Stock option grants to non-executive employees have become an important component of compensation policy in recent decades (Mehran and Tracy (2001), Murphy (2003)). While there is no firm consensus in the literature as to why options are granted to non-executives, many economic studies of non-executive option programs argue that free-riding among employees will outweigh any incentive effects provided by option compensation. Indeed, non-executive employee options have been referred to as incentives that have no incentive effects (Oyer (2004)), and several studies of non-executive option programs argue that pay-for performance is unlikely to be the primary motivation behind these option grants.
In this study, we shift focus away from the question of why stock options are granted to consider the question of evaluating their effects empirically. Though non-executive option programs may be motivated by reasons other than or in addition to effort enhancement, we ask whether option compensation for non-executive employees, and more specifically, the pay for (firm) performance incentives implied by these programs, affect firm performance. Is it indeed the case that free-riding outweighs any possible provision of incentives in this setting?
Whether stock options enhance firm performance is a question with important implications for corporate decisions regarding workforce compensation as well as for the financial regulatory environment. There is a common belief among practitioners that reducing the attractiveness of options as a form of compensation for non-executive employees (e.g., expensing stock options in financial statements) will derail an important form of incentive compensation. For example, John Doerr, a partner of venture capital firm Kleiner, Perkins, Caufield, and Byers, noted in 2004 that If the Financial Accounting Standards Board is allowed to mandate expensing of broad-based options, they're going to basically go away for 14 million Americans who use them…whose companies use them as a way to create a powerful ownership incentive.
Many academic treatments of non-executive option programs, however, consider grants to company rank and file too diffuse to create incentive effects, in contrast to option grants provided to CEOs or other top executives. Stock option grants align the incentives of the worker with increasing the value of the whole firm, rather than with his individual performance (Core and Guay (2001), Oyer (2004), Oyer and Schaefer (2005)). Much of the academic literature, following the intuition set forth in Alchian and Demsetz (1972), argues that because these stock options compensate employees for joint performance improvements, employees must share the rewards from higher effort, resulting in dilution of worker incentives and mitigation of additional effort.
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Incentives, Targeting and Firm Performance: An Analysis of Non- Executive Stock Options
