Might compensation games be distorting the entire US economy? I wrote last week about my belief that using money to motivate people was a bad idea. As a leader of a company, you need to figure out a fair compensation scheme, but you shouldn’t try to also use it as a source of getting people to do the right things.

If the potential waste and misdirection of effort resulting from poorly constructed compensation games were limited to just a few companies, or just small companies of knowledge workers, this problem might not deserve a lot of visibility. But in an article in the July 21st edition of The Economist discussing unusually high levels of corporate profits, one of three possible explanations offered is the aggregate effect of motivating people with money. If this explanation is accurate, mixing compensation with motivation is bad news on a national level.

Bad options?

Stock options are a common way for larger corporations and tech startups to reward employees. An option is the ability to purchase stock of the company at some point in the future for a fixed price (the strike price). If the company’s stock price exceeds the option strike price before the option expires, then the employee can exercise the option (buy the stock at the lower, fixed price from the company) and immediately sell the stock at the higher market price, thereby capturing the difference in price as a capital gain. For example, if your company grants you an option to buy 10,000 shares at $1/share, and in three years the market price of the stock is $7/share, you wind up with a gain of $60,000 (and a hefty tax bill).

When managers are motivated with share options, they benefit personally from higher share prices. Higher share prices are in turn partially driven by positive changes to earnings per share (the profit a company makes divided by all the shares outstanding). The intent of using options to reward managers is to motivate them to increase the profits of the company through growth, new products and services, lowered costs, etc.

But there’s another way to increase earnings per share. A share buy back is when a company uses its profits to buy its own shares and in effect “retire” them. When a company uses cash to buy back its own shares, it immediately increases earnings per share since there are fewer shares outstanding. Because higher earnings per share is a positive sign for the company, the stock price often rises on this news. That in turn makes the options owned by the company’s managers more valuable.

So managers have two ways to increase the value of their options: a share buy back program, or the creation of new products and services, growth through acquisition, better sales, improved marketing, or lowered costs. One can have an almost immediate effect, the other is risky and may take years to improve earnings. If a manager is holding short-term options, the temptation to do a share buy back, or simply hold the cash, may outweigh doing the better thing for the long-term.

All together now

If the options used to motivate individual managers are causing them to play short-term games at the expense of the long-term health of the company, you’d expect to see high levels of profits even though the economy is not growing very strongly. You might also expect to see lower job growth. That’s exactly where we currently stand. Of course no single company can sway the whole economy, but the aggregate effect of many companies, managers and shareholders sitting on cash or buying their own shares instead of investing company profits may contribute to the economic doldrums of anemic growth and job creation we’re currently experiencing.