Thursday, May 19, 2005

Shares and Options

Some companies have schemes whereby employees are given shares in the company instead of a cash bonus. Some companies have schemes whereby employees are encouraged to buy shares in the company. Such saving schemes may have some tax advantages.

External investors like to see that employees have confidence in the company. Directors' shareholdings are of particular interest; directors are required to publish details of their share dealings, and are not permitted to trade in shares during the so-called closed period while the accounts are being prepared for publication (at which time they have access to inside information).

Terminology: Executive Directors (often just called executives) are managers who are members of the board of directors and also employees of the company. Directors who are not employees are called Non-Executive Directors or sometimes (rather inaccurately) Independent Directors.

Some companies have incentive schemes whereby directors and senior employees are awarded share options rather than shares. This essentially gives the employee the right to buy shares at a given price at some future date. Obviously if the share price increases dramatically such share options are worth a lot of money, since the employee can buy shares for a fraction of their market value.

Ordinary shares confer voting rights and may pay dividends. They represent a real share of the capital investment in the company. But with share options you get no vote and no dividend. It doesn't cost the company or its shareholders anything when the share options are handed out - which is one of the reasons why they like doing it. There is merely a future liability (because at some time in the future, someone will have to give the employee some cheap shares), which is often fudged in the company accounts.

So in terms of organizational behaviour, what is the difference between shares and share options?

Future rewards are more effective as motivators than past rewards. A gift of shares may not encourage an employee to work any harder, whereas share options might. Share options may be included in a recruitment package designed to attract high-flying executives and other employees.

Shares represent a stake in the company. The employee now has a double stake in the company - if the company fails, then this means losing both the job and the savings. An executive director who is thus doubly exposed may tend towards caution when making executive decisions. (But this is a short-term exposure, and a short-term motivation - once you leave the company and sell your shares, it no longer matters.)

Share options represent a longer-stake in the company's future. Employees are motivated to improve the longer-term value of the company, and are not just focused on short-term results. Share options provide the employee with a one-sided bet - if the share price goes up, the employee wins; if the share price goes down, the employee hasn't really lost anything.

And share options are more valuable if the share price is volatile. (This is based on a standard bit of economic theory known as the Brook-Scholes formula.)

In short: share ownership makes executives more risk-averse, but share options encourage risk-taking.

[Update] At least that's one theory. Got a better theory?

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