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The National Post, June 25, 2002
Options: Perception and Reality
By Reuven Brenner and Donald L. Luskin
The debate over compensation in public companies, and its accounting
treatment, has missed a basic observation with far-reaching implications.
Namely, that in order to know what people are doing within a company, one
must closely observe the structure of their compensations. Those who argue
that options align shareholders and management’s long-term interest turn out
to be off the mark. Options induce management to dedicate much effort and
time to managing perceptions rather than the company.
Let’s take a close look at this distinction, because it helps one understand
why, with recent movement toward changes in compensation, the next upward
cycle will be based more on real performance, rather than perceived
performance.
One knows roughly what people do in a company by how they are paid. Those on
fixed salaries -- by the hour, by month, for the year, or according to
quantities they produce -- are doing customary, easily measurable tasks. A
newspaper editor writes editorials, supervises the op-ed page, and he must
do both within strict time limits. Journalists are paid annual salaries and
expected to produce decent articles regularly, on time, and fitting the
"space requirements of the newspaper. Free-lancers write roughly 500 to
1,200 word articles, in general for a fixed fee, but they submit articles
whenever inspiration or their budget constraint strikes them.
The work of the vast majority falls into categories that can be described in
similar manner, be they secretaries, technicians, engineers, physicians or
university professors. Their employment contracts roughly describe the job
expectations, and if people roughly deliver, they get their salaries.
How are people working in R&D compensated? Since it may take years until one
comes up with a viable new idea with commercial value, how does one pay the
scientist, engineer, scriptwriter, author and the musician while they
experiment? After all, experiments are all costs: most R&D spending leads
nowhere; most scripts end up in wastebaskets, and most manuscripts and
melodies never pass commercial muster.
Society pays little for such experiments, with good reason. Hollywood’s
restaurants and gas stations are filled with musicians and scriptwriters.
New York’s restaurants are filled with dancers and actors working as
waiters. True, artists with some background of success can get retainer
arrangements from some of the larger companies, and are paid fixed amounts
until they stumble on the next "big idea," be it Spy Kids I, II, Austin
Power I, II, or James Bond From Here to Eternity. And once they stumble on
the latter they win the lottery.
Scientists’ compensation in R&D departments are not different. Since
management must allow for experimentation -- which means mistakes and costs
-- and yet it also needs measures that show that the scientists are doing
something that may be eventually useful, they give bonuses for registered
patents. In the case of professors, universities give merit bonuses for
publications, although here the award more often than not isn’t merited,
since governments subsidize both the journals and those filling the pages.
The consequence is a perception, generally invalid, that "science" was
produced.
This distinction between perception and reality brings us to the
much-debated issue of compensation for top management in public companies,
where stock options are a large component.
Under options compensation, once the stock price rises above the strike
price after the vesting period, management’s compensation is based on the
investors’ expectations and perceptions of how this particular company will
perform in the future – these expectations and perceptions are expressed in
the stock price that determines the value of the options when they are
exercised. Therefore, it’s not surprising that, with such compensation
packages in place, management dedicated more time and effort to managing
perceptions. Options compensation rewarded them for doing just that.
It took time for options compensation to have its unexpected effects on
stock markets and the institutions that support it. Investors, the press,
and academics had first to be convinced that the incentives would indeed
work. What led the public to share this belief?
Before the introduction of stock options in compensation, companies that had
solid performance and a decent track record saw their stock prices rise over
time. The CEO’s compensation was based on bonuses, increased salaries, and
actual ownership of stock. That said, when top management was compensated
solely with fixed salaries, it did not do its best for its shareholders.
When these companies changed compensation packages, and in case of LBOs, for
example, when management took loans to buy shares in the companies,
performance within the companies improved dramatically.
However, it was a mistake to jump from these well-known observations to the
conclusion that if, in addition to salaries and bonuses, management
compensation were based on options, shareholder value would be maximized
over time, and more wealth would be created. One can only infer from the
change in the structure of compensation that management will spend far more
time and effort in managing investors’ perceptions about share prices.
And that’s what actually happened. Management promoted a variety of academic
models developed during the 1980s, showing that options compensation
packages would be good for all parties concerned. Journalists and business
magazines jumped on the bandwagon, headlining the "compensation revolution."
Some massaged earnings and lobbied for accounting rules favoring
perceptions, rather than reality.
Accidental events helped shape the simplistic misperception. The 18 years to
2000 saw almost uninterrupted prosperity in the U.S. and -- the U.S. being
the engine -- around the world. Though the prosperity was due to a wide
variety of factors, starting with fiscal and monetary policies inspired by
Ronald Reagan and Margaret Thatcher to the downfall of communism, it takes
time until one sorts out what caused what. So while there was a temporary
correlation between changes in compensation packages and stock market
performance, it was the good times that brought about high valuations and
option-based compensations, rather than the other way around. Under such
circumstances, it is easy to forget that, while one can build some useful
equations to model simple patterns of behavior, once one adds a bit of
complexity - for example, that people can also manage expectations and not
only companies - the predictions of those simple rules no longer apply.
It’s neither the first nor the last time that correlation and causation have
been confused, leading to temporary episodes of self-fulfilling prophecies.
Since 2000, we have seen the process of correcting this error - fast.
Management compensation is moving back toward the reality of actual
performance-indicators within the company, and which are now subject to far
greater scrutiny. They are based less on analysts’ and investors’
perceptions and expectations, and more on performance and insuring
accountability. The incentives to spend time and effort to massage income
statements and balance sheets to manage those perceptions have diminished.
Also, granting options is now subject to far stricter controls than just a
few months ago.
As a result, management now has stronger incentives to deal with execution,
and to spend less time managing perceptions or misperceptions. Many CEOs who
specialized in managing perceptions will be fired, and those who can execute
will be hired. The next upside in the cycle will be based more on reality
than perceptions.
About the Authors
Economist Reuven Brenner holds the Repap Chair at McGill University’s
faculty of Management. He is the author of
The
Force of Finance, published this spring by Texere Publishing.
Donald Luskin is chief investment
officer of Trend Macrolytics, an independent economics research firm in
Menlo Park, California.
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