On The Optimality of Resetting Executive Stock Options

Abstract

Recent empirical work has documented the tendency of corporations to reset strike prices on previously-awarded executive stock option grants when declining stock prices have pushed these options out-of-the-money. This practice has been criticized as counter-productive since it weakens incentives present in the original award. We find that although the anticipation of resetting will typically result in a negative effect on initial incentives, resetting can still be an important, value-enhancing aspect of compensation contracts, even from an ex-ante standpoint. Indeed, we find a precise sense that some resetting is almost always optimal. We also characterize the conditions that affect the relative optimality resetting. We find, for example, that the relative advantages of resetting decrease as managerial ability to influence the resetting process increases, as the relative importance of external (industry-or economy-wide) factors in return generation increase, and as the direct or indirect cost of replacing the incumbent manager decrease. Our analysis, in summary, that the case against resetting is quite weak.