Out-of-the-money: the impact of underwater stock options on executive job search.

The need for future leadership in organizations is widely recognized, and often addressed through leadership development, succession planning, and building a top talent pipeline among existing employees. Equally important is retaining talented executives. Executive retention has become a concern for organizations as plunging stock prices have led to vastly devalued stock options, perhaps causing executives to look elsewhere for more lucrative stock option portfolios. Yet, there has been little research on the relationship between stock option value and executive retention. In a cross-company, cross-industry sample of 610 U.S. executives, we explored the relationship between underwater stock options and job search. We found a positive association between the percentage of underwater stock options in executives' portfolios and job search. This relationship was moderated as predicted, by executives' perceptions of alternative employment and money inadequacy beliefs.

**********

For the past 2 decades, stock option grants have become an increasingly popular form of executive compensation in the United States (Hall, 2000) and abroad (Taft & Singh, 2003). Hall and Murphy (2002) reported that in 1999, 94% of S&P 500 companies granted options to their top executives, up from 82% in 1992. Stock options have also increased in terms of their proportion of executives' total compensation. Hall and Murphy (2002) further reported that in 1999, stock options accounted for 47% of the total compensation of S&P 500 executives, up 22% from 1992. In addition to stock option grants and base salary, executive pay packages typically contain other components, such as annual bonuses tied to firm performance, benefits, and other long-term incentives such as restricted stock grants (Taft & Singh, 2003). However, recent reports indicate that stock options now represent the largest single component of executives' total compensation packages (St-Onge, Magnan, Thorne, & Raymond, 2001).

There are several reasons for the increased use of stock option grants in executives' pay packages. First, companies are not currently required to charge stock option grants against earnings (Bodie, Kaplan, & Merton, 2002), providing a unique way to reward executives and other employees without increasing labor costs. Second, stock options have been widely used as a means of aligning the divergent interests of executives and shareholders (Brandes, Dharwadkar, & Lemesis, 2003). Finally, stock options are widely used as a means of attracting and retaining top talent (Ittner, Lambert, & Larcker, 2003).

Stock options are nontradable rights to purchase a certain number of shares in one's company at a certain price known as the exercise price (Hull, 2002). The exercise price is often the firm's market price on the date they are granted (Hall & Murphy, 2002). Stock options are considered "underwater" (or "out-of-the-money") when the market price falls below the exercise price. Conversely, stock options are considered to be "in-the-money" when the market price is above the exercise price (Hull, 2002). When stock options are underwater they are considered to have no current value to the recipient even though they may have value in the future if the stock price appreciates (Hall, 2000). As long-term incentives, stock options usually cannot be exercised (i.e., the shares cannot be purchased) all at once, and not until a certain future date (often 4-5 years after the grant date). Stock option grants often are subject to vesting schedules whereby executives can exercise a small portion of a grant each year (e.g., 20% of the shares in a grant each year up to 5 years). Stock option grants typically expire after 10 years (Weeden, Carberry, & Rodrick, 1998). Most executives receive different stock option grants with a different exercise price each year (Linney, 1999) or even at multiple times per year. Therefore, at any given time, an executive's stock option portfolio likely consists of some options that are in-the-money and some that are out-of-the-money.

In contrast to their increased popularity, executives' stock option portfolios have experienced massive depreciation in recent years. One recent survey suggested that more than 80% of U.S. companies had some underwater options, with more than one third reporting that at least 50% of their outstanding options were underwater (Corporate Board, 2001). Widespread depreciation in the value of option portfolios is believed to have a variety of negative consequences for organizations, including reduced motivation and morale of option holders (Burwaza, 1998; Delves, 2001), and misalignment of management and shareholder interests (Daily, Certo, & Dalton, 2002). However, one of the most widely publicized concerns with depreciated stock option portfolios is the loss of key talent (Tully, 2000). Ittner, Lambert, and Larcker (2003) reported that employee retention was the most often cited objective for stock option plans among a sample of 194 "New Economy" firms. In addition, The National Center for Employee Ownership found that 93% of companies in a nationwide survey of U.S. companies indicated that the "retention of key employees" was a key objective of their stock option grants (Weeden, Carberry, & Rodrick, 1998). This retention concern does not appear to have subsided with the recent recession: "Despite a weakened economy, competition for key talent remains stiff: highly skilled employees holding worthless options may pay closer attention to calls from headhunters" (Delves, 2001, p. 28).

Stock options have been the subject of considerable research during the past 2 decades. Several studies using an agency theory framework have examined risk avoidance tactics among CEOs possessing stock options and other forms of variable pay designed to align the interest of shareholders and executives. One noted problem with stock options is that they may motivate executives to make decisions that minimize their own risk at the expense of shareholders (Wiseman, Gomez-Mejia, & Fugate, 2000). For example, previous research has explored how executives can mitigate personal risk by pursuing conglomerate mergers (Amihud & Lev, 1981), acquisitions (Sanders, 2001), using alternative accounting methods (Antle & Smith, 1986), and reducing R&D expenditures (Hoskinsson, Hitt, & Hill, 1993).