Perverse Incentives Driving CEOs: Stock Options

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When you're the CEO of a major public company, you're usually showered with a lavish pay package that includes a nice salary, a performance bonus (that's often paid whether you perform or not), access to a private jet, and everyone's favorite: stock options.

Options are an almost universal part of pay packages for CEOs, but the question I ask today is: Are they really a good way to align shareholder and CEO interests?

How stock options really work
Options in a company's stock are viewed as a great way to reward CEO for doing a good job because the upside potential is enormous if the stock rises. It also ensures that the CEO doesn't get paid well if shareholders suffer.


But it doesn't align risk well with CEOs and shareholders. It actually gives CEOs an incentive to take more risk than an owner of a company would normally take.

Say a CEO of a $1 billion company gets a salary of $5 million and has stock options to buy shares representing 5% of the company at the current share price. The CEO has a choice between two projects. Both require the same initial investment, but they have vastly different risk profiles. Project 1 has a 90% chance of success for a profit of $100 million, with a loss of $100 million if it fails. Project 2 will succeed only 40% of the time with a $1 billion profit, but it will lose $1 billion if it fails.

 

Success

Failure

Expected Value

Project 1

PV = $100 million

Probability = 90%

PV = -$100 million

Probability = 10%

$80 million
Project 2

PV = $1 billion

Probability = 40%

PV = -$1 billion

Probability = 60%

($200 million)

If you were the sole owner of a business, the choice would be easy. You would choose Project 1, because it's less risky and has a positive expected value. You wouldn't take on Project 2 because of its high risk and expected loss.

But if you're a CEO who is compensated primarily with stock options, the decision changes. If you choose Project 1 and it's successful, your company would rise in value by $100 million. Your options would now be worth $5 million -- a nice bump of a year's salary.

But if the CEO chose Project 2, the company could get a $1 billion bump in value, making those options worth about $50 million. In other words, the CEO would get 10 times as much compensation for a decision that could end up bankrupting the company if it goes wrong -- and which would go wrong more often than not. With CEO tenures getting shorter, choosing to go for a once-in-a-lifetime payday is a decision some CEOs might well make.

CEO pay isn't all the same
I didn't have to look very far to find CEOs who have a very disproportionate amount of their compensation in stock options versus shares they actually own:

Company-CEO

Number of Shares of Common Stock Beneficially Owned

Number of Beneficially Owned Shares That Are Exercisable Stock Options

Percent of Shares That Are Exercisable Options or RSUs

Total Number of Stock Options Awarded

CBS -- Leslie Moonves8.9 million6.9 million76.9%13.1 million
Gilead -- John Martin8.3 million6.3 million76.5%7.1 million
McKesson (NYS: MCK) -- John Hammergren1.6 million1.0 million (includes RSUs)62.8%1.7 million

Source: Most recent company proxy filings.

When the compensation structure shifts toward options, there is a financial incentive to take risks, and these three CEOs are highly tied to options. In fact, they own very few shares outright as a percentage of their beneficial ownership of their companies.

According to Forbes, McKesson CEO John Hammergren made $131.2 million in compensation last year. Included in that amount, $1.66 million was in salary, and $4.65 million was a bonus, but a whopping $112.12 million was from stock-related gains, including exercising vested stock options. In the past six years, he has averaged $50.79 million in overall compensation. It wasn't as if Hammergren is invested in the company's stock heavily, either. He owns 0.24% of the company, or about $51.9 million in stock, less than half of what he exercised in options last year.

What have shareholders gotten in return for Hammergren's enormous payday? A market average return of 9% during the past six years, hardly worth what he's been paid.

Second on Forbes' top-paid list was Ralph Lauren's (NYS: RL) founder of the same name. Lauren sold $37.14 million in stock and got a $19.5 million bonus as part of an overall compensation of $66.65 million, but his fortune and risks were more aligned with shareholders. He still owns 30.4% of the company's stock, and shareholders have enjoyed a 21% rate of return over the past six years.

Lauren made nearly as much as Hammergren in the past year, but his risks were more aligned with shareholders, and that's something investors should look for.

The problem for shareholders arises when most of a CEO's compensation is tied to stock options. It's a heads-I-win, tails-you-lose situation.

The $1 CEO
Taking a salary of $1 has become a popular option for CEOs who want to appear to have their interests aligned with shareholders. In the cases of Oracle's (NAS: ORCL) Larry Ellison, Google's (NAS: GOOG) Larry Page, and Kinder Morgan's (NYS: KMI) Richard Kinder, they all have enough shares in their respective companies to align their interests with investors. This has the appearance of being more aligned than other pay plans that feature options, but it doesn't mean that options don't sweeten the pot.

Ellison took a salary of $1 in 2011 but took 80.8% of his compensation in stock options, about the same as other executives are offered at Oracle. The company says this approach aligns shareholder interests with executive interests, but Ellison was granted 7 million stock options in 2011 with a value of $88.7 million at the fiscal year's end, a hefty payday for shareholders to pay and much more than the advertised $1.  

At the other end of the spectrum, Larry Page and Sergey Brin at Google have taken virtually zero in compensation in the past year because of their large stakes in the company, aligning them perfectly with shareholders. Richard Kinder also received a total compensation of just $1 in 2011.

Don't think a $1 CEO is giving a gift to shareholders. CEOs still make plenty of money, but those who don't sweeten the pot for themselves with options get a thumbs-up in my book.

Stock options aren't always best
Options are viewed as a great way to give CEOs upside potential if they perform well and nothing if the stock doesn't rise while they have the options. The problem is that the upside potential doesn't account for risk, and unless your CEO has a large position in the stock, like Google or Oracle's CEOs, they may have an incentive to take more risk than a CEO compensated with cash or stock.

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At the time this article was published Fool contributorTravis Hoiummanages an account that owns shares of Kinder Morgan. You can follow Travis on Twitter at@FlushDrawFool, check out hispersonal stock holdings, or follow his CAPS picks atTMFFlushDraw.The Motley Fool owns shares of Oracle and Google.Motley Fool newsletter serviceshave recommended buying shares of Google, McKesson, and Gilead Sciences. The Motley Fool has adisclosure policy.
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