Benefits from stock option incentives

Organisations typically try to get only one or two benefits from their stock option investment. But now with increasing sophistication of the design of incentive vehicles, we can get five or six benefits for the same economic investment in compensation. The typical benefits for organisations from incentives are as follows:

1. Motivate the Upside: Give management a significant stake in the growth in the company’s stock price or value. Stock options were and still are an excellent way to accomplish this.

2. Protect the Downside: Shareholders don’t want the management to concentrate solely on increasing the stock price. They also want them to safeguard current value. Incentives should cause the management to feel shareholders pain if stock prices fall. Full value restricted shares or owned shares help achieve this goal.

3. Create an Ownership Stake: Most boards and CEOs agree that the management should have a significant personal ownership stake in the company’s real ownership that substantially affects an individual’s personal wealth. Incentive plans should be structured to help generate and facilitate this ownership stake.

4. Reward Real Performance: Rewarding stock performance is not enough. Long-term incentives should establish long-term financial goals and reward long-term financial performance.

5. Retain Top Talent: Incentives should be structured with such clauses that cause significant financial pain if an executive leaves prematurely. This can easily be accomplished simultaneously with other objectives.

6. Compete Effectively: Perhaps it goes without saying, but the total package should provide competitive payouts that are in line with competitive performance median pay for median performance; 75th percentile pay for 75th percentile performance and so on.
The directors’ job is to work with management to create a Balanced Incentive Portfolio that achieves the Six Incentive Imperatives in a cost effective and relatively simple way. This requires balancing trade-offs between the different imperatives.

Many companies are trying different combinations of incentive vehicles to achieve their balanced portfolios. To create an organisation’s ideal portfolio, one should consider how well each vehicle achieves the various incentive imperatives and which of the imperatives are most important to the organisation. It may be noted that many companies are finding that different portfolio mixes are optimal for different employee groups.

The balanced incentive portfolio also allows you to vary compensation based on organisations levels and positions within those levels. Each level in the organisation, and subsequently each department, might have a different mix of goals and performance measures.
The research on stock options (ESOP) indicates that they increase employee satisfaction. But their impact on performance is less clear. For instance, one study compared 45 ESOP against 238 conventional companies. The ESOP outperformed the conventional firms both in terms of employment and sales growth.

Another study found that ESOP had total returns that averaged 6.9% points higher over the four years after the ESOP was set up than market returns of similar companies without an ESOP. But other studies have shown disappointing results.

ESOP has the potential to increase employee job satisfaction and work motivation. But for this potential to be realized, employees need to psychologically experience ownership.Incentive compensation packages should also be viewed from the perspective of what has been given in the past. It is not just annual compensation that affects behavior; it’s the total wealth and potential wealth that has been created by incentives given over the years.

Board members and owner managers should be asking, “How much will each executive’s personal wealth be impacted by changes in the company’s stock price or performance?” because the personal wealth effect may impact an executive’s behavior more than the effect of annual compensation. By assessing the current and future allocation of incentive pay relative to incentive imperatives, organisations can develop customised solutions tailored not only to an organisations strategy, culture, and risk orientation, but also to an executive’s own risk and reward profile.