After years of debate, research shows CEO stock options work
Despite getting a bad name after the global financial crisis, including stock options in a CEO's contract can be a valuable incentive to increase productivity.
The efficacy of stock options as part of a CEO's compensation has long been questioned, with many believing they lead to excessive risk-taking, which is rarely in the best interest of shareholders.
However, recent research from the Melbourne Business School has shown that stock options can actually help align CEO and shareholder interests by incentivising CEOs to increase their company's productivity.
Published in the Journal of Management Studies, the research by Melbourne Business School Professor of Business Strategy Geoff Martin, Professor of Marketing Don O'Sullivan and Associate Professor of Finance Leon Zolotoy, shows that including stock options as part of a compensation package can have previously unexplored benefits for firm performance.
Giving stock options a bad name
Following the global financial crisis (GFC) in 2008, a spotlight was shone on the role executive stock options played in the downfall of organisations.
"Stock options were heralded as one of the evils of the GFC," Professor Martin says.
"They give CEOs an exponential increase in wealth as share prices increase, so we had all these executives with a really strong incentive to up the share price, whatever the cost."
Since then, much research has been done into this relationship between stock options and risk.
"There were two schools of thought, and both gave options a bad name," Professor Martin explains.
"The first is that stock options incentivise excessive risk-taking, and the second is that they accentuate risk aversion once they accumulate value, as the CEOs want to protect their assets.
"Once the options accumulate value, CEOs also have a lot to lose if their risky behaviour doesn't pay off, or if the value of the company stalls or begins declining."
Shedding a new light
Professor Zolotoy who was first author on the paper, explained that in their paper they focused on productivity rather than risk.
"The core goal of stock options was to align incentives between shareholders and CEOs by fostering shareholder value," Professor Zolotoy explains.
"To date, most research explored the implications of CEO stock options for strategic risk-taking, yet ignored other ways in which they might increase value."
The team therefore focused instead on whether options ensure CEOs direct their efforts toward productivity.
They looked at 19,598 firms to establish the relationship between CEO option wealth and measures of their company's productivity.
They found support for their theory that CEOs with higher levels of stock option wealth were more incentivised to increase productivity as this was a mechanism for preserving the share price and therefore, their personal wealth.
The positive effects on productivity also increased as CEO option wealth increased.
"The more the stock options were worth, the more the CEO sought to increase productivity as a risk-free way to maintain, and increase share price," Professor Zolotoy says.
"We were able to show that option wealth isn't all evil – there is another effect here."
'Stock options should not be discounted'
The research provides food for thought for anyone designing a CEO compensation package.
"Our study offers important insight for boards and compensation consultants regarding the benefits of including stock options in their CEO's contract," Professor Martin says.
"While the GFC highlighted the risk associated with the use of stock options, our research has shown that this negative effect can be, at least partially, offset by the benefits that accumulated option wealth offers due to the incentives it creates for additional effort and productivity.
"Stock options should not be discounted."
To read the full research paper, visit Behavioural Agency and Firm Productivity: Revisiting the Incentive Alignment Qualities of Stock Options.
To learn more about our academic research, strengths and insights, visit the Faculty and Research page.