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Thursday, September 07, 2006

The Straight Talk On Stock Options

Peter Drucker once said,

Stock option plans reward the executive for doing the wrong thing. Instead of asking, 'Are we making the right decision?' he asks, 'How did we close today?' It is encouragement to loot the corporation.

Stock options and high tech industry are becoming almost synonymous- everywhere I turn, I hear the stores of rags-to-riches stories based on tech stock growth. Most executives inside tech companies are so brazen in capitalizing on their stocks that several managerial decisions/career moves are centered around stock options. It may be true that high-tech start-ups,and severely capital-constrained organizations cannot afford to ignore market pressures for short-term performance. Every new hire today wants to know his/her stock entitlements. Thomas Stewart in this month’s editor column of the HBR issue picks up the issue of executive compensation and in particular about the stock options. He contends that while originally aimed at aligning manager’s action with that of owner’s in effect it is aligning with the interest of the traders. He asks a rightful question – if the goal is to make managers as shareholders, why not just pay them half their compensation in company stock itself, bought in the market at the start /end of every month. Inside, Alfred Rappaport has a thoughtful article on ways to increase shareholder value. He argues that executives have developed tunnel vision in their pursuit of shareholder value, focusing on short-term performance at the expense of investing in long-term growth and opines that it's time to broaden that perspective and begin shaping business strategies in light of the competitive landscape, not the shareholder list. He offers 10 basic principles to help executives create lasting shareholder value. For starters, companies should not manage earnings or provide earnings guidance; those that fail to embrace this first principle of shareholder value will almost certainly be unable to follow the rest. Additionally, leaders should make strategic decisions and acquisitions and carry assets that maximize expected value, even if near-term earnings are negatively affected as a result. During times when there are no credible value-creating opportunities to invest in the business, companies should avoid using excess cash to make investments that look good on the surface but might end up destroying value, such as ill-advised, overpriced acquisitions. It would be better to return the cash to shareholders in the form of dividends and buybacks. The story of Berkshire Hathway illustrates the application of such principles. Rappaport also offers guidelines for establishing effective pay incentives at every level of management; emphasizes that senior executives need to lay their wealth on the line just as shareholders do; and urges companies to embrace full disclosure, an antidote to short-term earnings obsession that serves to decrease investor uncertainty, which could reduce the cost of capital and increase the share price.. Indeed an excellent read. I routinely hear that come jan/june, most key guys would have vested majority of options and so goes the common talk.. then comes the next tranche and life goes on.. Far from helping create value for shareholders, I observe in many cases, options impede dynamism. Stock options are sometimes jokingly referred to as "golden handcuffs" (in the same vein as golden handshakes or golden hellos), especially in a strongly rising market - the employee may feel compelled to work out the time until they are able to liquidate the stock even if they might otherwise prefer to leave the company. I see that there are several walking-dead executives in companies hanging on aimlessly and waiting for the vesting period. Several others may have to await their turn to get eligible for the feast. Looking at the story of several tech dinosaur’s Peter Drucker is indeed right. Stock options are a case of good intentions gone bad.Time that stakeholders and the board raise the right questions and deliberate on such issues.

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