I practice behavior, valuation and the incentive effect of employee stock options.

Periodic request number F8/wk08

Author J. Cabettis, John M. Bizjak, Michael L. Lemmon,

Executive compensation; Option practice; Employee stock options; corporate governance

Journal of financial economics

In 2005

Volume V.76 No.2

Page 445

abstract:

We use a large database about ESO exercise to record the characteristics of exercise behavior, and calibrate a utility-based model to measure how the differences of exercise behavior are manifested in option value and incentive. The option values and incentives calculated from model calibration are compared with those calculated from the model used to evaluate tradable options. Our analysis provides guidance for scholars and practitioners on how the differences in exercise behavior and mode choice affect the value and incentive measures of ESO, and emphasizes the importance of thoroughly understanding the potential economic forces that affect the behavior of ESO holders.

Second, the equity incentive system refers to the system choice that an enterprise grants managers or ordinary employees the right to buy a certain percentage of shares in the company at a predetermined price in the future, or directly grants managers or ordinary employees a certain percentage of shares in the company in an attempt to motivate managers or ordinary employees. The research on performance-based equity incentive system is based on the existing equity incentive system, focusing on the correlation between each link and performance, trying to establish a linkage mechanism between system implementation and performance creation, so as to make the equity incentive system play an incentive role more effectively. In this paper, the performance deviation, the source of exercise funds and the short-term behavior of operators in the implementation of the equity incentive system are deeply studied, and more data and cases are cited, aiming at analyzing the defects of the existing equity incentive system, trying to establish a performance-related model of the equity incentive system and enhancing the incentive function of the equity incentive system. This paper demonstrates the following viewpoints: 1. Under the existing capital market conditions, because of the weak correlation between stock price and enterprise performance, incentive stocks related to equity incentive system should not be listed and circulated, otherwise it will not only fail to motivate operators to create performance, but even lead to a greater moral crisis, prompting operators to take risks to raise stock prices and push the future of enterprises and investors to a desperate situation. Negative stock market, how to solve the circulation pricing problem of incentive equity? In the second chapter of this paper, the performance-related pricing mechanism-EVA pricing model is established. In this model, there is a linear relationship between the redemption price of equity and performance EVA, and the only source of equity appreciation is performance, which urges operators to actively create performance to raise the stock price. In this model, the source of equity cash funds is also pointed out, that is, the operator's exercise funds and performance growth. 2. The most favorable source of exercise funds should be the performance growth part. Taking performance dividends as the source of exercise funds can form a virtuous circle of incentive mechanism and enhance the incentive effect. This model is called dividend exercise mechanism, and the exercise funds come from performance dividends. The more achievements the operators create, the faster and more quantity they exercise, and the more profits they make, thus prompting the operators to actively create achievements to speed up the exercise and form a virtuous circle of incentive mechanism. 3. The equity incentive system focuses on long-term incentives, which should be locked in for a long time and stipulate long-term exercise in batches. On the one hand, it stipulates a longer time limit for exercising cash. One of the purposes of implementing the equity incentive system is to achieve long-term incentives, otherwise it is not much different from finding bonuses. Once the equity is cashed, its incentive function disappears, and it is necessary to stipulate the long-term redemption of the exercise. On the other hand, it is stipulated to cash in the exercise by stages. Another purpose of implementing the equity incentive system is to achieve long-term incentives. Because operators generally have a preference for cash benefits, that is, short-term benefits, if they can only cash their exercise rights in the distant future, they will not be able to meet their short-term preferences, and the incentive of the system will be greatly weakened. In order to achieve the balance between short-term incentives and long-term incentives, it is necessary to stipulate the right to cash in installments. In addition, it is stipulated that the exercise rights should be realized by stages and batches, so that the operators can only realize a small part of the equity income in each stage and batch, which can prevent the short-term behavior of the operators and effectively avoid the devastating risks like Enron and WorldCom. This paper is a preliminary study of the performance-based equity incentive system in the current economic environment, emphasizing that the equity incentive system must be able to achieve performance-oriented and long-term incentives. Therefore, the establishment of performance-related model and the balance of long-term and short-term incentives are the key. All the efforts in this paper are focused on solving these two problems. Stock incentive system is a system used by companies to motivate managers or ordinary employees. Under this system, in order to motivate managers or ordinary employees, the company will allocate them a certain number of stocks or stock options to make them become shareholders. The research on performance stock incentive system is based on the existing stock incentive system. This study focuses on the correlation between system structure and excellent performance. Through the research of this paper, the author tries to establish a targeted relationship between the implementation of incentive system and the implementation of performance linkage, in order to improve the effectiveness of stock incentive system. This paper mainly studies the performance deviation, the source of funds for purchasing options or stocks, and the shortsightedness of managers. Through a large number of data and cases, find out the defects of the existing SIS, establish a new model, and improve the efficiency of SIS. In this paper, the author demonstrates the following points. 1. In the capital market environment, the correlation between stock price and performance is weak, so it is strongly recommended that the stocks of listed companies should not be listed, otherwise the incentives for managers will be ineffective, and it may also lead to the risk of cheating to stimulate market prices, which will ultimately harm the interests of the company and shareholders. So how to price incentive stocks and how to cash them? The second chapter answers these questions by establishing EVA pricing model. In this model, there is a linear correlation between stock price and EVA. Under the pricing of this model, the appreciation of stocks becomes the only source of managers' performance, which will encourage managers to strive to raise stock prices. In this model, we can also find that the capital sources of stock realization are exercise capital and EVA. 2. Capital dividends can establish a good source of exercising capital and form a benign incentive circulation system, thus improving the efficiency of social insurance. This system is called the capital dividend exercise system. As capital dividend is the only source of exercise, and we know that the performance of managers is the only source of capital dividend, the better the performance, the more dividends, the faster the exercise, the more exercise, the more shares held by managers, the more income they earn, which encourages managers to work harder, thus forming a benign incentive cycle system. 3. Because SIS is used to obtain long-term incentives, managers' stock holding period must be quite long, and the rules of exercising and cashing in batches must be stipulated. First of all, in order to realize the long-term incentive function of SIS, the holding period must be quite long, otherwise it will not be better than cash dividend. Because once cashed, the incentive effect will disappear, so the holding period must be set long. Secondly, options or stocks must be exercised or cashed in batches during the holding period. Because managers have cash preference, that is, short-term income preference, if managers can't get income before the end of the long term, their short-term income preference can't be realized, so the incentive function of social insurance will be weakened. In order to coordinate long-term incentives with short-term incentives, options or stocks must be executed or cashed in batches. In addition, this prescription of dividing managers' stock income into several batches can prevent managers from short-sighted risks, so that companies can avoid disasters like Enron and WorldCom. This paper is a preliminary study on the stock incentive system based on excellent performance. The article holds that the implementation of stock incentive system should be able to motivate operators to achieve excellent performance, and the incentive period should be quite long. To achieve these effects, the key is to establish an EVA model and establish a balance between short-term incentives and long-term incentives. Most of the author's efforts are aimed at solving these two problems.