The Adoption and Characteristics of Performance Stock Option Grants

Traditional executive stock options are granted at fair market value on the grant date and vest over time. Although executive stock options are a popular compensation vehicle, they have received increasing criticism for providing inadequate incentives for executives to improve shareholder wealth. Critics of traditional options, together with a growing body of theoretical studies, call for the use of performance options that link option vesting or exercise to the achievement of performance targets. We examine the factors influencing the adoption and characteristics of performance (i.e., premium-priced and performance-vested) stock option grants to CEOs. We find some evidence that the characteristics of performance option grants (but not their adoption) are associated with the economic determinants identified in theoretical studies. However, many of the associations are opposite the predictions from the theoretical studies. We find stronger evidence that performance options are associated with exceptionally large option grants to CEOs of firms with weak governance structures and large pension fund holdings. Overall, our results are most consistent with the explanation that performance option grants are used to minimize criticism of controversial compensation decisions