Stock Options, Restricted Stock, and Incentives

Prior work has suggested that options represent an inefficient form of compensation because the value placed on an option by a risk-averse employee is much less than the cost of the option from the perspective of the firm. However, much of this work ignores or fails to properly incorporate the incentive effect of option-based contracts into their analysis. We use agency theory to model the optimal mix of options and stock in the compensation contract. In contrast to prior work, we show that restricted stock is generally not the optimal contract form. We present comparative static results to show how the mix between options and stock and the optimal exercise price of the options varies as a function of the exogenous parameters.