Why I’m Biased Against Stock Options
Someone who listens to the podcast emailed this question:
“I’ve heard Geoff speak about not liking management with tons of stock options but preferring they have raw equity. Could you elaborate on the reasons why? Is it because they have more skin in the game by sharing the downside with raw equity? Thoughts on raw equity vs equity vesting schedule?”
This is just a personal bias based on my own experience investing in companies. There is theoretically nothing wrong with using stock options instead of granting shares to someone. And, in practice, later hires are pretty much going to need to be given stock options or some other kind of outright grants. Otherwise, they’ll never build up much equity in the company.
I basically have three concerns about stock options. One is simple enough to sum up in a sentence. Obviously, CEOs and other insiders are very involved in setting the stock options they get. Other things equal, the bigger the option grants the more likely insiders are especially greedy. I’m not sure I want to own stock in a company run by especially greedy people. This might work if you had active control of the company. But, you’re going to be a passive outside shareholder. You don’t really have oversight powers as you would as a 100% private business owner. So, especially greedy insiders are probably ones you don’t want running your company. Big option grants (and low actual stock ownership) can be a symptom of unchecked insider greed.
Okay. We got the simple one out of the way. Now, let’s get into the more nuanced concerns about stock options.
My second concern relates to the influence insiders have on the company’s long-term capital allocation and strategy. The other is simply that I think that from a practical perspective more wealth can be transferred from owners to operators without a shareholder backlash if done via options than via cash.
Let’s talk about concern number one first. Concern number one is that insiders given a lot of options tend not to end up being long-term holders of a lot of stock with a lot of votes attached to it. Therefore, the incentives for insiders are not as long-term as I’d like and the stability of their control over the company is not as secure as I’d like.
When I discuss compensation and stock ownership on the podcast – I’m not really talking about employees. I’m talking about a super select group. My concern is people who are involved – or could easily become involved – in major capital allocation decisions made at corporate. So, basically: the board, C-level executives (especially the CEO and CFO), and major shareholders.
At most companies, it’s narrower than this. Most board members are relatively un-influential and relatively passive. Most major shareholders are institutions that tend to be passive or are shareholders where this stock alone is not large enough to be relevant to their overall performance. So, for many companies, nobody outside of the CEO and CFO are even that important to worry about share ownership. Also, many CEOs and CFOs are career executives (they may move companies) who aren’t going to serve much more than a 5-year term. Again, this makes them less relevant in an analysis of possible long-term capital allocation.
Who is more relevant? Any founder who is still around. Insiders who own a lot of stock (and have a lot of votes). Former executives who are still on the board and still active in the business. And long-tenured members of the management team. People like that.
Owning a lot of stock that someone is unlikely – or unable – to sell gives them a more long-term focus. And owning a large proportion of (a voting class) of stock gives them a lot of influence. So, I am focused on people who actually own stock in a company because these people will have the greatest influence on major capital allocation decisions in the future. In particular, these people will have a lot of influence over whether or not to sell the company, recapitalize the company, do a transformative merger, keep or remove a CEO, etc.
Do I have anything against giving lot of options to people lower in the organization, people who joined the company later, etc.? No. Especially not at larger organizations. At big companies, the only people who could potentially have much influence are founders or people connected to founders who got special classes of stock and kept that stock (so, members of the founding family). Later hires will never have much voting power. And, any company that gets to a certain size and lacks a founder who hangs on to his stock and lacks a dual-class share structure is going to be limited in how much true control insiders of any kind have. If nobody inside a company owns more than a couple percent of the stock and there is only one class of stock – that company can be taken over whenever its stock price is weak. There is little insiders can do to stop that.
I am most concerned in situations where the board, top management, etc. have small stock ownership relative to their compensation and where they have very few votes. These two things usually go together. So, like a board where everyone is paid $300,000 a year and nobody owns any stock. That’s concerning because $300,000 a year is definitely large enough to create bad incentives where the director wants to keep their board seat more than they want to increase the stock price in the long-run. Having few votes is also concerning, because it means current control is in the hands of people who can’t necessarily count on continuing control. If the CEO, CFO, board, etc. don’t own a lot of stock – they are basically just running things up to the point where shareholders disagree with them. They seem to be in control. But, their control can be tested and they have no stable support among the shareholder base other than the typical “status quo” bias that you see in a lot of proxy voting.
More ownership by insiders helps ensure continuity of control and often continuity of capital allocation, long-term strategy, etc. However: this doesn’t mean it’s good. It just amplifies the innate goodness or badness the insiders bring to this company. It gives them a freer hand to act for the long-term. So, if I like management – more ownership by management is better. And, if I don’t like management – more ownership by management is worse.
There are companies where I’d buy into the stock if management didn’t own so much. But, because I dislike management and management owns enough stock to have firm, long-term control of the company – I ignore the stock. Many long-term “dead money” stocks fall into this situation. Value investors and activist investors would buy into those companies and change management, capital allocation, and maybe even long-term strategy if they could. But, they can’t. And, so the stocks remain cheaper than they would be if there weren’t these ironclad takeover defenses combined with incompetent, dishonest, or self-serving management.
I do want to clear one thing up about stock options though. I really don’t have a problem with a company like Amazon (AMZN) or something where there is an insider with a large ownership position who is happy to have a lot of stock options given to employees. This doesn’t concern me. When it comes to dilution, an outside shareholder is in the same boat as the insider who owns a lot of stock. If anything, the insider is more biased to being a long-term (almost permanent) holder of the stock than you as an outside shareholder are. If he thinks he’s getting value for his dilution – that’s really a business judgment you can agree with or not. But, it’s not a cause for concern in terms of incentive mismatches between you and the insider.
I don’t want to go through a long list of naming every company where the reverse is true. But, in the world of micro-caps that I invest in – I can think of cases where a CEO was granted more than 10% of a company and sold more than 10% of a company and still ended his tenure with more shares than he started it with. In these cases, stock options are often a way to pay out larger bonuses than shareholders would otherwise be willing to swallow.
The Chief Operating Officer of Meta recently decided to leave the company. Estimates are she made stock sales of like $1.5 billion or more during her 14 years at the company. That averages out to more than $100 million a year. It’s just unlikely shareholders would’ve been in favor of $100 million a year in cash compensation (salary and bonuses). But, they’ll accept it if it’s done in stock since that is very difficult to quantify.
One way of thinking about this is the market cap of the stock. If you have a $1 billion company and say you are going to outright grant 1% to 2% a year to top executives – that doesn’t sound like too much dilution. It sounds roughly right to investors. And they’ll accept it. But, that’s actually $10 to $20 million a year. For a smaller company to pay that out directly in cash would get more attention.
But, Berkshire probably does exactly that at some of its operating units. It uses huge cash bonuses to compensate the heads of some business units with high paid executive type compensation – but, without any share dilution (just a lot of cash).
There are a few industries where very large cash bonuses have been historically common (investment banking, advertising, entertainment). I’m honestly less worried about huge cash bonuses sneaking up on a shareholder versus huge share issuance. Share issuance (whether through options or any other form) is easier to game in terms of timing and structuring in ways that can make the wealth transfer from owners to operators especially big. Looking at the last 10-15 years of a company’s history, I think I can account for large cash payments pretty well. But, if the company sometimes issues a lot of stock to insiders – that’s something I’d be more worried might happen in the future to a greater extent than I might predict on the day I buy the stock.