Taking stock: Are employee options good for business?

April 20, 2011

More American companies, especially start-ups and those in the technology industry, are offering broad-based employee stock options (ESOs) as part of their compensation packages.

As the market recovers, many workers view stock options as a way to get a piece of their company's action and share a stake in its overall performance. But what's in it for employers?

Offering a program of ESOs for executives and non-executives alike helps not only workers but also employers who are hoping to attract a quality workforce, foster company loyalty and retain staff over time. Three professors in the W. P. Carey Department of Finance have researched aspects of employee stock options and found additional benefits to companies, including tax advantages and employee engagement.

Long-Term Forecast

While the future is difficult to forecast, "there's a long-term trend" of offering stock options, says Laura Lindsey, assistant professor of Finance, who published a paper in The Review of Financial Studies titled "Incentives, Targeting and Firm Performance: An Analysis of Non-Executive Stock Options."

In 1990, for example, about 1 million employees participated in ESO plans. Today the number of participants has climbed to 9 million participating in 3,000 plans, according to the National Center for Employee Ownership.

One reason for the uptick, Lindsey says, was the high profile of technology companies in the '90s: the practice was cast in a favorable light, leading more traditional companies to follow suit.

"It became the norm as to how people get hired," Lindsey says.

At one time, ESOs were only the purview of top brass, says Ilona Babenko, assistant professor of Finance. Today, she says, 80 percent are offered to non-executive employees. In some industries, workers have come to expect such opportunities and are savvy about what they mean and how to deploy them.

Babenko collaborated with Finance assistant professor Yuri Tserlukevich on two papers exploring employee stock options that were published in The Journal of Finance, "Analyzing the Tax Benefits from Employee Stock Options" and "Employee Stock Options and investment." Both papers demonstrated the positive effect of ESOs.

A Stake in the Game

Stock options are the part of a firm's wage compensation package that allows employees, and sometimes other affiliated workers such as suppliers and consultants, to purchase that company's stock at a rate (usually) below market price. Often these offers come with restrictions, such as vesting, which requires purchases be spread out over several years. If workers leave the company voluntarily or involuntarily, they often forfeit their options.

Lindsey's article, co-authored by Yael Hochberg, assistant professor of finance at Northwestern University, examined the advantages of offering ESOs to workers at all levels, not just executives, as a way of turning employees into stake holders in company performance. In an effort to ensure a higher yield from their own stock holdings, would employees monitor each other and prod those working below their potential?

Lindsey says traditional theoretical arguments suggest that the incentive effects from a broad granting of stock options would be too diffuse to have an effect on a firm's performance. She and her colleague questioned that theory and set out to test it. Using the S&P 1500, they examined whether stock options granted to non-executive employees affect a company's performance by exploring the link between broad-based option plans, option portfolio implied incentives (the change in employee wealth from a change in stock price) and the company's operating performance.

The researchers found a cause-and-effect between option-implied incentives and a firm's return on assets. This implied incentive-performance correlation is concentrated in companies with fewer employees and those with higher growth opportunities for each employee, as well as companies that grant options broadly to non-executive workers.

Companies that instead target their stock options to specific groups of employees produce no equivalent improvement in their overall performance, the researchers discovered. This is perhaps due to the "free-rider problem," in which some individuals benefit from a situation to which they haven't contributed.

Because each worker's performance is tied to the health of the company as a whole -- and to juicier stock returns -- employees are less likely to put up with snoring from the next cubicle. Slacking impacts each individual.

"Our result can be viewed as a shift in the corporate culture, such that shirking isn't tolerated," Lindsey says.

Companies might want to motivate those employees whose job performance will most affect the performance of the whole firm and who will best respond to incentives. But how can those employees be identified apart from the laggards?

The answer is broad-based plans. Without such plans, Lindsey says, everyone might "free ride." The goal is not to target only those likely to respond to incentives, or who need them to resist shirking. Broad-based incentive plans motivate everyone similarly. Workers are then impelled to monitor each other for peak performance. Babenko and Lindsey suggest that could foster an air of cooperation that benefits everyone.

Traditionally, offering ESOs helps a company in at least three ways:

  • You attract higher quality workers because they recognize their value to their company. 
  • Vested provisions encourage workers to stay with the company in order to realize the stock plan's full value.
  • Employees work harder because it's to their benefit to grow the company.

Babenko says there is a causal effect between incentive and non-executive ESOs, though the extent is unclear.

Boosting the Bottom Line

The researchers also discovered that businesses offering ESOs boost their bottom line.

Babenko and Tserlukevich found that employee stock options helped companies reap tax benefits. A company can take a tax deduction for stock options at the time when its taxable income and tax rate are high, while a deduction for wages is taken regardless of the taxable income. Had those companies paid the same value to employees in wages instead of stock options, their corporate tax bill would increase by approximately 10 percent, Babenko says.

"It is much more valuable to take a deduction when your company is making a profit and can save 35 cents on a dollar than when it has losses and does not owe any tax anyway," she says. With both forms of pay, the company can deduct the same value. The variant is when the company can deduct. Wages are a constant deduction regardless of whether the company's income is high or low. With stock options, however, the company can take a deduction, equal to the stock price minus the strike price, at the time when employees exercise them.

Research shows that stock options historically are exercised at the time the company has high stock returns, corresponding to the time when the company has higher taxable income. But this is exactly the time when the company has high tax rates. 

On average, they pay a lower tax bill.

"For the company, it's good," Babenko says.

Providing stock options can also trigger cash flow when employees exercise their ESOs, she says. Even if the stock option plan is set up with a cashless exercise feature, the company still gets the money at the time of exercise. Cashless exercise means that when employees exercise their options they do not have to pay anything to the firm, but simply receive a difference between the current price of stock and the strike price of their option. In this case, the company receives the funds from the broker, who exercises the stock options for the employees and sells the stock.

Previously, stock options were considered a liability for firms. But in their paper on employee stock options and investment, Babenko, Tserlukevich and Michael Lemmon, professor of finance at the University of Utah, discovered ESOs bring in substantial funds. Cash flow associated with stock option sales is comparable to proceeds from seasoned equity offerings, which are specifically geared at raising funds: a great source of income.

"You don't have to go through the regulatory hassle associated with seasoned equity offerings or pay any transaction costs, such as underwriter fees," Babenko says. "In addition, the cash inflow is received by firms when they have good investment opportunities and thus need money."

The authors find that the companies that receive funds associated with stock option exercises are able to significantly increase profitable investment, which implies it helps them to relax financing constraints and achieve better performance.

Are ESOs right for your company?

While some industries are more amenable than others to ESOs, their launch can have a ripple affect. In Silicon Valley, the highly competitive environment has not only made such compensation packages standard at high-tech firms and companies heavily involved in research and development, but has also promoted the same model in related and even unrelated businesses in the region, Babenko says.

"You talk to your friends (about ESOs), and you demand more of them," she says.

The size and age of a company can factor into its decision on whether to offer ESOs. Small, cash-strapped start-ups might offer stock options in lieu of some wages. For older companies, it can be difficult to change a compensation program once it's in place.

One variable to consider before instituting a stock option plan at your company is to gauge the nature of your workforce. Are they willing to take chances or are they risk-averse?

Offering ESOs might attract not only a higher quality employee but a different type of worker as well, Babenko says, perhaps one that has a stringent work ethic or more of an entrepreneurial spirit. 

Many employees are eager to purchase stock in their own companies and would welcome the opportunity to buy at a reduced rate -- at least when the market is healthy. In years when the stock market is robust, ESOs can prove attractive incentives for employees, about half of whom quickly sell their stock at a profit, Babenko says.

When the market falls, however, employees holding less valuable stock or who find their portfolios underwater with stocks worth less than their market value are reluctant to embrace such plans.

Given a choice, those workers are more likely to duck ESOs in favor of higher wages.

"You want the bird in the hand," Babenko says.

Bottom line:

  • High profile of technology companies in the '90s utilized employee stock options, casting the practice in a favorable light and leading more traditional companies to follow suit.
  • Eighty percent of stock options are offered to non-executive employees.
  • Broad-based incentive plans motivate everyone similarly, so workers are impelled to monitor each other for peak performance.
  • Small, cash-strapped start-ups might offer stock options in lieu of some wages. For older companies, it can be difficult to change a compensation program once it's in place.