Michael Douglas, in his Academy Award winning portrayal of Gordon Gekko in the movie “Wall Street,” declares in his famous “greed” speech that the company has “33 different vice presidents” that are not needed. The point being that Gekko, the stockholder, is a principal while the Corporate Executive Officer, or CEO, of the company is the agent, and the speech represents the “principal–agent problem.” The problem is that the CEO is not motivated enough with a simple wage to aggressively take risks to increase stock holder value; instead, the CEO hires a bunch of vice presidents to make it look like he is doing something when in fact he has no vision for making the company profitable.
This brings up stock options, which can work as an incentive mechanism to help create value for the shareholder. This is one solution to the principal-agent problem. Often smaller companies are not public and simply cannot offer stock options, but larger public firms can and do. The question we need to ask, though, is if stock options are effective? And do they increase income inequality?
Usually, the owner of a stock, like your retirement fund or the Alaska Permanent Fund, wants to know that the value of the stock is increasing. However, for that to happen, the value of the company must increase through an increase in market share, an increase in product value or a decrease in operating costs. Therefore, you need a way to motivate the CEO to do all that so that your stock’s value increases.
If the CEO only receives a simple wage, then she would be indifferent to increases or decreases in company value, other than the fact that she might be fired. Normally, though, she will be reticent to change the company and probably not take big risks to really bump up the long term earnings of the company. However, if the CEO obtains incentivized remuneration, she would be more inclined to make successful strategic decisions.
Note, the stock owner is diversified and since he is diversified, he wants his suite of stocks to increase significantly overall. Some make huge gains even if a few lose value. So the stock owner typically wants all of the CEOs for the companies in which he owns stock to be aggressive. Then if one or two of those aggressive CEOs are completely unsuccessful and cause a loss, he is still covered by the big gains made by the other CEOs in his portfolio. But inducing aggressive business strategies is hard to do when the CEOs only receive a simple wage: the CEO sees no benefit to her risky actions.
So to induce aggressive risk taking, the company can give the CEO a stock option. In that case, if the stock value goes up, the CEO is given an option to buy a certain amount of stocks at the old stock price that existed at the time of hire. If she buys at the old price, she can immediately resell at the new price and keep the difference. If the value of the stock it is lower, she does not have to take the option. So, in essence, it is a no lose proposition.
The idea is that if she aggressively increases the company’s value, the stock price will go up and she will be rewarded with the stock option increase in value. But crucially the stock investor is rewarded too as his stock value goes up. If the CEO is unsuccessful, she does not lose anything. Given most stocks will increase in value and only a few will lose, then there is an overall gain for the diversified shareholder.
Bear in mind, the CEO can initiate a stock buy-back, which is simply using retained earnings or debt to buy back stock and create a temporary increase in stock value. The thing to note is that using debt or especially retained earnings to buy stock means foregoing other, new investments into research and development or expansion. Those investments might have helped to grow your company. Therefore, stock buy-backs can end up merely increasing the value of the CEO’s options, but at the expense of reducing long term value. And indeed, new investments as a percent of earnings have been lower since the early 1990s when stock options became popular. As one of my finance professor colleagues quoted, “Today’s CEOs are well motivated to optimally reorganize their firms but may still find it optimal to waste money on corporate jets.”
Dr. Douglas B. Reynolds is a professor of Economics at the University of Alaska Fairbanks’ School of Management. He can be contacted at firstname.lastname@example.org. This column is brought to you as a public service by the UAF Community and Technical College department of Applied Business and Accounting.