Monday, July 15, 2002

How To Succeed At Business Without Really Achieving

I saw a friend this morning who said that he just doesn't enjoy my business columns as much as the political ones; I just don't let loose with enough zingers when discussing accounting, I guess. Or he didn't notice the "Bush bear market" comment. The New York Times ran a similar op-ed on Friday by Walter Cadette, but my editor and my email server both know I sent off my column on Thursday evening before reading it.

East Valley Tribune, July 14, 2002

One great myth of the last decade was that giving top executives huge stock option packages would align their interests with the shareholders’. If the stock did well, management did well; if the stock didn’t do well, management wouldn’t do so well--at least theoretically.

There are several problems with this theory. In a boom market, options reward, quite handsomely, mediocre or even inferior performance. Option plans usually consider only the company’s stock price, not its performance relative to competitors, or to the market. If the average stock rises by 15 percent, then below-average performance of 10 percent still gets underperforming management wonderful rewards.

It’s also doubtful if companies, in the Bush bear market, will keep insisting on strictly linking executive compensation to share price. Already, boards are basing executive compensation decisions on loosely-defined “other factors.”

Even if the stock price tanked, executives are get rewarded--for internal reorganizations, cutting costs, or other allegedly worthy corporate goals. However, using those other criteria, by definition, weakens the connection between executive compensation and shareholder value, suddenly a good thing now that executives dread taking home merely their salaries.

Worse, many companies will “move the goalposts.” Employees may have options with “underwater” exercise prices, well under the current market price. Companies have started re-pricing previously-issued options, wiping out bad years, letting management off the hook, and giving them essentially new options.

Senior executives claim that they need to reprice options to keep valuable employees. But the employees who benefit the most are the ones with the most options, those same senior executives. Repricing options is the original “heads I win, tails we flip again” gimmick; management wins big if the stock price rises, and if it falls, they reset the game for another coin toss.

(Watch this dodge in action with the Business Roundtable’s reluctant endorsement of making all stock option plans subject to prior shareholder approval. Companies will start adopting plans, after shareholder approval, which allow the directors to reprice options issued under the plan without shareholder consent.)

But the most significant problem is that unlike a shareholder, an option holder shares only in the potential gain, and not in any risk. If the share price rises, both the shareholder and the option holder indeed win. However, if the share price falls, only the shareholder suffers; the option holder loses nothing.

Sure, management may miss a wonderful windfall but, unlike their shareholders, option holders don’t lose their investment. Management can wait for another, better day to exercise those options, or leave to pursue “other personal interests” or some other euphemism. But they haven’t lost any money--unlike the company’s actual owners.

Options give senior managers incentives to place risky bets, to shade the numbers, and to push the boundaries of legal requirements and shareholder obligations, because the rewards for success are so fabulous and the penalties for failure--at least for most--so minimal.

It’s like playing the lottery each week with the shareholders’ money. Management gets much of any winnings, but if the company doesn’t win, they just buy another ticket, again with the shareholders’ money. And the bizarrely favorable accounting treatment of options, which allows company to deduct them when paying taxes but ignore them in announcing earnings and profits, means that management only need disclose their lottery ticket purchases in an annual financial statement footnote.

By giving a huge share in the upside but no risk in the downside, today’s option culture gives management tremendous financial incentives to make risky moves, to gamble with shareholders’ money. It’s “heads I win, tails you lose;” I may miss out on a huge gain, but only you risk losing anything.

That’s no recipe for aligning management’s interests with shareholders’; it’s the recipe for today’s business disasters.

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