"How Employee Stock Options Give Corporate Officers Personal Motivation to Raise Stock Prices Instead of Paying Dividends"

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So far, we've been assuming good faith on the part of the upper management of The Wonderful Acme Company. Maybe poor judgment -- but good faith.

We've been assuming that they have the best wishes of the stock owners at heart. After all, the it's the stock holders who are the actual owners. Management are just employees, right?

Actually, there's usually an overlap, and to some degree that's wonderful.

Congress Unintentionally Encouraged the Use of Employee Stock Options

In 1993 Congress passed a law forbidding companies from deducting management salaries over the amount of $1,000,000 as an expense on their taxes.

There'd been a lot of publicity about how some CEOs were paid gazillions of dollars while their janitors received only the minimum wage and, more logically, the stock price of their companies went down.

This is part of Section 162(m) of the Internal Revenue Code.

Congress Gave Corporate Executives an Incentive to Increase Share Prices at Any Cost

But Congress exempted incentive-based forms of compensation from the $1,000,000 cap, and the IRS ruled that stock options were covered by this.

Soon, many companies especially in the high tech field began issuing stock options to managers.

The idea behind this had good intentions -- and you know what road is paved of good intentions. The idea was to encourage upper management to do a good job by making them owners in the company, so that they would also benefit by an increase in stock price.

Since upper management's overall job was to grow the value of the company, and the company's value is measured by the market price of its stock, why not set up stock options structured so that management would get extra shares of stock -- but only if they reached a certain price.

So Corporation Management Does Whatever is Necessary to Raise Stock Prices

And of course, once a manager has received their shares of stock, they're interested in increasing the value of those shares of stock

So in theory, anything they can to raise the market price of the company's stock will benefit all stock owners.

Yes, management will benefit greatly, but so will all other owners of the stock, so why should they complain?

So if The Wonderful Acme Company's upper management is working for stock options in the company, they want to raise the company's stock price.

In theory, they should do this by such ordinary and traditional business practices as increasing sales, decreasing expenses and just plain running the company better.

So far, so good.

Increasing Stock Share Prices Increases the Value of Stock Options

But when they look at that $60,000 at the beginning of the year, their interest as potential stock owners is now to use it somehow to increase the market price, so it will go up in price to where they will be rewarded by exercising their stock options

And make a lot more money than their measly salaries.

So paying it out to current stock holders is not even an option on the table, because that will not raise the market price (at least, until the market of common stock buyers starts demanding high dividend payouts, but that's not happening yet. It might well start happening in a few years.).

So they're motivated to look at alternatives. The ones we've already discussed can be legitimate. Buying a new widget making machine to increase production. Buying The Small Terrible Company to get a supply of cheaper wadgets. Buying back stock.

All these can certainly be legitimate, even applauded by current stock holders.

Not Every Way of Raising Share Prices is in the Best Interest of Stock Owners

But where is the line between using after-tax profits to pay out dividends to current stock holders and grabbing that money to put it to use in other ways -- which may not have anything to do with The Wonderful Acme Company's core business?

It's a fine line, and it's hidden in the heart of the managers who make these decisions.

And sometimes their choices may turn out well, even if taken for the wrong reasons. And sometimes their choices may not work out well, just because they're no guarantees in life.

The emphasis on stock dividends can lead to downright crooked actions on the part of upper managements, in terms of making revenues look too good, hiding problems, and so on -- Enron is the best known example. But there's also Tyco, WorldCom, Adephia and HealthSouth.

Stock Options Give Corporate Executives the Incentive to Lie About Company Profits

Dividend investors have the advantage of knowing that a management paying out 50% of net after-tax profits every year is looking out for the interest of stock holders.

And if management also owns stock (which it should), all the better. They get their fair share of those dividends, and are encouraged to keep on doing a good job. For you and themselves.

In the long term. Instead of hoping to pump up share prices through temporary tricks and then dumping their own shares onto the market.

True Shareholder Value is Created by Growing and Improving the Business Itself, Not Manipulating Stock Prices

The same week in 2003 that Microsoft announced its first ever dividend, it also stopped its program of rewarding employing with stock options.

Now they get shares of stock that pay dividends.

Company management that likes to receive dividends instead of dumping its shares for the capital gains are people working hard to keep those dividends high and increasing.

And you'll reap the benefit also.

Employee stock options can be a legitimate way of rewarding employees, especially in the early life of a company before it can afford to pay market price for talented and experienced employees, but they should not affect management business decisions.

Why do so many investors let companies fail to pay dividends even when they could? The financial world now glorifies price appreciation. It's their mindset and the culture of capital gains.

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