that is in great demand. If the tech sector busts, the accountants’ options would be worth less, but there also would be fewer opportunities for them to job hop.

On the other hand, in the Chicago area, where the supply of accountants is large but high-tech firms are a relatively small employer, the software firm would be better off paying higher wages with lower options grants. If the Chicago firm issues options and pays less cash to its accountants, the accountants might become wealthy when the technology sector is doing well, even though the demand for their services would be unchanged. Significantly, however, if the technology sector and the firm perform poorly, the firm’s accountants would suddenly find their cash compensation inadequate, and, with their options under water, many would leave the firm for other companies in Chicago.

Times have changed in the labor market, and firms should review their options-granting policies, not just their accounting policies. An employer that needs wage flexibility, and that has a market value related to its workers’ market wages, should consider issuing stock options broadly. But remember that these options are not great for motivating recipients; the options are used to manage and smooth compensation costs as labor markets change.

Paul Oyer,
Paul Oyer  is associate professor of economics at Stanford University’s Graduate School of Business. His research concentrates on incentives, the effects of firing costs, and other areas of the economics of human resources.
Get s+b's award-winning newsletter delivered to your inbox. Sign up No, thanks
Illustration of flying birds delivering information
Get the newsletter

Sign up now to get our top insights on business strategy and management trends, delivered straight to your inbox twice a week.