Impact of Employee Stock Options on Performance

Knowledge@Wharton 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.

The Problem with Financial Incentives

We have often talked about incentive plans and their impact on motivating R&D teams.  In”Impact of Incentive Bonus Plan” we discussed that unless the bonus plan can be tightly coupled with real metrics, they may actually reduce performance.  The article “You are getting a bonus so why aren’t you motivated,” we learned that bonuses are not effective at motivating R&D teams.  We have discussed other forms of motivation for R&D teams and what drives satisfaction in virtual R&D teams here..  Now there is another interesting article in Knowledge@Wharton: The Problem with Financial Incentives — and What to Do About It – Knowledge@Wharton that talks about aligning incentives with work.

Bonuses and stock options often improve performance. But they can also lead to unethical behavior, fuel turnover and foster envy and discontent. In this opinion piece, Wharton management professors Adam Grant and Jitendra Singh argue that it is time to cut back on money as a chief motivational force in business. Instead, they say, employers should pay greater attention to intrinsic motivation. That means designing jobs that provide opportunities to make choices, develop skills, do work that matters and build meaningful interpersonal connections.

There are three important risks that excessive reliance on financial incentives brings:
1. Incentives may enhance performance but do not guarantee that the performance improvement will come with ethical behavior and actual improvements

“Several years ago, Green Giant, a unit of General Mills, had a problem at one of its plants: Frozen peas were being packaged with insect parts. Hoping to improve product quality and cleanliness, managers designed an incentive scheme in which employees received a bonus for finding insect parts. Employees responded by bringing insect parts from home, planting them in frozen pea packages and then ‘finding’ them to earn the bonus.

This is even more difficult when behavior being rewarded (R&D) is so complex that the what expected results to be rewarded are difficult to measure at best and unknown until a much later date at worst.

Research by Wharton management professor Maurice Schweitzer and colleagues demonstrates that when people are rewarded for goal achievement, they are more likely to engage in unethical behavior, such as cheating by overstating their performance. This is especially likely when employees fall just short of their goals. Harvard Business School’s Michael Jensen has gone so far as to propose that cheating to earn bonuses — such as by shipping unfinished products or cooking the books to exceed analysts’ expectations — has become the norm at many companies.

It is the last statement above that I have seen abused often in bonuses in R&D environment.

When strong financial incentives are in place, many employees will cross ethical boundaries to earn them, convincing themselves that the ends justify the means. When we value a reward, we often choose the shortest, easiest path to attaining it — and then persuade ourselves that we did no wrong. This tendency to rationalize our own behavior is so pervasive that psychologists Carol Tavris and Elliot Aronson recently published a book called Mistakes Were Made (but not by me) to explain how we justify harmful decisions and unethical acts.

2. Incentives demoralize employees who do not get them and actually reduce performance and fuel turnover.

Numerous studies have shown that people judge the fairness of their pay not in absolute terms, but rather in terms of how it compares with the pay earned by peers. As a result, pay inequality can lead to frustration, jealousy, envy, disappointment and resentment. This is because compensation does not only enable us to support ourselves and our families; it is also a signal of our value and status in an organization. At Google in 2004, Larry Page and Sergey Brin created Founders’ Awards to give multimillion-dollar stock grants to employees who made major contributions. The goal was to attract, reward and retain key employees, but blogger Greg Linden reports that the grants “backfired because those who didn’t get them felt overlooked.”
This claim is supported by rigorous evidence. Notre Dame’s Matt Bloom has shown that companies with higher pay inequality suffer from greater manager and employee turnover. He also finds that major league baseball teams with larger gaps between the highest-paid and lowest-paid players lose more games; they score fewer runs and let in more runs than teams with more compressed pay distributions. The benefits to the high performers are seemingly outweighed by the costs to the low performers, who apparently feel unfairly treated and reduce their effort as a result.

Similarly, Phyllis Siegel at Rutgers and Donald Hambrick at Penn State have shown that high-technology firms with greater pay inequality in their top management teams have lower average market-to-book value and shareholder returns. The researchers explain: “Although a pay scheme that rewards individuals based on their respective values to the firm does not seem unhealthy on the surface, it can potentially generate negative effects on collaboration, as executives engage in invidious comparisons with each other.”

Other studies have shown that executives are more likely to leave companies with high pay inequality. The bottom line here is that financial incentives, by definition, create inequalities in pay that often undermine performance, collaboration and retention.

3. The final risk is that financial incentives generate a sort of addiction. Better performance requires increasingly higher bonuses.

In the 1970s, Stanford’s Mark Lepper and colleagues designed a study in which participants were invited to play games for fun. The researchers then began providing rewards for success. When they took away the rewards, participants stopped playing. What started as a fun game became work when performance was rewarded. This is known as the overjustification effect: Our intrinsic interest in a task can be overshadowed by a strong incentive, which convinces us that we are working for the incentive. Numerous studies spearheaded by University of Rochester psychologists Edward Deci and Richard Ryan have shown that rewards often undermine our intrinsic motivation to work on interesting, challenging tasks — especially when they are announced in advance or delivered in a controlling manner.

The authors suggest emphasizing the intrinsic reward of doing something interesting and being creative. In fact, I have personally been in situations where the financial incentives were more than adequate, but my creativity, ability to learn new skills and a sense of purpose were completely unfulfilled.  I was dissatisfied and had to leave.  So, the solution the authors suggest follow rather logically from the risks:  provide employees with Autonomy, Mastery and Purpose.

Autonomy means the freedom to create new solutions, when to do it and how to do it. Creativity, in my opinion, is one of the strongest motivators.

Extensive research has shown that when individuals and teams are given autonomy, they experience greater responsibility for their work, invest more time and energy in it, develop more efficient and innovative processes for completing it and ultimately produce higher quality and quantity. For example, in a study at a printing company, Michigan State’s Fred Morgeson and colleagues found that when teams lacked clear feedback and information systems, giving them autonomy led them to expend more effort, use more skills and spend more time solving problems. Numerous other studies have shown that allowing employees to exercise choices about goals, tasks, work schedules and work methods can increase their motivation and performance.

The problem with autonomy is also R&D management. Unless managers are able to generate clear goals and metrics for measuring results, autonomy will not actually produce any results. Since these objectives and metrics are hard to define, many managers just avoid giving autonomy.

Mastery involves ability to learn new skills and develop knowledge / expertise.  Ability to learn is limited because it requires exploration of new problems.  R&D managers need to setup interesting challenges for their employees – this is probably the single most important driver of innovation.

Research shows that when employees are given opportunities for mastery, they naturally pursue opportunities to learn and contribute. For instance, research by the University of Sheffield’s Toby Wall and colleagues documented the benefits of giving operators of manufacturing equipment the chance to develop the skills to repair machines, rather than waiting for engineers, programmers and supervisors to fix them. The operators took advantage of this opportunity for mastery to create strategies for reducing machine downtime, and worked to learn how to prevent problems in the future. As a result, they were able to complete repairs more quickly and reduce the overall number of repairs.

Purpose is the experience that one is contributing in meaningful ways:

Adam Grant (one of the authors of this piece) has shown that when employees meet even a single client, customer or end user who benefits from their work, they gain a clearer understanding of the purpose of their jobs, which motivates them to work harder and smarter. For example, when university fundraisers met a single scholarship student who benefited from the money that they raised, the number of calls they made per hour more than doubled and their weekly revenue jumped by 500%. And when radiologists saw a photo of the patient whose X-ray they were evaluating, they felt more empathy, worked harder and achieved greater diagnostic accuracy. In The India Way, Wharton management professors Peter Cappelli, Harbir Singh, Jitendra Singh (one author of this piece) and Michael Useem observe that Indian companies have found success in motivating employees by cultivating a strong sense of purpose and mission. As Adam Smith, the father of economics, wrote in A Theory of Moral Sentiments: “How selfish soever man may be supposed there are evidently some principles in his nature which interest him in the fortunes of others, and render their happiness necessary to him, although he derives nothing from it except the pleasure of seeing it.”

Neither the authors nor I think that financial incentives are a bad idea.  I believe that bonuses can be a great motivator for R&D teams / managers.  However, they have to be tied to real metrics to ensure that the resulting behavior is what the company needs.  Many companies decide on short-term measures such as stock prices to determine performance bonuses because metrics that actually measure performance in longer-term R&D / long product development cycles are much harder to develop.

Researchers Amy Mickel of California State University, Sacramento, and Lisa Barron of the University of California, Irvine, have argued that managers should think more carefully about the symbolic power of financial incentives: who distributes them, why they are distributed, where they are distributed and to whom they are distributed.