Large Option Grants to CEOs Appear to Hurt Investors

In their new study "Swinging for the Fences: The Effects of CEO Stock Options on Company Risk-Taking and Performance" (Academy of Management Journal, Oct./Nov. 2007), Donald Hambrick of Penn State University and William Gerard Sanders of Brigham Young University report that companies whose CEOs had very large option grants tended to have much more variable stock price performance than other companies and performed much worse than expected. Hambrick and Sanders analyzed 950 randomly selected companies listed in the Standard & Poor's 500, midcap, and small-cap indices. They measured the proportion of CEO compensation paid in stock-option grants over three-year periods, then looked at the size of company investments in R&D, capital investments, and acquisitions in the fourth year and stock price returns in the fifth. Option grant size was calculated as the Black-Scholes value.

They then looked at predicted financial performance based on a variety of control measures versus what they company actually did. They found that the higher the proportion of CEO pay in options, the bigger the investments and the larger the swings in performance. These greater risks might be acceptable to investors except that big losses compared to expectations based on the model were more likely than big gains-40% more likely where options constituted over half the CEO's pay.

The findings support a critique made by many observers (including the NCEO) of outsized equity grants to CEOs: They encourage excessive risk taking. The higher the volatility of stock returns, the more valuable options are (because because executives can "lock in" the value of a short-lived spike in stock price). Coupled with the fact that most CEOs stay in their jobs five years or less, there is tremendous incentive to take large risks.