A Comparison of Options, Restricted Stock, and Cash for Employee Compensation

Topics: Employee stock option, Risk aversion, Expected utility hypothesis Pages: 34 (12547 words) Published: April 20, 2008
A Comparison of Options, Restricted Stock, and Cash
for Employee Compensation
Paul Oyer and Scott Schaefer
September 4, 2003
Using a detailed data set of employee stock option grants, we compare observed stock-optionbased pay plans to hypothetical cash-only or restricted-stock-based plans. We make a variety of assumptions regarding the possible bene ts of options relative to cash or stock, and then use observed option grants to make inferences regarding rms' decisions to issue options to lower-level employees. If the favorable accounting treatment is the sole reason underlying rms' choices of options over cash-only compensation, then we estimate that the median rm in our data set incurs $0.64 in real costs in order to increase reported pre-tax income by $1. This gure is several times larger than the willingness-to-pay for earnings reported by Erickson, Hanlon and Maydew (2002), who study rms that (allegedly) commit fraud in order to boost earnings. If, on the other hand, rms' option-granting decisions are driven by economic-pro t maximization, then observed stock option grants are most consistent with explanations involving attraction and retention of employees.

Oyer: Graduate School of Business, Stanford University, pauloyer@stanford.edu. Schaefer: Kellogg School of Management, Northwestern University, s-schaefer@northwestern.edu. We thank Corey Rosen and Ryan Weeden for providing the NCEO data. We thank Rachel Hayes, Kevin J. Murphy, Madhav Rajan, Stefan Reichelstein and Je Zwiebel for valuable discussions.

1 Introduction
Employee stock options have generated substantial media and political attention recently, thanks largely to the ongoing policy debate about accounting methods for option grants. Though options were once rarely granted below top executive levels, broad-based option plans have become more common in recent years.1 In some sectors of the U.S. economy, stock options appear to be the default method by which rms share ownership with employees. This need not be the case, however, as evidenced by Microsoft Corporation's recent decision to grant restricted stock to employees instead of stock options. This decision highlights the fact that rms face a number of alternatives to stock options, including restricted stock and cash, as means for compensating employees. The presence of these alternatives raises the question of why so many rms would choose options over cash or restricted stock. Given that options impose greater risk costs on risk-averse employees than would either cash or restricted stock, there must be bene ts (or, at least, perceived bene ts to the decision maker) that o set these costs. One possibility, detailed in Hall and Murphy (2003), is that the use of option-based pay arises from the favorable accounting treatment of option grants. Unlike cash and stock, most options granted to lower-level employees never a ect the rm's income statement. Hence, managers may not internalize the costs of options when making grants to employees. Other authors, including Core and Guay (2001), Kedia and Mozumdar (2002), and Oyer and Schaefer (2003), have argued that there may be substantial economic bene ts to rms from granting stock options broadly to employees. Options may help rms attract and retain employees, provide incentives, or nance investment by reducing cash wage payments. If options are selected for these reasons, however, it must be the case that options perform better on these dimensions than would comparable cash or restricted stock compensation packages. In this paper, we compare stock options, restricted stock, and cash as compensation instruments for lower-level employees. We focus on the cost/bene t comparison made by a decision maker within the rm (who may or may not have the same objective function as shareholders), and pose three main questions. First, suppose the only bene t from any form of equity-based compensation is the favorable accounting treatment of stock...
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Essay on Stock Options
  • Employee Stock Options Essay
  • Stock Options Essay
  • Essay on Stock Options
  • Employee Compensation Essay
  • Stock Options Essay
  • Essay about Sally Jameson Valuing Stock Options in a Compensation Package
  • Essay about Employee Compensation

Become a StudyMode Member

Sign Up - It's Free