The Executive Compensation Controversy - Fondazione Rodolfo ...

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THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSIS2.2.2. The “Cost” vs. the “Value” of Incentive CompensationIn constructing measures of total compensation, it is important to distinguish betweentwo often-confused but fundamentally different valuation concepts: the cost to the companyof granting the compensation and the value to an executive from receiving the compensation.Consider, for example, a company that decides to give a share of restricted stock to its CEOvesting in five years (that is, the CEO is restricted from selling the share of stock for fiveyears, and receives the accumulated dividends (plus interest) upon vesting). Suppose furtherthat the market price of a share of stock is €10. The economic or opportunity cost of thestock grant to the company is the amount the company could have received if it were to sellan unrestricted share to an outside investor rather than giving the restricted share to the CEO.Ignoring the slight dilution discount associated with issuing a new share, the company couldraise €10 by selling the share to an outside investor. Thus, the company’s cost of grantingthe share is the price of the share on the open market.Alternatively (but equivalently), by granting the restricted share to the CEO, thecompany is effectively promising to deliver one share of stock to the CEO in five years. Ifthe company had no shares available to issue, it could satisfy this contract by purchasing ashare on the open market in five years at a price that might be higher or lower than €10. Ifthe company wanted to perfectly hedge the “price risk” of its future obligation, it couldpurchase a share of stock in the open market today (for €10) and deliver it to the CEO it tothe CEO in five years. Thus, again, the company’s cost of granting the share is simply theprice of the share on the open market.But, what about the CEO? The CEO would clearly prefer to have €10 today than apromise to receive one share of stock in five years; after all, he could always take the €10and buy a share of stock today, but will likely have other more-preferred uses for the €10.Moreover, if the CEO is risk averse and undiversified (in the sense that his overall wealth ispositively correlated with company stock prices, through existing stock ownership, optionholdings, and the risk of being fired for poor performance), the value the CEO places on theshare of restricted stock will be strictly less than the fair market value of the share. Moreover,the CEO’s value will predictably decrease as the CEO becomes more risk averse or lessdiversified.Similarly, suppose that the company decides to give a stock option to the CEO. Theopportunity cost of granting the option is the amount an outside investor would pay for it.The outside investor is generally free to trade the option, and can also take actions (such asshort-selling the underlying stock) to hedge away the risk of the option. Black and Scholes-17-
THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSIS(1973) and Merton (1973) demonstrated that, since investors can hedge, options can bevalued as if investors were risk neutral and all assets appreciate at the risk-free rate. Thisrisk-neutrality assumption forms the basis of option pricing theory and is central to all optionpricing models, including binomial models, arbitrage pricing models, and Monte Carlomethodologies. Ignoring dilution, forfeiture, and early exercise (more on these later), thesenow-standard methodologies provide reasonable estimates of what an outside investor wouldpay, and therefore measure the company’s cost of granting options.However, Black-Scholes values do not measure the value of the non-tradable option toa risk-averse executive. In contrast to outside investors, company executives cannot trade orsell their options, and are also forbidden from hedging the risks by short-selling companystock. In addition, while outside investors tend to be well-diversified (holding small amountsof stock in a large number of companies), company executives are inherently undiversified,with their physical as well as human capital invested disproportionately in their company.For these reasons, company executives will generally place a much lower value on companystock options than would outside investors.Lambert, Larcker and Verrecchia (1991) and Hall and Murphy (2002) proposemeasuring the value of a non-tradable option to an undiversified risk-averse executive as theamount of riskless cash compensation the executive would exchange for the option. 26Suppose that an executive has non-firm-related wealth of w, holds a portfolio S(•) ofcompany shares and options, and is granted n options to buy n shares of stock at exerciseprice X in T years. Assuming that w is invested at the risk-free rate, r f , and that the realizedstock price at T is P T , the executive’s wealth at time T is given by(1) W T ≡ w(1+ r f ) T + s(P T ) + n•max(0,P T -X).If, instead of the option, he were awarded V in cash that he invested at the risk-free rate,his wealth at time T would be:(2) W TV≡ (w+V)(1+ r f ) T + s(P T ).26 Meulbroek (2001) measures the value:cost “inefficiency” of options using a completely different (nonutility-based)but complementary approach. Her method enables her to make precise estimates of what she callsthe “deadweight cost” of option grants without knowledge of the specific utility function or wealth holdings ofexecutives. Her approach produces a lower bound estimate of the value:cost inefficiency since her goal is toisolate the deadweight cost owing to sub-optimal diversification, while abstracting from any additionaldeadweight cost from the specific structure of the compensation contract.-18-
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