This paper examines employee stock ownership plans (ESOPs) and stock options as a form of employee compensation, tracing their origins in the United States from the late 1930s through the dot-com era and into the post-2008 financial crisis period. It explores the rapid expansion of stock options beyond executives to middle management and general employees, the challenges of accurately valuing these instruments, and the accounting reforms introduced by the Financial Accounting Standards Board in 2004. The paper also evaluates whether stock options effectively incentivize performance or primarily serve as retention tools, and presents the case of Ericsson as an example of a firm that successfully adapted its stock option strategy to manage productive processes rather than labor market dynamics.
Employee stock options (also known as American call options) are call options granted to the employees of a firm as a form of compensation in addition to salary. As Glimstedt (2006) explains, "The employee stock option had its origins in the US in the late 1930s as a tax dodge for salaried corporate executives; they wanted a form of compensation that would be subject to the 25% capital gains tax rate rather than the 91% marginal tax rate that New Deal legislation had imposed on salaries in the highest income bracket."
In the Old Economy, stock options were the sole province of top-level executives. The rise of the New Economy saw rapid growth in employee stock options, moving down from executives to middle management to the average employee. Offering stock options to employees began in the technology sector in the 1960s as a means to attract talent at all levels (Glimstedt, 2006). Moving into the 1990s, employee stock options remained primarily a feature of the American New Economy sector — information, internet, and telecommunications firms — but since the mid-1990s have played an increasingly important role in employee compensation packages of international firms operating in all sectors. This correlates with the general economic boom of the 1990s, as well as the rapid increase in technology-based start-ups and Internet commerce in general.
With the rise in general availability of stock options to employees has come a corresponding rise in debate about the practice of granting them. Are they good for the company? Are they good for the employee to whom they are granted? What real purpose do employee stock options serve, and at what expense? Given the extreme volatility of today's market, do employee stock options provide any real benefit to the employee, or are they primarily a means of benefitting upper management by artificially inflating the value of firms' stock? And given that an increase in the quantity of a firm's stock — firms tend to issue new stock when employees exercise options — serves to dilute the stock for large investors, are employee stock options in the best interest of investors?
The ability to offer a non-cash-based means of compensation remains attractive and useful for companies lacking capital but requiring talent. Employee stock options flourished in tight labor markets with high levels of worker mobility as a means by which firms competed to retain talent. Mobility in the current labor market is nearly frozen, however, and the question of whether employee stock options still serve to attract, retain, and motivate employees is highly questionable.
In 1992, companies listed on the S&P 500 granted $11 billion in options. This rate continued to rise through the 1990s in correlation with the dot-com bubble. In 2000, S&P 500 companies granted $119 billion in options. This amount subsequently declined over the next two years to $71 billion in options (Hall and Murphy, 2003). The average real pay of CEOs of these same firms paralleled the rise and fall of stock option grants. According to Hall and Murphy, the average real pay of CEOs of S&P 500 firms was $3.5 million in 1992, $14.7 million in 2000, and $9.4 million in 2002 (using 2002 constant dollars).
According to the National Center for Employee Ownership, approximately one third of the workforce of stock-issuing companies owned stock in their companies via a wide variety of plans in 2009 (National Center for Employee Ownership). This translates to as many as 30 million workers and nearly one trillion dollars of asset value.
Prior to 2004, stock options were not considered expenses on a firm's balance sheet. However, due to growing concerns about the real cost of increasing employee stock options, and in the immediate aftermath of the corporate scandals of 2003 — most notoriously, Enron — the Financial Accounting Standards Board required firms to estimate and report "the grant-date-fair-value" of employee stock options granted under Statement of Financial Accounting Standards No. 123 (revised). This was a decisive move toward accounting transparency in direct reaction to the scandals, as well as a means of restoring investor confidence following the bear market of the early 2000s.
Opponents of the regulation argued that what actually fell under new regulation by the FASB in its 2004 ruling was accounting practice, and that increased transparency in accounting has little to do with the market value of stock. Knowledge of accounting practice does not lead to understanding of a firm's value. According to this view, the information is irrelevant both to serious investors who understand valuation and to minor investors who do not. Furthermore, in today's market, financial advisors compete on the basis of their method of valuation. Part of the valuation method would therefore include the best possible assessment of employee stock options, independent of how the firm itself reports these largely estimated expenses. Not only do the 2004 regulations fail to contribute to a better understanding of a firm's real value, they also reduce competition among analysts for assessing that value, since all firms must use the same accounting practices with regard to employee stock options (Calomiris, 2004).
Despite this apparent leveling of the playing field, the persistent problem with employee stock options highlighted by the reporting requirement is precisely this: how are firms to value employee stock options? The real value of an option depends entirely on the moment at which the employee chooses to exercise it. Therefore, a firm cannot simply account for the spread at full maturation of the option, that is, at the end of the vesting period. Employee stock options tend to have long vesting periods, ranging from two to fifteen years, meaning that the real value of any given option is virtually unpredictable.
Typically, if an employee leaves the firm during the vesting period, the options are forfeited. As Leung and Sircar (2009) point out, most employee stock option holders exercise early. In 2003, Hall and Murphy hypothesized that the perceived cost of granting options was actually lower than the actual economic cost of doing so:
"When a company grants an option to an employee, it bears an economic cost equal to what an outside investor would pay for the option. But it bears no accounting charge and incurs no outlay of cash. Moreover, when the option is exercised, the company (usually) issues a new share to the executive and receives a tax deduction for the spread between the stock price and the exercise price. These factors make the 'perceived cost' of an option much lower than the economic cost." (Hall and Murphy, 2003)
The understanding of the economic costs of employee stock options has unfolded gradually over the last two decades. Leung and Sircar (2008) note that for employee stock options with ten years to maturity, the average exercise time is between four and five years. Given this tendency, combined with the fact that fear of job loss and other forms of risk aversion lead employees to exercise options early, the costs to the firm are not straightforward. As Calomiris (2004) explains:
"First, there is a cash premium, implying that the cost to the firm of paying $1 million in cash compensation to employees is typically greater than the cost to the firm of paying $1 million worth of stock options to employees. Second, the cost difference between these two forms of payment is highly firm-specific, as it depends on the extent to which the particular firm values cash as a means of reducing its dependence on high-cost external finance. Thus, an accounting rule that assumes cash equivalence of options for expensing overstates the expense of the options, and overstates the expense more for some firms than for others."
It is difficult to make an accurate assessment of the value of outstanding employee stock options. Because of long vesting periods, stock options appear to contribute to employee longevity. Core and Guay (2001) found that a firm's need for capital directly correlates with the number of stock options offered to employees, and further that governance decisions within a firm are also directly related to compensation structure. As they note: "Internet firms place lesser reliance on earnings as a measure of managerial performance as compared to manufacturing and non-internet technology firms" (Core, 2001).
Because these firms were operating in literally uncharted territory at the beginning of the era of Internet commerce, it was nearly impossible to determine whether managerial performance had a direct impact on a firm's earnings. There was generally no means of estimating the future profitability of Internet-based businesses, as there was nothing in prior business practice with which to compare them.
"Whether options motivate performance or increase risk"
"Ericsson's evolution from retention to incentive model"
"Post-2008 repricing trends and final assessment"
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