The effect of risk incentives in
stock options on firm value
Romy Bakker
10738150
26-06-2018 (Final version)
BSc Economics & Business
University of Amsterdam
Specialization: Accountancy & Control
Supervisor: Nan Jiang
Word count: 5425
Statement of Originality
This document is written by Romy Bakker who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document are original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Abstract This study examines the effect of stock options on risk taking and if this effect is favorable for shareholders. Therefore the effect of stock options on risk taking, performance and various characteristics that influence these effects are examined. Many researchers have focused on the topic stock options because it is used as a compensation form more often. Most previous research results show that stock options induce more risk-taking behavior. However, it is inconclusive if this amount of risk-taking is also firm value maximizing. If stock options do not have their intended effect they might not be favorable for shareholders and firms should choose an other compensation form. Based on a literature review, I found that stock options do result in more risk taking. However, it is not clear if this is wise risk-taking. Some researchers argue that stock options might result in excessive risk-taking which can harm firm value. Also, there are different characteristics that can influence the effect of stock options on the actions of CEOs. These findings are inconclusive but suggest that stock options do not necessarily solve the agency problem as is sometimes assumed. This study contributes to prior literature by providing an overview of contradictory research and suggestions for future research. Samenvatting Deze studie onderzoekt het effect van aandelenopties op het nemen van risico’s door managers en of dit effect gunstig is voor aandeelhouders. Daartoe wordt het effect van aandelenopties op het nemen van risico's, waarde en verschillende kenmerken die het effect beïnvloeden onderzocht. Veel onderzoekers hebben zich geconcentreerd op aandelenopties, omdat deze steeds vaker als compensatie worden gebruikt. Eerdere onderzoeksresultaten tonen aan dat aandelenopties meer risicovol gedrag in de hand werken. Het is echter niet doorslaggevend dat deze hoeveelheid risico ook zorgt voor meer waarde voor een bedrijf. Als aandelenopties niet het beoogde effect hebben, zijn deze misschien niet gunstig voor aandeelhouders en kunnen bedrijven beter een ander soort compensatie kiezen. Op basis van literatuur kan geconcludeerd worden dat aandelenopties wel leiden tot meer risicobereidheid. Het is echter niet duidelijk of dit ook verstandig risicogedrag is. Sommige onderzoekers beweren dat aandelenopties kunnen leiden tot buitensporige risico's die de waarde van de onderneming kunnen
schaden. Ook zijn er verschillende kenmerken die het effect van aandelenopties op de acties van CEO’s kunnen beïnvloeden. Deze bevindingen suggereren dat aandelenopties het agency-probleem niet noodzakelijk oplossen, zoals soms wel wordt aangenomen. Deze studie draagt bij tot eerdere literatuur door een overzicht te bieden van tegenstrijdige onderzoeken en suggesties voor toekomstig onderzoek.
Table of contents Statement of Originality ... 2 Abstract ... 3 Samenvatting ... 3 Table of contents ... 5 1. Introduction ... 6 2. Literature review ... 7 2.1. Equity incentives ... 7 2.1.1. Stock ownership ... 7 2.1.2. Stock options ... 8 2.2. Agency Theory ... 9 3. Literature discussion ... 11 3.1. Effect on managerial risk taking ... 11 3.2. Stock options and stock ownership ... 13 3.3. Attraction and retention ... 14 3.4. Non-executive stock options ... 15 3.5. Differences in industries ... 16 3.6. Effect on performance ... 16 4. Conclusions ... 19 References ... 20
1. Introduction There is a lot of attention concerning CEO compensation, the concern is often that these compensations are abnormal. Nowadays almost every large company uses stock option compensation to reward their CEOs for several reasons. The most important reasons being attraction, retention and motivation of employees. Many people assume that stock options have the right incentives for CEOs to act in the interest of shareholders. Since stock options align compensation with firm performance, you would expect employees with stock options to act in a way to improve stock price. Stock options let employees gain if stock prices rise, but protects them from downside risk. This makes it seem that stock options would increase risk-taking behavior, which is what shareholders want. However, there is also a downside to those risk incentives. Accounting scandals at for example Enron are linked to excessive risk taking caused by too much stock options. Stock options are found to be a solution to the agency problem which occurs if both the agent (manager) and the principals (shareholders) are utility maximizers. In that case it is likely that the manager will not always act in the best interests of the shareholder, because they have different interests. In general managers are risk-averse and shareholders are risk-neutral, so incentives are needed to align their interests. Without the right incentives, managers might turn down risky, but positive NPV projects. This leads to a lower firm value, so managers need incentives to be less risk-averse. Most researchers find that stock options indeed lead to more managerial risk taking behavior. But some find that stock options might lead to unwise risk taking (Sanders & Hambrick, 2001). According to Hanlon, Rajgopal and Shevlin (2003) stock options are economically efficient, but others find that stock options might not have an positive outcome for shareholders and firm value (Sanders & Hambrick, 2001; Hall & Murphy, 2002). Even though stock options use is very common in large companies, there is no conformity about the effect in prior literature. It is important to know what the impact of stock options as a compensation form is and what might influence intended effects. Therefore, my research question will be: Is the effect of risk-incentives in stock options beneficial for firm value? To answer this question I will rely on prior research about the association between stock based compensation and incentives. Research on
this topic is inconclusive. This study contributes to prior literature by providing an overview of differences in prior research and its suggestions and implications for future research. Section 2 consists of an explanation of some important concepts. In section 3 the literature is discussed to give an overview of the differences and results. Finally, section 4 provides a conclusion and implications for future research. 2. Background 2.1. Equity incentives Companies use different kinds of monetary incentives for employees to motivate, select and retain them. Some examples of monetary incentives are salary, annual bonusses and equity based incentives like stock and stock options. These can be combined into a compensationplan specialised for the industry, firm or function. The most important and component with the most effect of monetary incentives for executives are the equity incentives. The most important function of equity incentives is to align the interest of executives with shareholders. Equity incentives align the executives’ wealth with firm value, and therefore they should act in the interest of common shareholders. There are a few sorts of equity incentives; Restricted stock has a specified period in which the stock can not be traded, performance shares are granted it certain performance targets are achieved, and stock opions give employees the right to buy shares at a specified price. This paper will focus on the effects of stock options and whether those are benefial or detremential for shareholders. I will start discussing stock ownership and stock options and examine the differences, after that the agency theory and intended effects for shareholders will be discussed. 2.1.1. Stock ownership Using stock as compensation for managers has a few advantages. First, it attracts employees that are convinced of their ability to increase firm value. If not, they would not take the risk of being compensated in stock instead of for example a predetermaned
salary. Further, stock bonds its employees to the company. Especially if it is restricted stock being issued, it will help retain employees. Because in the period before being able to trade the stock, employees probably prefer to have as much influence as they can by working in the firm. The most important reason to grant stock to executives is to align their interests with those of shareholders. If executives own stock in their company, their wealth is directly linked to firm performance and therefore linked to shareholders’ wealth. 2.1.2. Stock options Stock options account for a great deal of CEO compensation: At their peak in 2001 stock options counted for over 50% of CEO compensation of major US firms. In 2005 stock options were still the biggest form of compensation, accounting for 41% (Sanders & Hambrick, 2007). A stock option is the right to buy shares in a company at a specified price and date. Stock options do have some conditions. Shares can be bought after the vesting period, which is usually three to five years. If exercised early, the owner will have to pay a penalty for exercising early. Usually stock options are granted at the money, this means thtat the exercise price of the option is equal to the stock price at the time of granting. The option is non-tradable. These conditions attempt to align managers’ interest with those of shareholders. If the market price of the stock increases to a level higher than the exercise price, the value of the option is the difference. So, the wealth of executives is aligned with firm value. However, a big difference with stock ownership is that if the firm experiences losses and stock prices go down, executives with stock options will not experience any loss. They will simply not exercise thier options and lose nothing. Compared to stock ownership, in which case managers experience losses as well as gains, you would expect stock options to induce more risk-seeking behavior. In conclusion, because stock options provide only upward potentioal en no downside risk, they provide extra incentives to enage in riskier projects. Agency theorists expect this to align managers’ incentives with shareholders’ incentives (Jensen & Meckling, 1976). Companies use employee stock options for different reasons. Many companies use, just like restricted stock, stock options to retain and attract capable and motivated employees. Employees willing to work for stock options instead of a predetermined
wage are often confident about their capability to meet their performance targets, because this will result in a higher payoff. Less capable employees will prefer a predetermined wage. Restrictions on the option, such as the vesting period, will bond the employee to the company and therefore decrease the employee turnover rate. These long-term incentives will help attract and retain good employees for a long period. Another substantial reason that companies issue employee stock options as compensation is to preserve and generate cash flow. The cash flow comes when the company issues new shares and receives the exercise price and receives a tax deduction equal to the intrinsic value of the option when exercised. The most important reason discussed in this paper is the ability to align executives compensation with the company's performance. Stock options are only valuable for employees if the share price is higher than the exercise price. This should provide them incentives to work hard for high share prices. This results in an alignment with shareholders interest, which is high firm value. Stock options also provide incentives to take on riskier projects, because they do not experience any downside risk. This paper will focus on the risk incentives provided by stock options and its effect on firm value. Shareholders are generally risk-neutral and managers risk-averse. Because stock options are valuable if share prices are higher than the exercise price and managers will not lose anything if the share prices are lower, they tend to take more risk with stock options than without. 2.2. Agency Theory According Jensen and Meckling (1976) the agency problem occurs if both the agent (manager) and the principals (shareholders) are utility maximizers. In that case it is likely that the agent will not always act in the best interests of the principal. This issue can be resolved by aligning the interest of manager and shareholders, a possibility to do so is aligning managers’ wealth with firm value by using equity compensation. In their study, Haugen and Senbet (1981) prove that stock option compensation can play a vital role in reducing agency costs. According to the agency theory, if only predetermined salary is used and there are no extra incentives, three problems will arise that could be solved with stock or stock options: shirking, short sightedness and risk aversion (Sanders & Hambrick, 2007).
First, stock and stock options tie CEOs rewards to company performance. Therefore they will work harder to achieve good performance and solve the shirking problem. Second, shortsightedness will no longer be a problem. CEOs will underinvest in the future if they do not have incentives to invest in projects that will only benefit their successors. Stock and stock options make it possible for CEOs to also gain from better firm performance themselfs and therefore provide the right incentives. Third, stock options provide incentives to take greater risk on behalf of shareholders because with stock options, managers are only affected with upside gains, but they are protected agains downside risk. In the next section these risk-incentives will be discussed in more detail. It is generally assumed that shareholders are risk neutral and CEOs risk averse because their economic portfolios and reputation are tied to the company and therefore they are subject to undiversified risk. Shareholders, however, have diversified risk and are therefore risk neutral. Stock options allow CEOs to engage in upside gains without a limit, and take away the risk of losses. CEOs are able to buy shares at the exercise price of the stock options, with upside gains, this exercise price is lower than the share price and managers participate in gains. In case of losses, CEOs will not experience any loss from their options, because they do not own the shares yet en can choose not to exercise their options. Research shows that decision makers who have nothing to lose but do have something to gain prefer riskier projects (Ross, 2001). This means that stock options provide incentives to engage in riskier projects. Rajgopal and Shevlin (2002) provide empirical evidence that stock options indeed provide managers with incentives to solve risk-related incentive problems. The most important goal of incentives is to make sure that shareholders are treated in a beneficial way. It is argued that a convex payoff would mitigate risk-related
problems (Coles, Daniel, & Naveen, 2006). Guay (1999) proves that shareholders should
manage the convexity of the relation between firm performance and managers’ wealth. Guay finds that stock options increases the convexity of the relation between firm performance and managers’ wealth, stock holdings however have much less effect. Furthermore, Armstrong and Vashishtha (2012) provide evidence of the differential effect of stock options on two components of total risk; systematic risk and idiosyncratic risk. Systematic risk is hedgeable and idiosyncratic risk is specific to a firm or industry and can be solved by diversification. Managers favor systematic risk over
idiosyncratic risk and will be looking for projects that consist mainly of systematic risk. This could hurt shareholders because it takes time and money to do so. Shareholders would like the highest firm performance since this represents the share price. Therefore, firm performance should be related to the compensation policy a firm uses. In the context of this paper it is important to make sure how the interest of CEOs with stock options are aligned with those of shareholders and what influences that. In the next sections theoretical and empirical literature will be discussed. Influences on the effect of stock options and the effects of stock options on risk-seeking behavior and firm value will be examined by reviewing various contradictory literature. 3. Literature discussion 3.1. Effect on managerial risk taking Many companies use stock option pay as a tool to solve the agency problem. Risk-related agency problems can arise when risk-averse and undiversified managers pass up expected positive net present value projects with too much risk (Jensen & Meckling, 1976). Shareholders usually have a diversified stock portfolio, and are therefore risk-neutral. One of the intended effects of stock options is to solve these risk-related agency problems and align managers’ with shareholders’ incentives. Since shareholders would like managers to take more risk, stock options should resolve in more risk-taking. Most theory provides evidence that stock options provide incentives to risk-averse managers to invest in higher risk projects on behalf of shareholders (Rajgopal & Shevlin, 2002; Jensen & Meckling, 1976; Haugen & Senbet, 1981; Guay, 1999; Hall & Murphy, 2003; Sanders & Hambrick, 2007) The convex shape of stock option contracts motivate higher degrees of risk-taking (Rajgopal & Shevlin, 2002; Guay, 1999; Coles et al., 2006). Common stock does not create convexity between the relation of firm performance and managers’ wealth and thus induces less risk-taking behavior than stock options do. The effect of stock options also differs from the effect of stock ownership because stock compensations
create downside risk, while stock options have no downside risk, which is why they increase preferences towards risky projects (Sanders, 2001). Sanders and Hambrick (2007) decompose the concept of risk-taking behavior in three elements: the size of the investment, the variance of possible outcomes and the probability of extreme losses. They measure risk by examining R&D investments, capital investments and acquisitions. These kind of investments are mostly warning signs for risky long-term investment behavior. The results of this study show that stock option pay indeed generates more investment spending and therefore increases risk-taking behavior. Furthermore, stock options have a negative relation to firms’ risk hedging (Rajgopal & Shevlin, 2002). Hedging is a sign of risk aversion, so this also indicates that stock options encourages managers to take greater risks with than without stock options. Park and Vrettos (2015) offer evidence that stock options do indeed effect total risk. However, convex compensation contracts like stock options can have an unintended effect on risk composition because they encourage executives to take on hedgeable systematic risk rather than idiosyncratic risk. So despite, as the results of Rajgopal and Shevlin (2002) suggest, the decrease in firms’ risk hedging, stock option compensation might result in a kind of risk that is hedgeable. Armstrong and Vashishtha (2012) agree with most researchers that stock options do increase total firm risk, but they take into account the two components of risk; systematic risk and idiosyncratic risk. They study if the effect of vega, the sensitivity of the managers wealth to firm risk, on total risk is driven more by an increase in systematic risk or by an increase in idiosyncratic risk. This distinction is important because the components have different effects on managers’ subjective value of their equity portfolios. Risk-averse managers are induced to increase the total risk by increasing systematic risk rather than idiosyncratic risk. An increase in systematic risk always increases the CEOs subjective value of his portfolio because he could hedge any unwanted increase in the firm’s systematic risk. An increase in idiosyncratic risk result in a lower increase of the value of the CEOs portfolio, because this component of risk can not be hedged. They find a strong positive relation between vega and total and systematic risk, but no significant relation between vega and idiosyncratic risk. This means that, if they are both available, CEOs prefer projects with systematic risk over projects with idiosyncratic risk.
Armstrong and Vashishtha also find that stock options make CEOs alter firm risk by their sensitivity to the stock price, or delta. This is related to systematic and idiosyncratic and thus, total risk. This suggests that it might not be a problem that managers prefer projects with systematic risk over idiosyncratic risk. Because in this way they are still induced to invest in projects with idiosyncratic risk. In conclusion, stock options do induce more risk-seeking behavior and seem to solve risk-related agency problems. Not clear however is if this increased amount of risk taking also results in beneficial outcomes for sharehoders and firm performance. The next section will further examine the effects of stock options and stock ownership. 3.2. Stock options and stock ownership It is common to practice research based on the assumption that stock option pay is a substitute for stock ownership, since they both reward executives who achieve high stock prices. Research practice has suggested an belief that stock option pay and stock ownership have similar effects (Sanders, 2001). However, there is an important difference in risk. Stock ownership and stock option pay let the person who owns it benefit the same as shareholders if stock prices increase. But if stock prices decline, executives will not exercise any options if the stock price is at or below the exercise price of the option. So in case of a decline in stock price, stock owners will lose along with shareholders, while executives with stock options will not experience any loss. Because stock options provide a floor against downside risks, it makes sense that they are more willing to take risks, since they have nothing to lose. Sanders (2001) examined the difference between stock ownership and stock option pay. He found that if CEOs were compensated with stock options firms were more likely to engage in acquisitions and divestitures and if CEOs owned stock they were less likely to engage. This proves that risk characteristics of stock options are not the same as those of stock ownership. Guay (1999) also proves that stock options provide more convexity than common stock, and therfore induces more risk-taking. While most research assume that both should have similar effects, the lack of downside risk in stock options compared to stock ownership makes a great difference. Sanders (2001) shows that the effect of stock options can be influenced by various characteristics. One characteristic is tenure, new CEOs are willing to take more
risk than CEOs that have been on the job longer. But even among long-tenured executives, stock options positively affect risk-taking behavior. Risk incentives are also influenced by firm performance. If firm performance is high, executives are less likely to take on new risks with acquisitions and divestitures. They are then more willing to keep the same strategy (Sanders, 2001). It is noteworthy that these characteristics did only affect the effect of stock options, the effects of stock ownership were not significantly influenced. Even though many studies assume that stock ownership and stock options have similar effects, the difference should be taken into account when designing compensation plans 3.3. Attraction and retention One important reason for a firm to choose stock options as a compensation form is to attract good and hard working employees and to retain them. Stock options are more attractive to employees that have high skills and believe they have the ability to make their options finish in the money, and thus raise the stock price (Ittner, Lambert & Larcker, 2003). Option-based contracts do also attract employees who are less risk averse. Therefore stock options already influence risk-taking behavior by selecting employees with specific characteristics. This sorting role is especially important for firms that are operating in high risk environments and those that are pursuing new products, markets or business models. Those firms require employees that are willing to take risks, otherwise there will not be enough growth. This sorting role works best in firms and situations where employees are able to impact stock price with their skills (Ittner, Lambert & Larcker, 2003). If employees are not able to impact stock price, incentives based on firm performance and stock prices will not work because these employees are not in a position to increase their wealth. Besides attracting a certain type of employee, stock options, as well as restricted stock, motivates employees to remain with the firm. Since nowadays employee turnover rates are growing, it is important for firms to bond good employees. It is costly and timely to attract and train new employees too often. Stock options require employees to remain with the firm at least for a period of time before they are able to exercise their options, the vesting period. If the employee exercises his options early and leaves the firm he will generally get a penalty. To achieve these objectives, stock options must be
non-tradable. If stock options would be tradable, executives could simply sell their options and there would no longer be an incentive or sorting effect (Hall & Murphy, 2002). The costs of options often exceed the value of the option from the perspective of a risk-averse, non-diversified manager who can not sell the stock option or hedge it against any risk. Therefore the cost of shareholders is higher than the value for managers, and this difference must be weighed against the advantages like attraction, retention and incentives to be efficient (Hall & Murphy, 2002). 3.4. Non-executive stock options Most research on stock options focusses on option grants to executives. In new economy firms the use of stock option plans covers employees throughout the company, also non-executives (Ittner, Lambert, & Larcker, 2003). Non-executive employees are defined as all employees other than the five most highly compensated executives (Ittner et al., 2003; Core & Guay, 2001). If employees are in a position to impact stock prices with their actions, stock options can also effectively provide incentives to non-executives. However, usually these employees have less impact than executives. This reduces the advantages of broad based equity grants (Ittner et al., 2003). Core and Guay (2001) find evidence that firms that grant non-executive stock options do this for incentive purposes and as a means of internal finance. Stock options can be granted if firms have great financing needs or face financing constraints. To grant stock options firms do not have to pay cash. If stock option grants are used for non-executives, it is important to determine the effect of different economic factors like risk aversion and the influence to impact stock price. Multiple studies found that employee risk aversion influences option exercises (Core & Guay, 2001; Ittner et al., 2003). These factors are likely to differ across functional areas, so this must be examined before granting stock options. Ittner et al. (2003) found that stock options for non-executives are mostly used in highly technical functions. One reason is that the degree of information asymmetry between employees and shareholders is higher in technical functions because those employees have specific information. With more information asymmetry it is more important to provide incentives to employees. Another reason why stock options are used to provide incentives in technical functions is the availability of certain performance measures. In
technical functions a lot of private information is known by employees, which makes it difficult to measure performance directly. In other functions areas like sales or production, it is easier to measure performance by operational performance measures and provide incentives in that way. In technical areas this usually very hard, but because these areas often do have impact on stock price, stock options are likely to provide incentives. 3.5. Differences in industries Some industries require more risk-taking behavior than others. For example firms that deal with technical issues, product development, or oil and gas firms. They need to take a great risk, because they can not know if the product is going to sell or if there is enough oil in the place they are investing. These factors make sure that stock option incentives are likely to be more important in these kind of firms, called ‘new economy firms’ that are pursuing unproven and riskier strategies (Ittner et al., 2003,). Agency theory however suggests that incentive pay decreases if the performance measure becomes more noisier. This could happen with young firms like firms that are in the early stage of product development, high growth firms or firms undertaking extensive research and development or investment, since the availability and quality of performance measures vary with growth opportunities and life cycle of the firm. Firms in the early stages of product development, high growth firms and firms undertaking extensive research and development of investment in intangible assets, standard performance measures do include all expenses associated with investments, but do not reflect future returns (Ittner et al., 2003). Therefore, those firms base incentives on more forward looking measures like stock options. 3.6. Effect on performance So there are many factors that can influence the effect of stock options and whether or not it is smart to grant them. However, there still is no consensus on the relationship between stock option compensation and future firm performance. In this section the results of studies on this topic will be examined and an overview of differences will be given.
Many researchers, starting with Jensen and Meckling (1976) with the agency theory, suggest that stock option compensation can align manager’s incentives with those of shareholders (Core & Guay, 1999; Hanlon et al., 2003; Rajgopal & Shevlin, 2002). This would mean that granting stock options is in line with firm value maximization. In their study, Hanlon et al. (2003) provide empirical evidence that employee stock option grants are positively related to future operating income. They examine the values of stock option grants to top five executives. Also Rajgopal and Shevlin (2001) find empirical evidence that stock options make managers more risk-seeking and induces them to undertake more risky but positive net present value projects. If stock options solve the problem that managers pass on risky but net present value project, there should be higher variation in future cash flows. Rajgopal and Shevlin find that in their study about the exploration risk in oil and gas firms. There is a positive relation between risk and stock option incentives and therefore stock options seem to be firm value increasing. Some researchers, like Hall and Murphy (2002), find options inefficient and some believe that managers control their own pay and compensate themselves more than necessary (Hanlon et al., 2003). Hanlon et al. test this thought in their research, but they do not find any evidence for such. But more research has been conducted on the downside of stock options. Sanders and Hambrick (2007) show that stock option compensation can result in extreme levels of performance. Risk incentives in stock options make CEOs more risk seeking, but it is uncertain if this is favorable risk seeking. Sanders and Hambrick decompose managerial risk taking in three components and examine the effects stock option has on those. First, the size of the investment. They show that high levels of stock options result in high levels of investment spending. Second, the size of the outlay of an investment. This is the most used measurement of risk. It is clear that stock option stimulate investment spending, but they also lead to more aggressiveness in their outlays in research and development, capital spending and acquisitions. Third, the possibility of extreme loss. Stock option pay is associated with performance extremeness. Even though CEO stock options engender large levels of spending, it is not the high level of investment spending that causes performance extremeness. The results of Sanders and Hambrick clearly point away from investment magnitude and more toward investment style possibly including a tendency to engage in long-odds projects. So their theory points to the likelihood that CEOs with high stock option pay undertake big projects with long odds.
Besides evidence of more risk-taking, Sanders and Hambrick show that this does not only result in positive outcomes. The level of risk-taking and its effect depends on the level of stock option pay. With stock option pay of more than 50% big losses are more common that big gains. So stock options have the biggest effect on the third element of risk which is the possibility of extreme loss. Thus, high levels of stock of stock options seem to motivate CEOs to take big risks. This outcome is in line with many previous studies and what would be expected according to the agency theory (Jensen & Meckling, 1976). However, it turns out that option-loaded CEOs have an unwanted tendency to generate more big losses than big gains. So it seems that many agency theorists did not envision that the extreme performance due to high option pay was more likely to be in the form of big losses than big gains and therefore does not serve its purpose to align the actions of CEOs with the interest of shareholders. Because even risk-neutral shareholders would not desire this outcome. Aboody (1996) finds a negative association between the value of all outstanding employee stock options and share prices for a broad set of firms. This implies that stock options might not have a positive effect and that there is indeed too much risk taking. It is also difficult to measure stock options, since employees would often value them different from how the company would value them. Employees value options only half the price of their costs to the firm (Hall & Murphy, 2002). This means that all the benefits like attraction, retention and incentives should be sufficient to fill in the wedge. It seems hard to measure if this is the case, but the difference in valuation of an employee and the costs for a firm might be a problem. Another view is that stock options might not necessarily induce managers to undertake risky but positive net present value projects. Armstrong and Vashishtha (2012) find that if CEOs can choose between net present value projects with idiosyncratic risk and other projects with systematic risk, they would choose the latter. This happens because systematic risk is hedgeble, and therefore CEOs might increase total risk but not necessarily increase firm value. Of course this is not what shareholder want. It could be extra costly if CEOs take time and effort to search for projects with systematic risk if this does not even increase firm value. Overal there is no consent about the effect of stock options on firm value. Even though stock options are often assumed to solve the agency problem, several studies
prove that stock options might also have a reversed effect. Stock options should therefore be used as a compensation form only in the right amounts and circumstances. 4. Conclusions The aim of this paper was to provide an overview of the effect of stock options on risk-taking and firm value. Stock options are widely used to provide incentives that help align managers’ incentives with those of shareholders. Without the right incentives, risk-averse and undiversified managers walk away from risky, but positive net present value projects. Agency theorists believe that stock options help solve this problem by providing a compensation form that aligns performance to managers’ compensation. Stock options make it possible for managers to engage in upside gains, but protects them against downside risk. This results in more risk-seeking behavior and seem to solve risk-related agency problems by providing risk-incentives. However research has shown that those risk-incentives might not result in wise risk-taking. Because of the lack of downside risk, stock options could result in excessive risk-taking. Managers no longer take into account that firm value might decrease and only look at the upside gains possible. This results in extreme firm performances, big gains and big losses. If high levels of stock option pay is granted, it could result in more big losses than big gains. Furthermore, there are many factors that can influence the effect of stock options. Stock options might work better in technical areas and young and growing firms. The effect is also dependent on the level of risk aversion of managers, tenure and firm performance. In conclusion, stock options induce more risk-taking behavior. However there is no consensus on the effect on firm performance. Many aspects and economic determinants should be taken into account before granting stock options. Stock options in the wrong amount or circumstances could lead to a decrease in firm value. Future research could study characteristics that influence the effect of stock options and the industries in which they are most effective. I found that stock option are mostly used in new economy firms and technical functions. It would be interesting to examine how certain characteristics influence the effect of stock option pay in different industries.
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