Stock options are bafflingly complex financial instruments. As a result, companies often end up having option programs that are counterproductive. I have, for example, seen many Silicon Valley companies continue to use their pre-IPO programs—with unfortunate consequences—after the companies have grown and gone public.

The options issued to executives usually have important restrictions. Most, but not all, have a vesting period, usually of between three and five years; the option holder does not actually own the option, and therefore may not exercise it, until the option vests. Option holders do not usually receive dividends, which means they make a profit only on any appreciation of the stock price beyond the exercise price.

The value of an option is typically measured with the Black-Scholes pricing model or some variation. Black-Scholes provides a good estimate of the price an executive could receive for an option if he could sell it. Since such an option cannot be sold, its actual value to an executive is typically less than its Black-Scholes value.

The last two factors—volatility and dividend rate—are particularly important because they vary greatly from company to company and have a large influence on option value. They lose their value quickly and can end up worth nothing. But the potential for higher payoff is not without a cost—higher volatility makes the payoff riskier to the executive. Dividend Rate. Companies reward their shareholders in two ways: by increasing the price of their stock and by paying dividends. Most option holders, however, do not receive dividends; they are rewarded only through price appreciation. Since a company that pays high dividends has less cash for buying back shares or profitably reinvesting in its business, it will have less share-price appreciation, all other things being equal.

Therefore, it provides a lower return to option holders. Research by Christine Jolls of Harvard Law School suggests, in fact, that the options explosion is partially responsible for the decline in dividend rates and the increase in stock repurchases during the past decade. If you are an executive, you can raise the value of your options by taking actions that increase the value of the stock.

For a framework on how to measure the value of nontradable executive and employee stock options, see Brian J. Hall and Kevin J. The main goal in granting stock options is, of course, to tie pay to performance—to ensure that executives profit when their companies prosper and suffer when they flounder. Many critics claim that, in practice, option grants have not fulfilled that goal.

Executives, they argue, continue to be rewarded as handsomely for failure as for success. As evidence, they either use anecdotes—examples of poorly performing companies that compensate their top managers extravagantly—or they cite studies indicating that the total pay of executives in charge of high-performing companies is not much different from the pay of those heading poor performers. The studies are another matter. Virtually all of them share a fatal flaw: they measure only the compensation earned in a given year.

As executives at a company receive yearly option grants, they begin to amass large amounts of stock and unexercised options. When the shifts in value of the overall holdings are taken into account, the link between pay and performance becomes much clearer. By increasing the number of shares executives control, option grants have dramatically strengthened the link between pay and performance. For both measures, the link between pay and performance has increased nearly tenfold since Given the complexity of options, though, it is reasonable to ask a simple question: if the goal is to align the incentives of owners and managers, why not just hand out shares of stock?

The answer is that options provide far greater leverage. For a company with an average dividend yield and a stock price that exhibits average volatility, a single stock option is worth only about one-third of the value of a share. The company can therefore give an executive three times as many options as shares for the same cost. In addition to providing leverage, options offer accounting advantages. The accounting treatment of options has generated enormous controversy. On the other side are many executives, especially those in small companies, who counter that options are difficult to value properly and that expensing them would discourage their use.

The response of institutional investors to the special treatment of options has been relatively muted. They have not been as critical as one might expect. There are two reasons for this. First, companies are required to list their option expenses in a footnote to the balance sheet, so savvy investors can easily figure option costs into expenses. Even more important, activist shareholders have been among the most vocal in pushing companies to replace cash pay with options.

In my view, the worst thing about the current accounting rules is not that they allow companies to avoid listing options as an expense. That discourages companies from experimenting with new kinds of plans.

Assignment

As just one example, the accounting rules penalize discounted, indexed options—options with an exercise price that is initially set beneath the current stock price and that varies according to a general or industry-specific stock-market index. Although indexed options are attractive because they isolate company performance from broad stock-market trends, they are almost nonexistent, in large part because the accounting rules dissuade companies from even considering them.

The idea of using leveraged incentives is not new. Most salespeople, for example, are paid a higher commission rate on the revenues they generate above a certain target. Such plans are more difficult to administer than plans with a single commission rate, but when it comes to compensation, the advantages of leverage often outweigh the disadvantages of complexity. You also have to impose penalties for weak performance. The critics claim options have unlimited upside but no downside. The implicit assumption is that options have no value when granted and that the recipient thus has nothing to lose.

But that assumption is completely false.

Should an Investor Hold or Exercise an Option?

Options do have value. Just look at the financial exchanges, where options on stock are bought and sold for large sums of money every second. Yes, the value of option grants is illiquid and, yes, the eventual payoff is contingent on the future performance of the company. But they have value nonetheless. And if something has value that can be lost, it has, by definition, downside risk. In fact, options have even greater downside risk than stock. Consider two executives in the same company.

One is granted a million dollars worth of stock, and the other is granted a million dollars worth of at-the-money options—options whose exercise price matches the stock price at the time of the grant. The executive with options, however, has essentially been wiped out. His options are now so far under water that they are nearly worthless.

Far from eliminating penalties, options actually amplify them. The downside risk has become increasingly evident to executives as their pay packages have come to be dominated by options. Take a look at the employment contract Joseph Galli negotiated with Amazon. The risk inherent in options can be undermined, however, through the practice of repricing. When a stock price falls sharply, the issuing company can be tempted to reduce the exercise price of previously granted options in order to increase their value for the executives who hold them.

What to Expect at Options Expiration | TD Ameritrade

Although fairly common in small companies—especially those in Silicon Valley—option repricing is relatively rare for senior managers of large companies, despite some well-publicized exceptions. Again, however, the criticism does not stand up to close examination.

For a method of compensation to motivate managers to focus on the long term, it needs to be tied to a performance measure that looks forward rather than backward. The traditional measure—accounting profits—fails that test. It measures the past, not the future. Stock price, however, is a forward-looking measure.

Forecasts can never be completely accurate, of course.

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But because investors have their own money on the line, they face enormous pressure to read the future correctly.