How do Stock Options affect Executive Compensation Amounts?

Appreciation in a company’s stock value is one reason that executive compensation amounts appear to be so high.

Publicly-traded companies are required by the Securities and Exchange Commission to publish a table showing how much their top executives were paid the prior year.  Companies usually publish this table in the proxy that is sent to shareholders soon after year end.  The table breaks down compensation by person and by category.

Some readers may notice how high the executives’ compensation amounts were and question why the company spent so much of the shareholders’ money this way.  But readers should realize that the company may not have spent so much money after all.  In fact, most of an executive’s pay may have come in the form of exercised stock options.  The company may have granted options to an executive up to ten years earlier.  Then, the value of the company’s stock increased over a period of years.  Once the executive exercised the options, the appreciation of the underlying stock was reported as part of his or her compensation.  In other words, the pay package may have included amounts that were not cash from the company, but were appreciation in the stock market.

Let’s look at a simplistic example.  A CEO is granted options to acquire 10,000 shares of her employer’s stock.  The stock’s value on the grant date is $10 per share.  That value ($10) becomes the strike price, which means the CEO will have to pay $10 to exercise each option.  Eight years later, the stock value has increased to $50 per share.  The CEO exercises the options and the company issues her 10,000 shares of stock.  Those shares are immediately sold on the market for $500,000.  The company gets $100,000 of the sale proceeds (the strike price).  The CEO gets the other $400,000 of cash and that $400,000 is included in the CEO’s reported compensation.  There are three important points to notice in this example:

1. This $400,000 of compensation was generated by appreciation of the stock, which all of the company’s shareholders would have enjoyed during that time.
2. The company did not pay the CEO in cash.  In fact, the company received $100,000 of cash when the options were exercised.
3. The $400,000 included in the CEO’s pay for the year of exercise was actually from options granted to her eight years earlier.

Some dilution of the stock occurred, however, which would not have occurred if the options had not been exercised.

This is not to say that executives always deserve as much pay as they receive.  Some earn every penny, others do not.  But it is helpful to understand what is in the compensation amounts and where the numbers come from.

Privately-owned companies and non-profit organizations cannot readily offer stock options as part of their compensation packages.  Therefore, to be competitive with publicly-traded corporations, private companies and non-profits may have to offer larger salaries and cash bonuses.