Weiner gained $74.5 million exercising previously awarded stock options and another $2.5 million from shares that vested last year, LinkedIn said Monday in its annual proxy statement. So even if, as a board member or shareholder, you’d want to stimulate your CEO to take more risks, stock options may not get you the kind of risk you’re after.LinkedIn CEO Jeff Weiner linked up with some impressive stock and options gains in 2012. They investigated 365 earnings manipulation cases and showed that CEOs with many “out-of-the-money” options were more likely to misrepresent their company’s financial results (and get caught doing it!). Moreover, Professor Xiaomeng Zhang and colleagues from the American University have examined the relationship between stock options and earnings manipulations plain illegal behavior. ![]() That’s because they didn’t care much about the losses (after all, their options were worthless anyway) all they were interested in were the potential gains. However, they also showed that they weren’t always very good bets… The option-loaded CEOs delivered significantly more big losses than big gains. They found that CEOs with a lot of stock options made much bigger bets for instance, they would do more and larger acquisitions, bigger capital investments, and higher R&D expenditures. They examined 950 American CEOs, their stock options, and their risk-taking behavior. Research by Professors Gerry Sanders from Rice University and Don Hambrick from Penn State has shown that these things work. The stock options to buy at $100 are equally worthless whether the stock trades at $90 or at $60. However, if he loses, and the share price plummets even further, say to $60, no worries - it doesn’t matter. If the risk pays off and the share price rises well above $100, the stock options will become worth a lot of money. For example, if by August 2009 the share price is $90, he will be inclined to engage in risky “win or lose” moves. In that situation, if the CEO of Company X has many stock options, it stimulates him to be very risk-seeking. However, if the company’s January 2010 share price has instead dropped to $90, your option is worthless, or what we call “out-of-the-money”: you’re not going to exercise your right to buy at $100 when the market price is cheaper. If you are given the right to buy a share in Company X for $100 in January 2010 and by then the share price is $120, you will have made 20 bucks. Options, as you might know, represent a right to buy shares at a certain price at some fixed point in the future. ![]() “More risk!?” you might think, “Do we really want CEOs of large corporations to take MORE risk?! Is it not, given recent events in the world of business, preferable for our top executives to be a little less interested in risk-taking?” Ah, that’s what you might think now, but it is not what agency theory thinks, and it is not what the incentive structure of most public corporations nowadays is geared to do.īecause stock options do stimulate risk seeking behavior, as we know from academic research. And the theory prescribes that you should give them stock options, rather than stock, to stimulate them to take more risk. But why stock options?Īgency theory doesn’t only say that people will be lazy and deceitful if given the chance it also says that managers are inherently risk-averse - much more risk-averse than shareholders would like them to be. So we give top executives stock - and lots of it - to incentivize them. Yep, these economists have an uplifting worldview. Otherwise, they will only do things that are in their own interest, and will be inactive, lazy, or plain deceitful. It is basically a theory, stemming from economics, that says that you have to align the interests of the people managing the firm with the interests of its shareholders. This practice - of offering CEOs stock-based pay - is a recommendation straight out of something called “ agency theory.” It is one of the few academic theories in management academia that has actually influenced the world of management practice. Eighty percent! How many people (employed in the same large corporations these executives lead) have a salary that is eighty percent dependent on some measure of their achievements? Not many, I suspect.īut, in theory, these large corporations that reward their top managers through stock are right - and I am saying “in theory” for a reason. However, for CEOs this component is often as high as eighty percent. You might say, “Because it constitutes performance-related pay through options, you financially reward top managers for their achievements.” Fair enough - for many of us mortals, our pay depends to some extent on our performance. Any idea why we continue to reward top executives with stock options?
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