How to Increase a Company’s Risk Taking

Do stock options for outside directors encourage bolder decision making? Or could such financial incentives actually inhibit risk taking?

To be sure, the relationship between the CEO and the outside directors on a company’s board is complex. Typically, directors play a monitoring role in which they review and approve (or veto) the CEO’s major proposals, such as the acquisition of a business or a substantial investment in a new technology. At other times, the directors themselves might develop a new strategy that the CEO and other senior executives must then implement. But what happens when a company has continually been too conservative in its decision making, especially when aggressive competitors have been quickly gaining market share? In other words, what levers can an organization pull to become less risk-averse, for example, to seek new revenue streams from an emerging market in order to bolster a sagging product line?

One solution has been to provide the CEO with stock options: the right to buy a company’s stock at a pre-specified price at a set date in the future. It is important to note that the options do not necessarily have to be exercised. If the stock price plummets, the executive can simply elect not to purchase it when the predetermined date arrives. Thus, there is little downside risk in owning a stock option, but there can be a tremendous upside if the stock price soars.

Past studies have shown that providing CEOs with stock options does tend to increase the risk taking of those individuals. Significantly less research, however, has investigated the effects of stock options upon outside directors. Do such incentives also lead to greater company risk taking? And what’s the relationship between the two types of incentives — CEO and director stock options? Do they reinforce each other, and if so, in what ways?

Such questions were recently investigated by a team consisting of Yuval Deutsch, associate professor of policy and entrepreneurial studies at York University’s Schulich School of Business in Toronto, and Thomas Keil and Tomi Laamanen, professors of strategic management at the Helsinki University of Technology’s Institute of Strategy and International Business in Helsinki. The researchers examined data for the Standard & Poor’s Composite 1,500 companies between 1996 and 2002. (Details of the research are contained in Are the Wolves Watching Over the Sheep? The Joint Effect of Board and CEO Incentives on Firm-Level Risk-Taking.)

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