Regulating for efficiency

Chapter 17: Principal–Agent Issues and Adverse Selection: Can Everyone Agree?

the holder of the call is under no obligation to buy the stock and the option isn’t exercised. Any holder of a stock option has an incentive to work harder to increase the company’s stock price.

Your company offers its manager a 1,000-share stock option that can be exercised six months from now at the current price of $20.00 per share, the call price. If six months from now the stock price is $25.00 a share, the manager can make a quick $5,000. Here’s how:

1. The manager exercises the option and buys 1,000 shares at $20.00 per share.

The total cost is $20,000.

2. The manager sells the 1,000 shares at the market price of $25.00 per share.

The revenue from the sale is $25,000.

3. The difference between the revenue and cost is the manager’s financial gain, or $5,000.

If instead the company’s stock price decreased to $15.00, the manager wouldn’t exercise the option. Thus, the manager with a stock option has no risk of loss.

Stock options can carry a variety of restrictions. Vesting requirements limit the manager’s ability to sell the shares or options. Typical vesting requirements include requiring the manager to continue to work for the company for a specified number of years; some specific event to occur, such as an initial public offering (IPO); or certain performance targets to be reached, such as sales or profit goals. These vesting requirements help ensure that the owner’s and manager’s interests are the same.

In addition to increasing managerial effort, stock options can be used by start-up companies to reward employees, while keeping wages and salaries low. Thus, a new firm’s employees have a strong incentive to work hard to make the company successful.

One advantage of stock options over profit-sharing is managers focus more on the long-run value of the stock. Profit-sharing may lead to a shorter-term focus because it’s based on current outcomes.

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Keeping managers in line

Profit sharing and stock options involve using carrots to increase managerial effort. As an alternative, you can use a stick in the form of a negative consequence for poor performance. The advantage of this method to the