Two interesting articles in the latest Journal of Economic Perspectives. Lucien A. Bebchuk and Jesse M. Fried focus on the agency problem.
Managers have an interest in compensation schemes that camouflage the extent of their rent extraction or that put less pressure on them to reduce slack. As a result, managerial influence might lead to the adoption of compensation arrangements that provide weak or even perverse incentives. In our view, the reduction in shareholder value caused by these inefficiencies, rather than the excess rents captured by managers, could be the largest cost arising from managers’ ability to influence their compensation.
On the subject of stock options, Brian J. Hall and Kevin J. Murphy write,
When a company grants an option to an employee, it bears an economic cost equal to what an outside investor would pay for the option. But it bears no accounting charge and incurs no outlay of cash. Moreover, when the option is exercised, the company (usually) issues a new share to the executive, and receives a tax deduction for the spread between the stock price and the exercise price. These factors make the “perceived cost” of an option much lower than the economic cost.
…This insight provides a strong case for a requirement that options be expensed. The overall effect of bringing the perceived costs of options more in line with economic costs will be that fewer options will be granted to fewer people: stock options are likely to be reduced and concentrated among those executives and key technical employees who can plausibly affect company stock prices.
For Discussion. When a high-tech company gives stock options to a secretary, is this because the secretary over-values stock options and accepts less compensation otherwise? Or is it because the firm undervalues the options and overcompensates the secretary? Or are options correctly valued by both sides?