Overall, EG Corporation’s financial performance had been mediocre for the last five years. Earnings growth had not kept pace with inflation, and return on equity had been hovering around 10 percent. Part of the problem was that EG had been hit with unfavorable ”extraordinary items” that had depressed bottom line results. Beyond this, though, the company had failed to deliver on overall commitments for growth and operating earnings in its businesses for the last few years. From an investor’s standpoint, the company’s stock price had lagged the market for the last several years. Analysts bemoaned the company’s lackluster performance, especially in view of its strong brand position in Consumerco. They were disenchanted with the slow progress in building profits in other parts of the company. Some security analysts had gone so far as to speculate that EG would make a good breakup play. EG Corporation’s board and senior management were frustrated by their inability to convince the market that EG should be more highly valued.
In the mid-1970s in the United States, there was growing concern about the perceived divergence between managers’ and shareholders’ interest. In part, this feeling reflected anxiousness over 10 years of falling corporate profitability and stagnant share prices. The concern was also fueled by the increasing attention paid to stakeholder model arguments, which, in the eyes of shareholder value proponents, had become an excuse for inadequate performance. Meanwhile, a number of academics became interested in management’s motivation in decisions relating to the allocation of resources, a branch of research known as agency theory. In 1976, Jensen and Meckling published a paper, ”Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure.” They laid out how over the previous decades corporate management had pursued strategies and projects that were not likely to optimize resources from a shareholder’s perspective and called for redesigning management’s incentives to be more closely aligned with the interests of the shareholders. Stock options had been a component of the pay packages of most senior executives in the United States, but the size of option grants coupled with the anemic performance of the stock market as a result of high inflation, effectively made them weak motivators of managerial behavior.
The situation changed in the early 1980s. The emergence of the LBO, and especially the management buyout, created instances where both the performance of the company in shareholder value terms and the pay packages accruing to executives as a result of their equity holdings became very large and noted by the public. At about the same time, in 1982, the U.S. Federal Reserve Board embarked on a program that drastically reduced inflation, which in turn prompted a sustained rise in equity values. As a result of this confluence of factors, the role of stock options in executive pay soared.
Over the same period, boards of directors had come under increased criticism for perceived negligence in representing shareholder interests (which, at least under the legal requirements in the United States, they were supposed to do). A movement developed to require that nonexecutive board members have an equity stake in the companies they represented so that they would be more inclined to pay attention to shareholder returns, if only for self- interest. By the late 1990s, 48 percent of medium and large companies had a stock grant or option package for board members, in contrast to virtually none in 1983.
The widening use of stock options has greatly increased the importance of shareholder returns in the measurement of managerial performance. Such developments are not limited to the United States. Stock options and share grants have become important elements of executive pay in England and France. As the competition for executive talent becomes global, it seems likely that the use of stock options will become more and more popular in most open economies.