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Stock Strategist

Stock Options Aren't Ownership

Options offer managers a chance to cash in, not a stake in the firm.

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One of my favorite scenes in the movie Wall Street takes place when the character Gordon Gekko preaches to the shareholders of Teldar Paper about the lack of ownership among management in corporate America. "In the days of the free market when our country was a top industrial power, there was accountability to the stockholder," gripes Gekko. "The Carnegies, the Mellons, the men that built this great industrial empire, made sure of it because it was their money at stake. Today, management has no stake in the company!" Sadly, Gekko's comments remain true today.

It's important for management to own a stake in the companies they help run because it aligns their interests with shareholders. The best management teams think of shareholders as partners, and consequently only make (or lose) money when everyone does. You can find lots of information about management ownership in annual proxy statements that firms file with the Securities and Exchange Commission. There's typically a table at the beginning of the report that says how much management, directors, and major stockholders (i.e. over 5% of the firm) each own.

However, if you look closely at the footnotes, management ownership is oftentimes grossly overstated by the options they've been given by the board of directors. The SEC counts options exercisable within 60 days of a particular date prior to the time the proxy was filed as ownership. The problem is that owning options isn't the same as owning the stock. Management hasn't paid anything for the options, so they don't have the same risk as shareholders that have actually spent cash. If the company does something dim-witted and the stock price plummets, shareholders are the only ones that ultimately lose money; meanwhile, management's potential loss is capped at zero, but upside is unlimited. Management can even issue a new set of options at a lower price--or reprice existing ones and start the process over.

Technology companies are infamous for being run by management with ownership stakes comprised of mostly options. For instance, as of the most recent proxy,  PeopleSoft (PSFT) CEO Craig Conway owns 1.2% of the company. But after deducting options and unvested restricted stock, Conway only owns about 1,600 shares, or 0.0005% of PeopleSoft.  Adobe Systems (ADBE) CEO Bruce Chizen isn't much better. After backing out his 1.7 million options, Chizen owns a little more than 1,900 shares, or 0.0008% of Adobe as of the most recent proxy. Despite the fact that Chizen joined Adobe in 1994 and Conway joined PeopleSoft in 1999, neither executive has made a long-term commitment to their respective company because the majority of their ownership stake was given to them for nothing in the form of options.

There are exceptions.  Microsoft (MSFT) CEO Steve Ballmer's 4.4% ownership stake is entirely in stock. In fact, a search of every Microsoft proxy statement for the last 10 years, reveals that Ballmer and chairman Bill Gates haven't received a single option.  Learning Tree (LTRE) is another example of management team that's closely aligned with shareholders. CEO David Collins and president Eric Garen together own more than 47% of the company, nearly all of which is in plain old shares. It's even better when management and directors dip into their own pockets to buy stock.  Corning (GLW) director Gordon Gund spent $6 million buying the shares of his company on the open market last year.

Option supporters, typically the ones with the biggest grants, argue that options align shareholders and management interests because both have an incentive to see the stock price to rise. But this type of incentive can encourage unnecessary risk-taking. If management's only inducement is to boost the stock price, rather than grow the intrinsic value of the business (i.e. increase free cash flow), it may make stupid decisions--for example, making acquisitions or taking on debt--that destroy value. Some have gone as far as accounting trickery to boost profits. Even if the financials have to be restated, management can profit from a high stock price in the short term.

It's reasonable to demand that management own common stock in the companies shareholders have hired them to run. But giving away free options isn't the answer. Everyone should profit when management makes good business decisions and the stock price rises. Conversely, everyone should lose money when management screws up and the stock price plummets. But a management team that has its ownership stake tied up in free options doesn't play by this set of rules. Instead, it's only the shareholders who end up losing when management makes a wrong turn.

Mike Trigg does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.