The relationship between management and shareholders is sometimes referred to as an agency relationship, in which managers act as agents for the shareholders, using delegated powers to run the affairs of the company in the shareholders’ best interests. There is a potential conflict of interest that is inherent in this situation, since shareholders will be best rewarded by efficient performance, while managers may prefer a life where they don’t have to work too intensively and in which they are rewarded by high salaries and perks.
Other interest groups such as employees, suppliers, customers and the government may also have objectives that conflict with those of the shareholders.
Goal congruence occurs when the goals of the different interest groups coincide with those of the company as a whole. There have been many attempts to change the way in which managers are remunerated so as to improve the achievement of goal congruence between the managers and the shareholders, and the provision of share options form one of these methods.
In a share option scheme, selected employees can be given a number of share options, each of which gives the holder the right after a certain date to subscribe for shares in the company at a fixed price. The value of an option will increase if the company is successful and its share price goes up. The theory is that this will encourage managers to pursue high NPV strategies and investments, since they as shareholders will benefit personally from the increase in the share price that results from such investments. However, although share option schemes can contribute to the achievement of goal congruence, there are a number of reasons why the benefits may not be as great as might be expected, as follows.
a. Managers are protected from the downside risk that is faced by shareholders. If the share price falls, they do not have to take up the shares and will still receive their standard remuneration, while shareholders will lose money.
b. Many other factors as well as the quality of the company’s performance influence share price movements. If the market is rising strongly, managers will still benefit from share options, even if performance has been worse than expected. Similarly, even though the company may have been very successful, the share price will fall if there is a downward stock market adjustment, and the managers will not be rewarded for their efforts in the way that was planned.
c. The scheme may encourage management to adopt ‘creative accounting’ methods that will distort the reported performance of the company in the service of the managers’ ends.