Wednesday, August 1, 2001

Anchoring Employees with the Lure of Stock Options

STANFORD GRADUATE SCHOOL OF BUSINESS—Stock options have become commonplace additions to compensation packages in recent years. Yet, the experts say stock options are lousy incentive mechanisms for motivating rank-and-file employees at the largest companies to work hard. Consider, for example, an ambitious, newly minted MBA at a multibillion-dollar company who creates $1 million in shareholder value for his company. Through his stock options, the employee might personally reap a return of less than one dollar—hardly enough motivation for a trip to the break room vending machine, let alone an extra hour in the office. Other ways more closely tie an individual's salary to his performance, such as sales commissions or a manager's subjective evaluation.


Illustration by Michael Klein

Why then do large companies continue to use stock options as incentives when they have no direct incentive effects? The reason, says the GSB's Paul Oyer, is this: Stock options can serve as salary buffers to keep workers from leaving their firms when salaries or other benefits start to rise in the labor market around them. Oyer, an assistant professor of economics who has studied stock options extensively, specializes in a growing area of HR management known as personnel economics.

While the connection between market wages and stock options is not entirely new, Oyer's theory posits that stock options, and other compensation based on firm performance, help large companies design pay packages that will, when costs of employee turnover and renegotiating pay packages are high, retain workers even through wide fluctuations in market wages. "My argument has nothing to say about startups," says Oyer. "Their stock options are very strong incentives." Instead, Oyer's research addresses his initial puzzlement over the prevalence of stock options and other risk-bearing compensation schemes in risky industries, since individuals by nature are averse to risk.

Oyer found that stock options are effective in industries where individuals' market wages vary widely, in tight labor markets where worker replacement costs are high, and when the specific sector of a particular industry experiences greater common shocks, such as a sudden downturn in product demand.

These conditions are borne out in the recent roller-coaster fortunes of the high-tech economy. At the height of worker demand, wages rose to a certain point, yet workers continued fielding outside employment offers. Rather than making counteroffers, companies gave employees an incentive to stay with stock options that increased in value at a rate equal to the outside offers.

As the economy slowed, those same companies have benefited in the down market. "When the market was hot, companies did not make the high market wages a permanent fixture of their employee wages by promising them X dollars year in and year out, and then have to go in and reverse that when the demand for workers slowed," says Oyer.

Oyer's economic model examines the ways a large company can design a pay package so that a potential employee is willing to take the job, yet the company does not pay more than necessary to get the employee. Oyer's model considers how the firm must account for three costs: negotiating with current employees (or replacing them), passing risks to employees, and overpayment of wages. Faced with these costs, a firm has three ways it can tackle its compensation strategy.

First, the firm may choose to pay the costs of renegotiating pay every time an employee gets an outside offer or at every major fluctuation in market wages. "Wages are adjusted up or down according to the spot market," says Oyer. Companies may use this compensation method when wages do not often change or when employees are especially averse to risk.

Second, a firm may write employment contracts that include salary and stock options. If options, or some other measure of the firm's performance, are highly correlated to the labor market outside the firm, then the company can make the employee virtually impervious to outside opportunities. Even if the value of its stock options tanks, the firm can expect to retain employees because outside employment offers will have diminished. Employees allow part of their pay to be contingent on firm performance if they are compensated for the corresponding risk.

Finally, the firm may make some amount of pay contingent on firm profits but lower the employee's risk premium by fixing his total pay above his market wage. The company might do this when the costs of renegotiating pay are high and the correlation between the firm's stock price and the employee's outside opportunities is low. For example, a Web master at a financial services company may be paid more highly than his peers in the financial services industry because his market opportunities are tied more closely to those in the high-demand technology sector.

In related research, Oyer is analyzing data to determine why some firms give stock options to all employees and when options have been successful. Oyer is seeking confidential data from large companies willing to contribute to this ongoing effort.

Related Information

Fiscal Year Ends and Non-Linear Incentive Contracts: The Effect on Business Seasonality
Paul Oyer
The Quarterly Journal of Economics, CXIII, February 1998, 149-185. Abstract

The Timeliness of Performance Information in Determining Executive Compensation
Paul Oyer with Kevin F. Hallock
The Journal of Corporate Finance, 5, November 1999, 303-321. Abstract

A Theory of Sales Quotas with Limited Liability and Rent Sharing
Paul Oyer
The Journal of Labor Economics, 18, July 2000, 405-426. Abstract