A Comparison of Options, Restricted Stock, and Cash for Employee Compensation
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Join now to read essay A Comparison of Options, Restricted Stock, and Cash for Employee Compensation
A Comparison of Options, Restricted Stock, and Cash
for Employee Compensation
Paul Oyer and Scott Schaefer
September 4, 2003
Abstract
Using a detailed data set of employee stock option grants, we compare observed stock-optionbased
pay plans to hypothetical cash-only or restricted-stock-based plans. We make a variety
of assumptions regarding the possible benets of options relative to cash or stock, and then
use observed option grants to make inferences regarding rms' decisions to issue options to
lower-level employees. If the favorable accounting treatment is the sole reason underlying rms'
choices of options over cash-only compensation, then we estimate that the median rm in our
data set incurs $0.64 in real costs in order to increase reported pre-tax income by $1. This gure
is several times larger than the willingness-to-pay for earnings reported by Erickson, Hanlon and
Maydew (2002), who study rms that (allegedly) commit fraud in order to boost earnings. If,
on the other hand, rms' option-granting decisions are driven by economic-prot maximization,
then observed stock option grants are most consistent with explanations involving attraction
and retention of employees.
Oyer: Graduate School of Business, Stanford University, pauloyer@stanford.edu. Schaefer: Kellogg School of
Management, Northwestern University, s-schaefer@northwestern.edu. We thank Corey Rosen and Ryan Weeden for
providing the NCEO data. We thank Rachel Hayes, Kevin J. Murphy, Madhav Rajan, Stefan Reichelstein and Je
Zwiebel for valuable discussions.
1 Introduction
Employee stock options have generated substantial media and political attention recently, thanks
largely to the ongoing policy debate about accounting methods for option grants. Though options
were once rarely granted below top executive levels, broad-based option plans have become more
common in recent years.1 In some sectors of the U.S. economy, stock options appear to be the default
method by which rms share ownership with employees. This need not be the case, however, as
evidenced by Microsoft Corporation's recent decision to grant restricted stock to employees instead
of stock options. This decision highlights the fact that rms face a number of alternatives to stock
options, including restricted stock and cash, as means for compensating employees.
The presence of these alternatives raises the question of why so many rms would choose
options over cash or restricted stock. Given that options impose greater risk costs on risk-averse
employees than would either cash or restricted stock, there must be benets (or, at least, perceived
benets to the decision maker) that oset these costs. One possibility, detailed in Hall and Murphy
(2003), is that the use of option-based pay arises from the favorable accounting treatment of option
grants. Unlike cash and stock, most options granted to lower-level employees never aect the rm's
income statement. Hence, managers may not internalize the costs of options when making grants
to employees. Other authors, including Core and Guay (2001), Kedia and Mozumdar (2002), and
Oyer and Schaefer (2003), have argued that there may be substantial economic benets to rms
from granting stock options broadly to employees. Options may help rms attract and retain
employees, provide incentives, or nance investment by reducing cash wage payments. If options
are selected for these reasons, however,