Stock options, CEO risk taking, and earnings manipulations

Any idea why we continue to reward top executives with stock options? We accept it, nowadays, as a given, but why do we have that practice in the first place?

You might say “because it constitutes performance-related pay; through them, you financially reward top managers for their achievements”. Fair enough. Because for many of us mortals our pay depends to some extent on our performance. However, do realize that for CEOs, for example, this component is often as high as eighty percent. Eighty percent! Do you know many people (employed in the same large corporations that these executives head) whose salary is eighty percent dependent on some measure of their achievements? Not many I suspect.

But, in theory, these large corporations that reward their top managers through stock are right – and I am saying “in theory” for a reason. 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. It is basically a theory that stems from economics. It says that you have to align the interests of the people managing the firm (top executives) with those of its shareholders, otherwise they will only do things that are in their own interest, will be inactive, lazy, or plain deceitful. Yep, these economists have an uplifting worldview. But that is why we have such a huge performance-related component in the pay of most top executives.

But are you really sure you want people like that managing your firm? People who will be lazy and only operate in their own interest if given a chance? Do you really want a CEO who really needs performance-related pay and who otherwise, if put on a fixed salary, wouldn’t do much and just hang about? In case you missed it, I intended this as a rhetorical question…

But anyway, we give them stock – and lots of it – to incentivize them. But the question still lingers: why stock OPTIONS? And that’s a story in itself.

Agency theory doesn’t only say that people will be lazy and deceitful if given a chance; it also says that managers are inherently risk-averse; much more risk-averse than shareholders would like them to be. And the theory prescribes that you should give them stock options, rather than stock, to stimulate them to take more risk.

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, that we would like our top executives to be a little less risk taking for a change…? 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.

Because stock options do stimulate risk seeking behavior, as we know from academic research. Options, as you might know, represent a right to buy shares at a certain price at some fixed point in the future. If you are given the right to buy a share in company X for $100 in January 2010 and by then the share price of X is $120, you will have made 20 bucks. However, if the company’s share price by then has dropped to $90, your option is worthless; we say it is “out-of-the-money”: you’re not going to exercise your right to buy at 100 when the market price is merely 90.

In that situation, if the CEO of X has many stock options, it stimulates him to be very risk seeking. For example, if by August 2009 the share price is 90, he will be inclined to engage in risky “win or lose” moves. If the risk pays off and the share price rises well above a 100, the stock options will become worth a lot of money. However, if he loses, and the share price plummets even further, say to 60, no worries; it doesn’t matter. The stock options to buy at $100 were worthless anyway; whether the stock trades at 90 or at 60.

And, as said, research by for example Professors Gerry Sanders from Rice University and Don Hambrick from the Penn State University showed that these things work. They examined 950 American CEOs, their stock options, and their risk taking behavior. They found that CEOs with many stock options made much bigger bets; for instance, they would do more and larger acquisitions, bigger capital investments, and higher R&D expenditures

However, they also showed that they weren’t always very good bets… The option-loaded CEOs delivered significantly more big losses than big gains. That’s because they didn’t care much about the losses (their options were worthless anyway); all they were interested in were the potential gains.

Moreover, Professor Xiaomeng Zhang and colleagues, form the American University, examined the relationship between stock options and earnings manipulations; plain illegal behavior. 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!).

Hence, even if as a board member or shareholder you’d want to stimulate your CEO to take more risks – and I guess that is a big IF – I am not so sure that stock options will get you the kind of risk you’re after…

When knowledge hurts

Over the last decade or so companies have been told till it was a nuisance that their knowledge is their ultimate (if not only) source of competitive advantage. They have been encouraged – by management gurus, academics, and ample management consultants alike – that they should invest in knowledge development, protect it, and makes sure it gets identified, codified, and even put on the balance sheet.

The advice was to carefully identify best practices and make sure that you have systems that help these practices to be shared throughout the organization. This way, you will make optimal use of the great good and surely a healthy return will follow – or so the preachers said.

Many companies responded, as advised, by setting up internal systems that could be used to store and access all sorts of documents, as well as systems to aid the identification of experts in the organization and ways to contact them for advice.

But have these knowledge management systems turned out to be as good as was promised to us? Well… let’s say that a few caveats have emerged.

Because what we sort of forgot in the torrent of knowledge euphoria is that this stuff can also come at a cost. The cost of actually finding it, for example, in the jungle of corporate databases, but also the cost that comes with the fact that re-using prior knowledge doesn’t necessarily make you very original. And that’s a problem, especially when you need to stand out from the crowd.

Professors Martine Haas from the Wharton School and Morten Hansen from INSEAD, for example, examined the use of internal knowledge systems by teams of consultants in one of the big four accountancy firms, trying to win sales bids. They measured to what extent these teams accessed electronic documents and how much they sought personal advice from other consultants in the firm. They figured that, surely, accessing more knowledge must be helpful, right?

But they proved themselves wrong; to their surprise they found that the more internal electronic databases were consulted by these teams the more likely they were to lose the bid! Likewise for seeking advise from colleagues. This effect was especially pronounced for very experienced teams. These guys were much better off relying on their own expertise than trying to tap into experiences by others, whether it was in the form of electronic stuff of external advice.

Haas and Hansen figured that the opportunity costs of accessing all this prior knowledge must be huge; big enough to offset any potential benefits. Searching through the plethora of documents and soliciting advice from colleagues actually withheld the teams from making substantial investments into putting together a truly original and suitable proposal.

Things were even worse in situations in which competing firms were simultaneously bidding for the same lead, and being able to differentiate yourself from these rivals became crucial. In these cases, utilizing prior knowledge seemed to lead teams to develop cookie-cutter solutions when being original and innovative was what was really needed. As a result, they lost the bid.

The only times that a team benefited a bit from accessing internal knowledge sources was when it concerned a very inexperienced team. In such instances, talking to a few internal experts improved their chances of putting together a winning proposal. However, the internal document databases were always useless at best. The more these rookies tried to tap into the mountain of electronic documents available to them, they worse their chances of coming up with the winning bid.

The advice to derive from this research? Shut down your expensive document databases; they tend to do more harm than good. They are a nuisance, impossible to navigate, and you can’t really store anything meaningful in them anyway, since real knowledge is quite impossible to put onto a piece of paper. Yet, do maintain your systems that help people identify and contact experts in your firm, because that sometimes can be helpful. But make sure to only give your rookies the password.