What is the purpose of stock options?

Once again, stock options are making headlines. Criticized by many, one could almost forget the actual benefits of this compensation method! Here is a brief clarification for economists.

The Challenge: Maximizing Shareholder Value

In a context where an owner delegates the management of their company, how can they incentivize executives to exert effort that benefits them (ensuring executives do not overcompensate themselves, thereby reducing the dividends paid to the owner), given that they lack perfect information regarding their actions? The solution lies in aligning the interests of executives with the company’s market value. This involves following the principles of Agency Theory, explained here.

Constraint: limited corporate resources

How can companies attract high-potential executives when corporate resources are insufficient to compensate them at market value? Stock options provide an answer to this challenge by allowing executives (or managers) to acquire company shares at a predetermined price—specifically, when the company’s market valuation is still low. This creates the potential for significant profit if the share price rises between the time the option is granted and when it is exercised. Even better: if the share price drops, there is no obligation to exercise the option, meaning no loss is incurred…

Their success within the startup ecosystem is therefore perfectly understandable: these are companies with still-limited resources, yet those with the potential for significant market valuation.

Insider trading issues, which are frequently discussed, tend to affect large corporations rather than startups, as the smaller number of shareholders in the latter tends to equalize the level of information available to everyone. Most often, these scandals involve shares being manipulated or backdated by executives in an attempt to secure the lowest possible exercise price to maximize capital gains. Indeed, the information available to executives allows them to pinpoint the most opportune moment to exercise their options (as seen in the EADS case), to the detriment of minority shareholders. The question then arises as to whether it is possible to mitigate the effects of information asymmetry between executives and traditional shareholders.

To date, having assumed the existence of opportunistic agents, there is no solution in sight…