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 benets 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-prot 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 benets (or, at least, perceived

benets 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 benets 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, it must be the case that options perform better on these

dimensions than would comparable cash or restricted stock compensation packages.

In this paper, we compare stock options, restricted stock, and cash as compensation instruments

for lower-level employees. We focus on the cost/benet comparison made by a decision maker within

the rm (who may or may not have the same objective function as shareholders), and pose three

main questions. First, suppose the only benet from any form of equity-based compensation is the

favorable accounting treatment of stock options. If this is true, then how large are the real economic

costs the rm's decision maker is willing to incur in order to achieve this accounting-only benet?

Second, suppose there are real economic benets associated with equity-based compensation, but

that the benets arising from observed option grants could also be achieved by equivalently valued

(by the employee) restricted-stock grants. Suppose further that decision makers select options over

1 See Crimmel and Schildkraut (2001) and Oyer and Schaefer (2003) for detail on the incidence of broad-based

option grants.

1

stock grants in order to gain the favorable accounting treatment. Under this assumption, how

large are the real economic costs incurred in order to achieve this accounting-only benet? Third,

suppose the real economic benets associated with option-based compensation