Executive compensation packages are typically made up of a mixture of components that include a base salary, benefits, long-term compensation, annual bonuses, retirement contributions, stock, and call options on the company's stock. Stock options can, and often do, make up the largest portion of an executive compensation package. Since the 1980s, executive compensation has risen dramatically when compared to the rise in average wages, an increase that has followed the increase in popularity of options trading and executive stock options.
The popularity of issuing executive stock options has grown for several reasons:
- By tying rewards to the performance of the company's stock, stock options help make the executive's interests the same as the shareholders' interests. This helps a company overcome the agency problem.
- Stock options make an executive's lower base salary look more inline with average salaries in a company. This just looks good, especially if overall compensation is going up.
- If the firm isn't performing well, it doesn't have to pay out large amounts of fixed compensation to its executives.
- Most importantly, the popularity of stock options as a part of an executive compensation packages has come from the fact that, in the past, stock options did not have to be expensed against a company's earnings.
- Similarly, executives who receive options may not have to count them as income until the options are exercised. This makes writing call options a tax-prefered compensation strategy from the executives' perspective.
For executive stock options, the exercise price is normally set equal to the market price of the underlying stock for the date that the option is written. That is, we assume that all stock options are "at-the-money" when they are issued. When they are originally granted to an executive, they typically cannot be immediately exercised. A typical "vesting-period" lasts for one to five years. Some options have reloading options, which grant new options to executives when old options are exercised. Similarly, if the price of the company's stock falls, many options will be re-written with a new strike price and longer maturity to continue to provide incentives. These types of special issues make valuing executive stock options more difficult.
These special issues aside, we can use the Black-Scholes model to reasonably value an executive stock option. In some cases, if the number of shares that executive stock options will grant is high relative to the number of outstanding options, we would need to incorporate the diluting effect of the options by valuing them as warrants (see Warrant Pricing).