The Father of Stock Options Who Ascended to Heaven [Seungseop Song's Financial Light]

CEOs More Concerned with Protocol than Stock Prices
Struggling to Solve the 'Principal-Agent' Problem

Michael C. Jensen, Professor at Harvard Business School. Photo by University of Rochester, USA.

What kind of compensation do employees working at startups expect? High salaries? Various welfare benefits? Probably, 'stock options' are one of them. For new CEOs or executives, there is hardly a more attractive form of compensation than the stock options they will receive in the future. For regular employees, stock options can also encourage them to stay with the company and work hard. The now-common stock option system was triggered decisively by the research of one individual.

That person is Michael C. Jensen, a professor at Harvard Business School, who passed away at the age of 84 on the 2nd of this month. Professor Jensen was a scholar who studied corporate management, especially the 'principal-agent' problem, for a long time. The core of the principal-agent problem is as follows: the principal hires an agent to do work. The agent is supposed to work for the principal, but tends to act in ways that benefit themselves. They secretly pursue their own interests while the principal is not watching, even if it harms the principal.

Professor Jensen's interest in the principal-agent problem was influenced by the trends of the times. He began his studies in the 1960s. At that time, the business academia taught that companies should consider society and have a conscience. However, in the 1970s, economist Milton Friedman, who supported free-market economics, published an article in The New York Times stating, "The social responsibility of business is to increase its profits." He criticized the idea that companies should care about social issues as "preaching socialism."

Professor Jensen was one of the scholars who agreed with Friedman's statement. However, he discovered a flaw in Friedman's argument. He found that it is difficult for companies to pursue profits alone. CEOs (agents) hired by the owners (shareholders) are supposed to work for the benefit of shareholders and the company, but in reality, they managed the company for their own compensation and security. In other words, the principal-agent problem was widespread in companies.

In fact, the principal-agent problem appears in many companies. A typical example is when CEOs do not cut unnecessary costs and spend excessive money on their offices and protocol. Also, CEOs tend to avoid challenges for the company's long-term growth and invest only in short-term, certain projects. This is because achieving results within their own term is more important than the company's future.

In 1976, Professor Jensen published a paper titled "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure," reflecting his concerns. Co-authored with William Meckling, then a professor at the University of Rochester, the paper became one of the most cited in business academia. Above all, it had a decisive impact on changing companies' compensation systems. It gave entrepreneurs a great realization that how money is given is more important than how much is given.

Professor Jensen's solution was stock options. Stock options are a type of stock purchase right. They grant the right to buy company stock at a predetermined price within a certain period. This means that no matter how much the stock price rises, the stock can be purchased at the pre-agreed price. As the stock price rises, the person holding the stock options gains enormous profits. If a manager holds stock options, their interests align with shareholders in terms of 'stock price increase,' thus solving the principal-agent problem, according to Professor Jensen.

As time passed, Professor Jensen acknowledged the limitations of his theory, noting that stock options also have side effects. Many companies introduced stock options extensively following his argument, but since the 2000s, various scandals have erupted among Wall Street firms. In an interview with the media, he even said, "Stock options have become the heroin of management."