• Strategy
  • Monitor Group

So, Why Be Public?

This is a question more and more companies have been asking. Many of the traditional advantages of being public are no longer valid, and the mounting costs all the more obvious.

It was not until the advent of stock options—a virtual ownership mechanism designed to encourage managers to act like owners by rewarding them like owners—that many informed observers declared the principal/agent dilemma all but resolved. Options provided a clear incentive for executives to build shareholder value by giving them virtual equity stakes that might generate the vast majority of their net worth. The upside embedded in options dwarfed the value of salaries and cash bonuses. Options did suffer from visible flaws, such as occasionally generating mind-boggling windfalls for executives—as happened in the case of Disney’s CEO, Michael Eisner. Moreover, they seldom required executives to put their own capital at risk—a hazard that Jensen and others pointed out before the recent implosion.

Encouraged Recklessness

Without question, some options programs contributed to material improvements in corporate performance. Executives invested in building their own understanding of what contributed to share price appreciation and that of their organizations. But, in too many instances, the disproportionate gains available from the leverage options provided encouraged managers to become reckless. Regrettably, even tragically in some cases, recent scandals have revealed substantial flaws in the implementation of many option-based pay packages. As commonly instituted, options packages gave executives significant upsides with little associated downside. Far too often, ill-designed options packages rewarded managers who resorted to all sorts of manipulative practices to ensure their company’s short-term earnings growth. Fulfilling analysts’ earnings expectations led to share price appreciation, even when the strategies employed ultimately suborned a company’s long-term prospects.

Despite their inherent complexity, options presented executives with a relatively simple calculus: If they succeeded in raising share prices, they benefited; if share prices fell, the managers had lost an opportunity but suffered no direct negative consequence. Indeed, since boards occasionally helped managers recoup their lost opportunities by repricing “underwater” options plans, some executives found themselves in the enviable position of having what amounted to “all upside” plans.

In some instances, it is arguable that options proved less effective than old-fashioned salary and bonus schemes. In that old world of compensation, experts feared that managers acted too conservatively. Systems based on salary and bonus were believed to encourage executives to take too great an interest in preserving their managerial flexibility and growing the company, irrespective of the incremental impact of those strategies on the marginal returns for shareholders. While hardly an attractive proposition, it compares favorably with the worst of the options schemes, in which executives received rents usually reserved for entrepreneurs taking extraordinary risks, while assuming few actual risks themselves.

Microsoft’s decision to begin awarding restricted stock, instead of options, to eligible employees brought new attention to the now familiar problem of agency costs and the difficult task of aligning the interests of owners and managers. The Wall Street Journal recently revisited this issue, citing Jensen’s work on the subject. It described one of Jensen’s most recent proposals—to structure options in such a way that they prove valuable only if a company’s share price appreciates at a rate higher than its cost of capital. Acknowledging that the use of options “backfired” during the bubble, the paper concludes that Jensen’s ideas for structuring options to avoid their misuse and maximize their impact are “sensible.”

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