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  Problems of Options

Introduction to Problems of Options

Many see share options as a poor means of rewarding directors. Warren Buffett, one of the worlds shrewdest and so many successful investors, has made clear his opposition to their use. One problem that regards him is that share option schemes cannot distinguish among the performances achieved through individual directors. He argues:

Certainly stock (share) options frequently go to talented, value-adding managers and occasionally deliver them rewards which are perfectly suitable. (Certainly, managers who are actually exceptional almost all the time get far less than they should.) But while the result is equitable, it is accidental.

Once granted, the option is blind to individual performance. Since it is irrevocable and unconditional (so long like a manager stays in the company), the sluggard takes rewards from his options exactly like does the star. A managerial Rip Van Winkle, prepared to doze for ten years, could not want for a better 'incentive' system.

An additional problem relating the incentive value of share options, on which Buffett refers, is that, in which the share price falls considerably below the exercise price, the prospects of receiving advantages from the share options might become remote and any incentive value will be lost.

Both increases and falls in share price may be across the control of the directors and may just imitate changes in economy-wide or industry-wide factors. Whichever incentive scheme that is matter to the vagaries of the stock market is, so probable to present problems. There is all the time a risk that directors will either be overcompensated or undercompensated for their achievements.

Criticism of Buffett of share options is not restricted to their dubious incentive value. He also challenges the view that share options place directors in similar position like that of shareholders.

He argues:  the rhetoric about options often explains them like desirable since they put owners and managers in similar financial boat. Actually, the boats are far dissimilar. No owner has ever runaway the burden of capital costs, where a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential beside downside risk: an option holder has no downside. Actually, the business project in which you would want to have an option often is a project in which you would reject ownership.

This latter point, regarding the lack of 'downside' risk related with the acquisition of options, may have an influence on the risk-taking behaviour of directors

Share option schemes are relies on the supposition that shareholders are regarded with share price raises and that behaviour and incentives of directors should imitate this concern. Though, an excessive focus on share price might not be in the best interests of shareholders. Share price presents only one part of the total return of shareholders from the company: the other part is dividend income.

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