Chapter 7

Executive Equity Ownership

Introduction

q we examine the relationship between equity ownership and executive

behavior In theory, executives who hold equity in the companies they
manage—either directly in the form of stock ownership or indirectly
through options, restricted stock, and performance shares—have greater
incentive to improve the economic value of the firm.
q Equity holdings dissuade self-interested behavior, in that any action the
executive takes that impairs firm value will inflict corresponding damage to
the executive’s personal wealth

Executive Ownership Risk

q Equity ownership not only provides incentive for performance but also
encourages risk taking.

q some degree of risk taking is required for a company to generate returns in

excess of its cost of capital. It is the responsibility of the board of directors
to determine a company’s risk tolerance and establish a compensation
program consistent with this view of risk.

q The composition of an executive’s equity portfolio plays a considerable role

in determining his or her appetite for risk.

q An executive whose wealth consists entirely of direct stock investments—

either restricted shares or shares that have vested but not been sold—
stands to gain or lose wealth dollar-for-dollar with changes in the stock
price.

q Many boards like this arrangement because it is seen as putting the

executive on equal footing with the average investor. 
q Many boards like this arrangement because it is seen as putting the
executive on equal footing with the average investor. However, one
important distinction remains: although the average investor holds shares
as part of a diversified portfolio, the typical executive has a large,
concentrated exposure to a single stock and therefore is exposed to greater
personal financial risk. As a result, executives have a tendency to become
risk averse, and over time, this can reduce performance

q Researchers have shown that some executives decline to pursue new

projects that would otherwise be valuable to well-diversified shareholders

q Stock options can be used to counteract risk aversion. The intrinsic value of
stock options is a nonlinear function of share price. The value moves dollar-
for-dollar with stock price when the option is “in the money” (when the
stock price is above the exercise price), but the value is unaffected by stock
price when the option is “out of the money” (when the stock price is below
the exercise price).

q This encourages risk taking. As such, stock options are used to encourage
managers to become less risk averse by investing in higher-risk, higher-
return projects.

q Daniel, and Naveen (2006) found that executives with large stock option
exposure spend more money on research and development, reduce firm
diversification, and increase firm leverage—all actions that increase the risk
profile of the firm.

q In the same vein, Gormley, Matsa, and Milbourn (2013) found that a
reduction in stock option exposure is associated with a reduction in risk

q Managers with less payoffs decrease leverage, reduce research and

development, hold larger cash balances, and engage in more diversifying
acquisitions.  

q Armstrong and Vashishtha (2012) demonstrated that stock options give

CEOs incentive to increase systemic risk (which can be hedged through
financial instruments) but not idiosyncratic firm-specific risk.  
q Kim, Li, and Zhang (2011) found that companies whose chief financial
officers have considerable stock option exposure in their equity holdings
have a greater risk of a stock price crash (defined as a one-week stock
return standard deviations below the mean)

q The issue of whether stock options might be related to “excessive” risk

taking is an important consideration for boards and shareholders when
deciding on executive compensation packages.

q Unfortunately, no standard litmus test exists to distinguish an excessive risk

from an acceptable risk. An excessive risk might be one whose downside is
so large that the firm cannot financially bear it. 

q Larcker, Ormazabal, Tayan, and Taylor (2014) demonstrated a significant

increase in risk-taking incentives among banks prior to the financial crisis,
particularly banks that originated and distributed the securitized assets that
were central to the crisis.

q By 2006, the sensitivity of CEO wealth to stock price volatility at the average
securitizing bank was 15-fold higher than it had been in 1992 and
quadruple that of the average nonbank CEO.

q This suggests that incentives likely played a role in the crisis.  DeYoung,
Peng, and Yan (2013) found similar results.

q Fahlenbrach and Stultz (2011), however, found no evidence that greater

sensitivity of bank CEO wealth to stock volatility led to worse performance
during the crisis. They posited that “CEOs focused on the interests of their
shareholders in the buildup to the crisis and took actions that they believed
the market would welcome.

q Ex post, these actions were costly to their banks and to themselves when
the results turned out to be poor.
Equity Ownership and Agency Costs
q Equity ownership is intended to provide incentives that motivate managers
to improve corporate performance, but it also has the potential to
encourage undesirable behaviors. This occurs when an executive seeks to
increase the value of equity holdings in ways other than through
improvements in operating, financing, and investment decisions. Examples
include these:
1. Manipulating accounting results to inflate stock price or achieve
bonus targets
2. Manipulating the timing of option grants to increase their intrinsic
value
3. Manipulating the release of information to the public to correspond
with more favorable grant dates
4. Using inside information to gain an advantage in selling or otherwise
hedging equity holdings
When these actions occur, they represent the very agency costs that equity
ownership is intended to discourage.

q Equity ownership is intended to provide incentives that motivate managers

to improve corporate performance, but it also has the potential to
encourage undesirable behaviors.

q This occurs when an executive seeks to increase the value of equity

holdings in ways other than through improvements in operating,
financing, and investment decisions. Examples include these: