Sunday, August 30, 2009

Stock options, CEO risk taking, and earnings manipulations

Any idea why we continue to reward top executives with stock options? We accept it, nowadays, as a given, but why do we have that practice in the first place?

You might say “because it constitutes performance-related pay; through them, you financially reward top managers for their achievements”. Fair enough. Because for many of us mortals our pay depends to some extent on our performance. However, do realize that for CEOs, for example, this component is often as high as eighty percent. Eighty percent! Do you know many people (employed in the same large corporations that these executives head) whose salary is eighty percent dependent on some measure of their achievements? Not many I suspect.

But, in theory, these large corporations that reward their top managers through stock are right – and I am saying “in theory” for a reason. This practice – of offering CEOs stock-based pay – is a recommendation straight out of something called “agency theory”. It is one of the few academic theories in management academia that has actually influenced the world of management practice. It is basically a theory that stems from economics. It says that you have to align the interests of the people managing the firm (top executives) with those of its shareholders, otherwise they will only do things that are in their own interest, will be inactive, lazy, or plain deceitful. Yep, these economists have an uplifting worldview. But that is why we have such a huge performance-related component in the pay of most top executives.

But are you really sure you want people like that managing your firm? People who will be lazy and only operate in their own interest if given a chance? Do you really want a CEO who really needs performance-related pay and who otherwise, if put on a fixed salary, wouldn’t do much and just hang about? In case you missed it, I intended this as a rhetorical question…

But anyway, we give them stock – and lots of it – to incentivize them. But the question still lingers: why stock OPTIONS? And that’s a story in itself.

Agency theory doesn’t only say that people will be lazy and deceitful if given a chance; it also says that managers are inherently risk-averse; much more risk-averse than shareholders would like them to be. And the theory prescribes that you should give them stock options, rather than stock, to stimulate them to take more risk.

More risk!? you might think. Do we really want CEOs of large corporations to take MORE risk?! Is it not, given recent events in the world of business, that we would like our top executives to be a little less risk taking for a change…? Ah, that’s what you might think now, but it is not what agency theory thinks, and it is not what the incentive structure of most public corporations nowadays is geared to do.

Because stock options do stimulate risk seeking behavior, as we know from academic research. Options, as you might know, represent a right to buy shares at a certain price at some fixed point in the future. If you are given the right to buy a share in company X for $100 in January 2010 and by then the share price of X is $120, you will have made 20 bucks. However, if the company’s share price by then has dropped to $90, your option is worthless; we say it is “out-of-the-money”: you’re not going to exercise your right to buy at 100 when the market price is merely 90.

In that situation, if the CEO of X has many stock options, it stimulates him to be very risk seeking. For example, if by August 2009 the share price is 90, he will be inclined to engage in risky “win or lose” moves. If the risk pays off and the share price rises well above a 100, the stock options will become worth a lot of money. However, if he loses, and the share price plummets even further, say to 60, no worries; it doesn’t matter. The stock options to buy at $100 were worthless anyway; whether the stock trades at 90 or at 60.

And, as said, research by for example Professors Gerry Sanders from Rice University and Don Hambrick from the Penn State University showed that these things work. They examined 950 American CEOs, their stock options, and their risk taking behavior. They found that CEOs with many stock options made much bigger bets; for instance, they would do more and larger acquisitions, bigger capital investments, and higher R&D expenditures

However, they also showed that they weren’t always very good bets… The option-loaded CEOs delivered significantly more big losses than big gains. That’s because they didn’t care much about the losses (their options were worthless anyway); all they were interested in were the potential gains.

Moreover, Professor Xiaomeng Zhang and colleagues, form the American University, examined the relationship between stock options and earnings manipulations; plain illegal behavior. They investigated 365 earnings manipulation cases and showed that CEOs with many “out-of-the-money” options were more likely to misrepresent their company’s financial results (and get caught doing it!).

Hence, even if as a board member or shareholder you’d want to stimulate your CEO to take more risks – and I guess that is a big IF – I am not so sure that stock options will get you the kind of risk you’re after…

Sunday, August 23, 2009

When knowledge hurts

Over the last decade or so companies have been told till it was a nuisance that their knowledge is their ultimate (if not only) source of competitive advantage. They have been encouraged – by management gurus, academics, and ample management consultants alike – that they should invest in knowledge development, protect it, and makes sure it gets identified, codified, and even put on the balance sheet.

The advice was to carefully identify best practices and make sure that you have systems that help these practices to be shared throughout the organization. This way, you will make optimal use of the great good and surely a healthy return will follow – or so the preachers said.

Many companies responded, as advised, by setting up internal systems that could be used to store and access all sorts of documents, as well as systems to aid the identification of experts in the organization and ways to contact them for advice.

But have these knowledge management systems turned out to be as good as was promised to us? Well… let’s say that a few caveats have emerged.

Because what we sort of forgot in the torrent of knowledge euphoria is that this stuff can also come at a cost. The cost of actually finding it, for example, in the jungle of corporate databases, but also the cost that comes with the fact that re-using prior knowledge doesn’t necessarily make you very original. And that’s a problem, especially when you need to stand out from the crowd.

Professors Martine Haas from the Wharton School and Morten Hansen from INSEAD, for example, examined the use of internal knowledge systems by teams of consultants in one of the big four accountancy firms, trying to win sales bids. They measured to what extent these teams accessed electronic documents and how much they sought personal advice from other consultants in the firm. They figured that, surely, accessing more knowledge must be helpful, right?

But they proved themselves wrong; to their surprise they found that the more internal electronic databases were consulted by these teams the more likely they were to lose the bid! Likewise for seeking advise from colleagues. This effect was especially pronounced for very experienced teams. These guys were much better off relying on their own expertise than trying to tap into experiences by others, whether it was in the form of electronic stuff of external advice.

Haas and Hansen figured that the opportunity costs of accessing all this prior knowledge must be huge; big enough to offset any potential benefits. Searching through the plethora of documents and soliciting advice from colleagues actually withheld the teams from making substantial investments into putting together a truly original and suitable proposal.

Things were even worse in situations in which competing firms were simultaneously bidding for the same lead, and being able to differentiate yourself from these rivals became crucial. In these cases, utilizing prior knowledge seemed to lead teams to develop cookie-cutter solutions when being original and innovative was what was really needed. As a result, they lost the bid.

The only times that a team benefited a bit from accessing internal knowledge sources was when it concerned a very inexperienced team. In such instances, talking to a few internal experts improved their chances of putting together a winning proposal. However, the internal document databases were always useless at best. The more these rookies tried to tap into the mountain of electronic documents available to them, they worse their chances of coming up with the winning bid.

The advice to derive from this research? Shut down your expensive document databases; they tend to do more harm than good. They are a nuisance, impossible to navigate, and you can’t really store anything meaningful in them anyway, since real knowledge is quite impossible to put onto a piece of paper. Yet, do maintain your systems that help people identify and contact experts in your firm, because that sometimes can be helpful. But make sure to only give your rookies the password.

Friday, August 21, 2009


The desire to monetize online news is leading some to enthusiastically promote micropayment systems. A number of the leading newspaper sites are leaning toward a cooperative payment system that will allow readers to use a single account to access material at the leading papers. Such a system will not be technically difficult to implement, but getting the price right will be a significant challenge because of transaction costs and significant differences in the economic value of articles.

To create the best industry wide effects, a micropayment payment system would need to include as many papers as possible (see "The Challenges of Online News Micropayments and Subscriptions" The fact that a consortium is currently being sought only among the major players illustrates, however, that such a system would be cost inefficient because content from smaller papers would attract fewer transactions and be more expensive to service.

A widely inclusive system would encounter the problems of small payouts that have plagued collecting rights societies for authors, composers, and performers. Those systems have found that the costs of managing transactions, accounting and auditing, and conveying funds to rights holders incur higher expenses than the payments due many rights holders and that such a system is possible only when the rights holders and content that generate the most transactions subsidize those that generate the least.

This occurs because each right must have a separate account, uses of all rights must be monitored and recorded, funds must be collected, expenses for accounting, auditing and other administrative costs paid, and funds must be transferred to recipients. These activities incur significant transaction costs.

Even a cooperative system limited to newspapers that attract the largest number of customers will encounter transaction cost challenges.

In single content sales systems, for example, the cost of making transactions takes up the bulk of the price. In the sale of mobile telephone ringtones, for example, the composer, arranger, and performer get only about 20% of the price. For digital song downloads everyone associated with the content--songwriter, arranger performers, and record company--receive less than half. This occurs because merchant and financial transaction costs are very high. The cost for using a credit card adds 5 to 7 percent to merchant costs and the expense for bank processing of each transaction is a minimum of about 25 cents. Even electronic fund transfers between bank accounts incurs about 30 cents in transaction costs.

These realities will affect the structure and pricing of newspaper article micropayment purchases. The most efficient system for users and firms will require the use of prepaid customer accounts to reduce the number of bank system transactions. This will allow users to transfer funds to their accounts and then purchase articles at pennies a piece. Funds collected would be then periodically transferred to papers. Such a system could also include the option for occasional users to make credit cards purchases of articles, but the price would have to be $2 to $10 per article to make it worth the effort.

The biggest pricing challenge, however, is that some articles will be more valuable than others and will be most sought after by consumers. This means newspapers will have to figure out BEFOREHAND which stories fall into those categories and they will have to decide what prices to charge for them. Papers will have to hire personnel to try to figure out before publication which are the most economically valuable stories--something that will be extremely hard to do--or they will have to set prices based on the costs invested in creating each story (something current newspaper accounting systems do not support). In either case, increased costs will result. The only other reasonable option is to set prices per article based on the overall average cost of producing an article or a column inch of editorial copy. This, of course, over and under prices content simultaneously.

Moving to a micropayment system is not merely a matter of starting to charge for content online, but involves changing the fundamental business model of papers. Newspapers have historically bundled all content into one product available at a single price. In retailing, bundling has always worked best for getting consumers to buy more of the product at a lower price than if bought individually. With this tactic the producer gains profit because the costs of distribution and sales are collectively lower. A second tactic involves bundling products of unequal or uneven value that are sold together to achieve a joint price that is higher than would have been obtained individually.

Newspapers have historically benefited from such bundling by filling pages with relatively inexpensive news agency and syndicated content and by including huge amounts of information culled from public sources that did not require significant investment of resources or added value. Unbundling and selling individual articles with a micropayment system will produce little consumer willingness to pay for this type of content--a significant problem because it is the bulk of editorial content in most newspapers today. Unbundling will also increase transaction costs, thus reducing profitability. This will force higher prices on consumers that will affect demand.

Disaggregating the newspaper and making more money off some individual articles will also create pressure for additional payments from journalists who write the most valuable articles. This will also increase costs of the micropayment system.

Making money from online journalism is, thus, not just a matter of saying "Let's all start charging." It will require fundamental rethinking of the value chain, what content is offered, and how it is produced. It will also require significant thought about what's in it for consumers--something that is glaringly missing from current discussions of starting online payments. The consumer challenge is especially salient because most online news readers do not currently buy newspapers. If they are not willing to pay for news in print, why will they suddenly be willing to pay for that same news online? If papers can't figure that out, no decision to implement micropayments will end happily.

Wednesday, August 19, 2009


I received another letter from the Google Book Search Settlement Administrator this week informing me that my rights will be affected by the proposed settlement of the class action suit against Google for copyright infringement by scanning books and other publications. I have been a de facto part of the class action lawsuit because I am the author of numerous books, chapters, and other publications affected by Google’s decisions to scan and sell copies of materials still protected by copyright.

The settlement has been supported by the Association of American Publishers—which represents major publishers—because it protects their interests, but it is opposed by the National Writers Union and the American Society of Journalists and Authors because it seriously degrades the rights and interests of those who actually write the content. The split between publishers and authors is not surprising because anyone who has observed the uneasy relationships between musicians, authors, scriptwriters and recording, publishing, and production companies immediate recognizes they have very different and competing interests.

Under the proposed settlement, the court will take away portions of my copyrights that were created under legislation and protected by international treaties and it will give them to Google. The only way for me to protect my rights is to take deliberate affirmative action to opt out of the settlement and to seek to enforce my rights against Google individually—not a great option since its capacity to hire lawyers and stretch out litigation is far higher than mine.

The process and effects of the settlement are stunning and will dramatically alter authors’ rights. For nearly a hundred and fifty years copyright law has recognized that copyrights belong solely to the author (or persons to which the authors sell them) and that commercial uses of copyright material can only be made through negotiating terms of use and payment with the copyright owners.

The Google settlement will essentially rewrite copyright law by allowing the company to use the material without permission, without negotiating how the material will be used, and without negotiating compensation and payment provisions. It is particularly offensive because the court will be saying the government doesn’t have to protect authors’ rights, but authors’ have to protect their own rights. This is a significantly different approach from that which prosecutors and courts have taken in the cases of music, game, and software file sharers who have violated copyright on the Internet.

The settlement disassembles the basics of copyright law without legislative consideration and essentially forces the results on rights holders. Its effects are far reaching. Not only does the settlement apply to U.S. authors, but it is binding to authors worldwide even if they are not aware their rights are affected by the suit.

The settlement turns copyright upside down. Instead of protecting authors’ rights, the proposed settlement asks the court to reallocate the economic and moral rights to authors’ work, to give Google rights to use their material, and to determine the compensation authors must accept. To make matters worse, the effect of the settlement essentially gives Google a monopoly over the scanned publications and does require the company to make them available to other online services that might offer them at different prices or with different compensation for authors.

The proposed settlement is theft—pure and simple—and its proponents want to ravage and rewrite authors rights so that Google's acts will no longer be defined as larceny. The result will reward Google for illegally appropriating material, hardly a message that society should want to send to thiefs.

If the court accepts the settlement, authors will be victimized for the sake a $150 billion Internet company and the world’s biggest publishers. Where is the equity and the justice?

Friday, August 14, 2009


One of the most exciting developments in journalism is the widespread appearance of online news startups. These are taking a variety of not-for-profit and commercial forms and are typically designed to provide reporting of under-covered communities and neighborhoods or to cover topics or employ journalistic techniques that have been reduced in traditional media because of their expense.

These initiatives should be lauded and supported. However, we have to be careful that the optimism and idealism surrounding these efforts not be imbued with naïveté and unbridled expectation. All these initiatives face significant challenges that require pragmatism in their organization and sober reflection about their potential to solve the fundamental problems in the news industry today.

We need to recognize that these online initiatives are not without precedent. We can learn a great deal about their potential from other community- and public affairs-oriented media endeavors. Community radio, local public service radio and television, public access television, and not-for-profit news and public affairs magazines have existed for decades and provide some evidence about the potential of the startups. Most rely heavily on the same types of foundation, community support, and membership financial models that startups are employing and this gives them a head start in the competition of those resources.

Despite sharing fundamental objectives and goals, these existing news and public affairs enterprises exhibit wide differences in the services they provide and their effectiveness in offering them. Many suffer from precarious financial conditions.

For the most part, such initiatives are highly dependent upon volunteer labor, individuals with the best of intentions who contribute time and effort. Those who manage the operations must expend a great deal of effort to train, coordinate, motivate and support these volunteers. This incurs cost and takes time from other activities.

Most of the organizations operate with highly limited staffs of regularly employed personnel and this is especially true in news operations. Professional journalists working in these organizations tend to be poorly paid; few have health and retirement benefits; most do not have libel insurance that protects aggressive and investigative reporting; few have access to resources to invest time and money in significant journalistic research. The consequence of these challenges is that there tends to be high turnover because the operations typically rely on young journalists who use the organizations to gain professional experience and then move on to better funded or commercial firms.

The community and public affairs operations also exhibit widely disparate size and quality in their journalistic activities. Even most affiliates of National Public Radio—which is generally considered the most successful of non-commercial news operations—tend to have small and relatively undistinguished news operations. Most rely upon the exceptional content of the national organization, large metropolitan affiliates, and the best of the content collectively produced by other local affiliates. Affiliates with larger news staffs and quality tend to be limited to those linked to university journalism programs or in the best-funded metropolitan operations.

The challenges faced in these organizations should not deter the establishment of new online initiatives or keep the rest of us from supporting them. We need to be realistic about their potential, however. In the foreseeable future these startups will tend to supplement rather than to replace traditional news organizations. They may be part of the solution to the problem of news provision, but they alone are not the remedy.

Monday, August 10, 2009


Success in businesses is not the result of highly mysterious factors.

To be successful an enterprise must offer a product or service that people want; it must provide it with better quality and service than other providers—or at a lower price than competitors; it must change with the times and demand; and it must never forget to focus on customer needs rather than its own. And a limited number of competitors helps. Duh.

Many journalists have trouble understanding these principles, however, and we were treated to 2 classic stories in which journalists breathlessly announced this discovery over the weekend.

The New York Times told us about the “resurgent” Seattle Times. The Times is starting to reap the fruits of monopoly caused by the demise of the print edition of the Post-Intelligencer and the stabilizing economy. It has picked up most of the print readers from the P-I, raised its circulation prices, and been able to keep the higher ad rates that were charged when ads were put in both papers.

The Associated Press told us “Small is beautiful” and that local papers do not feel competition for big players like CNN, metropolitan television, and Craigslist because they focus on local news and advertising not available elsewhere. “Less competition means the print editions and Web sites of smaller newspapers remain the focal points for finding out what's happening in their coverage areas.”

Journalists are also starting to discover that the industry might not be as dead as they have been portraying it to be. A number of stories have reported that the drop in advertising due to the recession appears to be near bottom, that profits and share prices are rising, and there is no wholesale rush to the web by print newspaper readers.

These “surprises” are developing, I believe, because journalists have never covered their own industry with the same interest and vigor that they have covered other industries. This is partly true because they have adamantly and publicly expressed distain for the business side of the news industry and because they tend to accept and endlessly repeat the views of publishers without critical fact checking or seeking better understanding of the business dynamics of news. Whatever happened to the old journalism adage "If your mother says she loves you, check it out!"

Perhaps they will learn.