Thursday, January 20, 2005

Executive Options
The FT reports that BP will alter its executive compensation plan to eliminate options and focus on stock grants (presumably restricted for some vesting period, or until retirement.) Although this is seen as improving the alignment of interests between management and shareholders, the article is silent on what may be the most important reason that some firms have seen options lead to behavior very much out of synch with shareholder value.

It's easy to forget how options derive their value. Many commentators, and even some option recipients, focus on the value of the shares into which the options are converted when the target or "strike" price is exceeded. Instead, as demonstrated by Messrs. Black and Scholes, the value of options comes from the amount of time remaining before expiration and the volatility of the underlying asset, in this case the stock price. The longer to expiration and the more volatile the stock price, the more valuable the option. This is very different from the benefit accruing to the stock itself, which must see prices rise steadily to generate attractive returns for its holder.

As attractive as options have been as a low-cost--at least initially--way to reward top employees and give them a "piece of the action", they actually reward the creation of stock cycles of seesawing prices; the wider the swings, the better. While this has not been a problem at BP and other major oil companies, it is prudent for them to move toward rewards that motivate the behavior they really want. After all, people are remarkably adept at figuring out how to maximize their benefits under any given compensation system, no matter how poorly it lines up with the goals you are trying to achieve.

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