The $300 billion Teachers Insurance and Annuity Association’s College Retirement Equities Fund has criticized mega-grants of stock options to chief executives. My research shows the fund is right to do so.
In olden days, companies favored relatively modest annual option grants to top executives. Among other things, the annual grants allowed for a dollar averaging of strike prices, reducing the temptation to reprice the options later if the stock headed south for the winter.
But then a new practice began whereby the CEO, on a single day, received a stock option of such size that carpenters had to be employed a week before the grant to shore up the floor of the executive suite. The quid pro quo was that the CEO would not receive another grant for an unspecified number of years after the mega-grant. Sadly for shareholders, that number of years sometimes turned out to be as low as one.
To those who believe people in the business world would do anything to make another buck, a mega-grant held the promise of releasing as much energy as a 1,000-milligram shot of testosterone. Why, these folks argued, a CEO with an option mega-grant ought to be inspired to run circles around other CEOs who had to get along with your normal-sized option grants.
A little test
As a way of testing this theory, I went back to a database I created for the year 1996 containing pay data on 856 major-company CEOs. I focused on the 10 largest option grants made that year to CEOs who, as of May 12, were still in their jobs.
The biggest grant of all went to Walt Disney Co.’s Michael Eisner. On Sept. 30, 1996, he received options on 24 million split-adjusted shares in four different tranches. Options on 15 million shares carried a strike price equal to the then market price. The remaining 9 million shares, in equal portions, carried strike prices that were 25 percent, 50 percent and 100 percent above the then market price. I scored this option as having an estimated present value at the time of its grant of $180 million.
The smallest of the 10 grants went to Dell Computer Corp.’s Michael Dell. This grant, according to my calculations, had an estimated present value of $11 million at the time.
Setting aside for the moment the theory that larger options motivate more than smaller options, one might expect to see these 10 CEOs lap the field in total return of their stocks for no other reason than that CEOs typically call the shots as to the timing of their own grants.
If you figure your company’s stock price is going to drop in the near future, you don’t go to your board and ask for an option mega-grant. But if you think your stock is about to take off, that’s when you head to the boardroom as fast as your legs will carry you. So even if a pattern of superior performance were to be found, we still wouldn’t know for sure whether that was due to true motivation or simply good timing.
By May 12, the average mega-grant given to the 10 CEOs had been in place for 3.91 years. Below is a chart that shows how each company performed during the period between the date of grant and May 12. Also shown is the aggregate option paper profit that would have accumulated by May 12, on the assumption that the option had not yet been exercised. Finally, the table shows the beta on the stock, calculated monthly between the date of grant and April 30, 2000.
The table is presented in descending order of the size of the grant, as measured by the number of shares in the grant, multiplied by the market price as of the date of the grant.
At first glance, the theory that option mega-grants motivate would seem to have been proven, given that that the average company generated a 34 percent annual total return vs. a 23 percent annual return for the Standard & Poor’s 500 Index. But all of that extra gain is due to a single company, Dell Computer. Remove Dell and there is no significant difference between the returns of the remaining nine companies and the S & P; 500 Index. The median returns are also virtually the same as the S & P; 500.
A number of other points emerge from this analysis. First, the average company in the group is more risky than companies generally, as evidenced by the median stock price beta of 1.19. So simply matching the S & P; 500 Index is evidence of under-performance, not normal performance.
Second, in determining how much an executive will make from an option, the size of the grant is as important as the performance of the company. Witness Disney’s Eisner, who has racked up $366 million of paper profits from his 1996 grants, yet has under-performed the S & P; 500 Index. (In fairness to Eisner, he is not slated to get another option grant until 2006 at the earliest, so his mega-grant truly did come at the expense of future grants.)
Third, CEOs who have learned the hard way that large option grants will not necessarily nudge them out of their torpor continue nonetheless to remain enthusiastic fans of large option grants. Advanced Micro Devices Inc.’s Jerry Sanders had earlier options repriced six different times over a six-year period before he finally hit pay dirt. And a significant part of the $177 million of paper profits he has accumulated from his 1996 option grant appears to be the product of excellent timing. In the 914 trading days since his option was granted, the stock closed below his strike price on only 10 occasions.
Perhaps stock options do help a bit in motivating executive performance. But even if they do, the operative phrase is “a bit.” When the grant is of the size of the grants shown below, the ultimate costs may very well overwhelm any benefits that might have been derived.
Graef Crystal is a columnist with Bloomberg News.