Impact of Employee Stock Options on Performance

29 Apr 2011 Sandeep Mehta

[email protected] has a great article Incentive or Gift? How Perception of Employee Stock Options Affects Performance.  It appears that the idea that stock options drive people to work harder to increase the stock price is not quite true.

The story is not that people work harder to make the share price go up,’ Cappelli noted. ‘It is that if the share price goes up and people make money, they feel an obligation to work harder. That’s a bit of a surprise.

Employees seem to feel that the company has given them a gift ONLY if they can exercise the options at a profit.  Even then, they only work hard in that they feel some gratitude for the gift!  This is important for R&D managers to understand because options are increasingly a part of benefit packages.

The issue is significant because over the last two decades, American firms have both greatly increased use of a stock option plan as a form of employee compensation, and broadened the class of eligible employees to include more than just the most elite executives. According to the National Center for Employee Ownership, only one million U.S. employees held stock options in 1990. That figure has since skyrocketed to nine million workers now participating in roughly 30,000 different plans.

We have discussed incentives to drive R&D performance many times.  Most recently, we discussed that financial incentives alone might not be the best way to drive performance.  That post has a list of related articles that you might want to check out.  This article follows the same theme that we have discussed in the past. Lets dig in…
Incentives have to be aligned with required behavior to improve behavior. Most R&D team members can not define what they can do to improve share prices, so they do not actually see options as an incentive to work harder.

Boosting the research effort was a large amount of data provided by a major American public corporation. The firm granted stock options to the 4,500 employees — primarily store managers — based solely on their level within the company hierarchy, as opposed to job performance. Because these lower-level managers were largely responsible only for the sales performance in individual stores, there was little chance that their day-to-day work would actually directly influence share price, or that the manager would perceive such an impact.

So, what are some of the positives of employee stock options?  Clearly, employee retention is better – employees are not likely to leave if they have a lot of un-vested options.  The impact on performance seems to come from improved morale and is related to the actual profit employees make from the options.

… employees who profited handsomely from exercising their stock options appear to give a lot of the credit to the positive attributes of the company.

The article claims that there is significant improvement in performance.  It looks quite small to me and I wonder if a much better improvement can be gained from bonuses tied directly to required behavior…

The researchers found that a doubling of the profits from a sale of options resulted in a 1.3% increase in performance appraisal scores and a 1.1% decrease in performance-related dismissals — numbers that were statistically significant and meaningful in the broader context of the company data. According to Cappelli and Conyon, the data suggests that a company would have to increase the number of options awarded to employees by sevenfold to achieve the same impact on worker performance as a doubling of the profits from options.

The key problem is that profit from options are seen as gifts and any improvement in performance comes only once the profits are realized.

This shows that we’re not strictly economic in our relationships,” Cappelli says. “The proof of that is these folks who feel that they have been given a gift that they didn’t expect for their performance. There is nothing that requires them to reciprocate by performing better, but they do anyway.” Indeed, the research suggests that the improved performance after a profitable exercise of stock options typically lasts for a year or longer.

So instead of driving performance now, when we need it, we will drive performance when the share prices are actually higher…  Not quite a direct approach to improving performance and quite unpredictable in efficacy.

But the findings also raise questions for the many firms that offer stock options as a benefit, since the research shows that the impact on employee performance really depends on the price at which employees sell their shares, which changes in ways that are essentially unpredictable — and mostly out of the control of company leadership.

Finally, the most important problem: Employees need to know when to exercise the options to receive maximum profit.  The data shows that employees are not good at that (Personally, I have been very ineffective at timing).

One of the most critical variables was showing that the size of the stock profits realized by the managers was essentially the result of good luck in when they decided to sell, and not an indicator of either inside company knowledge or a special knack for timing the stock market. “Even top executives don’t do better than the average investor in making these selling decisions,” Cappelli states, noting that the majority of the employees in the study were store managers, not experienced stock traders. “Markets are pretty unpredictable, and there’s strong evidence that they don’t do well in timing the market.”

In summary, R&D managers should probably look elsewhere to motivate their teams – stock options are not it.

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