Two more reasons (that I hadn't mentioned in my last post) why giving your CEO options (besides being a bad idea in general) will also give him or her strong incentives to prefer buybacks to dividends (if any "return cash to shareholders" action is contemplated).
First, as a ("call") options holder, the CEO receives no benefits from dividends declared today -- call owners don't accrue dividends, holders of <i>stock</i> do. For the identical decrease to the firm's enterprise value (due to the departure of cash), buybacks should at least increase the options' present value (by the amount the buybacks increase the value of common stock, times the options' "delta" -- the latter can be pretty close to 1 if the option is, at this time, substantially in-the-money).
Second, the very granting of options produces likely risk of stock dilution -- those options are going to be exercised if they are in the money at some time between when the vest and when they expire, creating new stock in addition to what current stock-holders presently own. Just as buybacks should increase the value of common stock, so dilution should decrease it -- and, the market is a forecasting device, so, <i>impending</i> dilution (dilution that's reliably forecast to happen in the future) should also reduce the value of common stock (by some fraction of what it would be reduced by as and when the options get exercised, multiplied by the probability that options will expire out of the money -- roughly equal to delta -- and further diminished by the discount rate to apply due to the delay between now, and the time of the options' exercise).
Decrease in common stock value also decreases the value of the options the CEO holds (again, by the amount the dilution decreases the value of common stock, times the options' "delta") -- again, this is incentive for the CEO to have the firm do the buybacks.
If options are to be granted at all, buybacks (one grudgingly has to admit), in about the amount needed to avoid dilution, have reasonable returns to shareholders (mostly due to the tax treatment of various possibilities -- which, of course, is a very volatile thing;-).
And, in fact, there are industries where it's just about mandatory to give your employees options if you want to retain the top talent -- mostly industries in which your likely competitors for said top talent are likely to try to lure them away by dangling wads of options at them.
Employee options are relatively cheap to the firm granting them (and in particular, differently from just about any other form of compensation, require no outlay of cash by the firm at this time... nor at any future time either, necessarily, except that if and when the options are exercised buybacks costing cash will become desirable... but, still, not mandatory!).
Since call options give great leverage compared to owning stock (esp. restricted stock), they're particularly attractive to optimistic, "high-roller", "top talent" employees who are particularly desirable.
<i>And</i>, the crazy accounting treatment (by GAAP) of granting employees options is yet another motivation for the company to employ them in industries where they're culturally common. Note that each of the three points makes granting options as compensation <i>particularly</i> rewarding to start-up companies (who desperately need to preserve cash today, desperately need to attract and motivate over-performers, <i>and</i> really need accounting help to make their statements look decent in the difficult early times of low revenues, high outlays, and negative-if-any earnings;-). So, options are most commons in industries with large numbers of start-up companies, such as high tech; in those industries, options are usually found as part of compensation even in larger and more established companies, who'd otherwise risk having their best performers lured away by startups.
In addition, it's become customary to award options, in just about every industry, to at least the "cream" of top management (though often not to rank-and-file employees or even to middle management). This one new cultural trait I really deplore... it's certainly desirable to give top management a strong incentive to behave like stockholders, but, options don't do that -- stock does, even restricted stock (e.g. stock that cannot be sold for years after vesting -- enough years to hopefully allow the market to properly evaluate the company's value resulting from management's strategy, vision, and execution). Only startups (where volatility <i>is</i> desirable -- and the firm's not publicly quoted yet, so there are no shareholders to be damaged;-) should generously award options to top management (and all other employees... and suppliers, too, if they will take some reasonable amount in lieu of cash... remember, a startup's first commandment is to <b>conserve cash</b>!-).
Restricted stock, like options, would also require buybacks to avoid dilution, of course... but typically much less actual cash than needed to compensate for options of equivalent value when granted (the premium, or value, of a call options that is at the money when acquired -- as typically done for options granted to management or other employees -- is invariably lower than the underlying stock's price... except maybe for companies so wildly volatile they had <i>better</i> be startups!-). Accounting-wise, seeing that at an expense at time of granting -- or, at worst, of vesting -- rather than delaying it to exercise time, makes a lot of sense (but of course that's in part because it makes a company's financial statements a better match for reality, rather than "pretty them up" a bit... which no doubt is exactly why most companies dislike that!-).
Beyond the amount needed for dilution avoidance, buybacks are really a lottery at best, and in my view they're really undesirable for stockholders as a general rule -- as I hope to show in a future post. Absurd tax and accounting rules making buybacks (or options) "look good" should really be reformed, to avoid having the tax system provide distorting incentives to firms and their top management!
