Monday, April 20, 2009

The Problem with Stock Options

Dartmouth Professor Sydney Finkelstein provides a clear and concise critique of stock option compensation schemes on Naturally, his criticism focuses first and foremost on the fact that stock option compensation tends to encourage excessive risk-taking. Finkelstein rightfully also critiques the rush to reprice stock options now in the face of huge declines in stock prices.

In general, pay for performance has the potential to be effective as part of a broader human resource management system designed to attract, retain, and motivate talented people. However, no pay for performance plan is perfect. In the case of stock options, the downside is excessive risk-taking. As companies make key decisions on their compensation plans, they must always remember that the law of unintended consquences will prevail in most situations. While trying to motivate desirable behavior X, the plan often leads to undesirable behaviors Y and Z as well.