Brian Reed: Eliza, hey — I want to start with something that felt almost too clean when I read it, because I keep thinking I'm misreading it.
Eliza Ward: Too clean how?
Brian Reed: There's a study — accelerate option vesting by one year, R&D drops five to seven percent. Not two years later. Not gradually. The money stops moving to long-term research the moment the personal payout window shifts. One year on a calendar and you can see it in the actual spending data.
Eliza Ward: It's real. And it's the cleanest version of a much bigger argument about stock options — which is that the instrument designed to solve the principal-agent problem actually built a different problem in.
Brian Reed: Hang on — say what the principal-agent problem actually is, because I want to make sure we're building on the right foundation here.
Eliza Ward: The structural conflict between a manager — who has their own risk tolerance, their own career horizon, their own paycheck — and shareholders, who need that manager to maximize the company's long-run value. Those interests don't naturally line up. Options were the proposed fix: give the manager upside in the stock, suddenly their interest tracks the shareholder's. In theory.
Brian Reed: In theory. But the vesting window is — what, three to four years typically? So the manager's horizon isn't 'long-run value,' it's 'what does this stock do before my options vest.'
Eliza Ward: Exactly. And that horizon got baked in fast — partly because of how Silicon Valley used options as a capital-conservation tool in the eighties and nineties, and then the 1993 tax law exempted performance-based pay from a new million-dollar deductibility cap, so suddenly every public company had a financial reason to issue options at scale.
Brian Reed: So a tax deduction loophole is basically how the three-to-four year vesting window became standard across corporate America.
Eliza Ward: That's — yeah, that's the thing nobody tracks back to U.S. Congress in 1993. And now we have a structure where an executive's personal incentive peaks right when the company needs them thinking furthest ahead. That's not a design flaw. That's the design.
Brian Reed: But here's what I don't fully have yet — like, what does that actually feel like from the inside? Because 'misaligned incentive' is abstract. What's the executive actually doing differently?
Eliza Ward: Think about it this way. A friend bets on a horse race — but the deal is, if the horse wins, they collect. If it loses, they just tear up the ticket. Zero penalty. Now ask yourself: which horse do they pick?
Brian Reed: The long-shot. Every time.
Eliza Ward: Every time. Not the reliable finisher. The volatile one with the big payout. That's the asymmetric payoff — unlimited upside, no personal downside — and that's a stock option. The executive captures everything if the stock rises and just walks away if it falls below the strike price.
Brian Reed: So the downside protection means they're not actually thinking like an owner. An owner loses real money when things go badly.
Eliza Ward: That's the exact line Brian Hall and Kevin Murphy draw. Their empirical work — and this shaped the academic consensus — showed that the asymmetric payoff doesn't just reduce caution, it actively encourages risk-seeking and short-horizon optimization. You're not aligned with shareholders. You're playing a different game with their money.
Brian Reed: And institutional investors — I mean, they were pushing for this. They thought it was the fix.
Eliza Ward: They did. Shareholder primacy ideology — the whole 1980s governance frame that said maximizing shareholder value is the one job — made options look like the obvious instrument. Institutional investors drove adoption across S&P 500 companies through governance pressure. They wanted executives with skin in the game.
Brian Reed: Except 'skin in the game' with options is — wait, actually it's not skin in the game at all. It's a free lottery ticket.
Eliza Ward: Right. And nobody — not the boards, not the compensation committees, not the institutional investors pushing for it — nobody stress-tested what a one-sided payoff does to decision-making under that three-to-four year vesting window.
Brian Reed: The theory said alignment. The structure was saying something completely different the whole time.
Eliza Ward: That's the sentence. The theory said alignment. The structure — because the executive never shares the downside — was engineering something closer to a bet. And you can't design your way around that with vesting tweaks alone. That asymmetry is load-bearing.
Brian Reed: Which means the next question is — what does a rational executive actually do with that instrument? Not a corrupt one. A rational one.
Eliza Ward: Walk it through.
Brian Reed: No wait, let me make it concrete. It's Q3 2024. Software company CFO. Her options vest in nine months. She's not panicking, she's just — she's doing math at her desk. And the math says: if EPS goes up, the stock goes up, her options clear above strike. That's the only equation that matters right now.
Eliza Ward: And EPS has a denominator.
Brian Reed: Exactly — shares outstanding. So she schedules a share repurchase program, funds it with low-rate debt, and EPS lifts eight percent over the next two quarters. Not because the business grew. Because the denominator shrank.
Eliza Ward: And not a single line of actual business performance changed.
Brian Reed: Not one. That's the part that — I mean, it's almost elegant in a grim way. She didn't lie on the earnings report. The EPS number is real. The share count really did go down. She just used debt to manufacture a signal that looks like growth.
Eliza Ward: But isn't this where we have to name the 1993 tax law as the thing that set the trap? Because boards didn't adopt options at scale because they thought buybacks were clever. The Revenue Reconciliation Act capped deductibility of executive cash above one million dollars — but explicitly exempted performance-based pay. Options suddenly cost the company nothing on the books.
Brian Reed: Right — and that's when compensation consultants started circulating the same peer benchmarks to every board's compensation committee, and the design just... propagated. Silicon Valley had already made equity feel culturally progressive — like you're giving workers a stake — so large corporates imported the model without the startup context that made it make sense.
Eliza Ward: Which is how you get earnings management as the accounting version of the same move. Instead of shrinking the denominator, you shift when revenue lands — pull it forward, defer the expense — just enough to clear the number Wall Street is watching before the vest date.
Brian Reed: And again — rational, not corrupt. The accounting rules leave room. She's choosing where in the room to stand.
Eliza Ward: That's the mechanism. The vesting clock doesn't create fraudsters. It creates a strong rational incentive to use every legal degree of freedom in the direction of near-term stock price. Every quarter.
Brian Reed: And the part we haven't even gotten to yet is what that same clock does to the decisions that never show up in an earnings report at all — the R&D line, the ten-year infrastructure project — that's where the real cost gets buried, and it's basically invisible to the instrument.
Eliza Ward: That's the cost that never appears on any dashboard. And the 5–7% R&D drop is the only place we actually measured it — one year of vesting pulled forward and you can see executives pulling capital out of the thing that compounds over a decade. That's not accounting. That's a factory being quietly dismantled.
Brian Reed: And who notices? Because it's not in the quarterly report.
Eliza Ward: Nobody above the VP level. It's — okay, picture this. A hardware engineer at a semiconductor company, early 2022. She's been told the new chip architecture project is greenlit. Eighteen-month runway. Then the CEO's options vest in fourteen months and the capex review happens. The project doesn't get killed — it gets 'deferred pending market conditions.' She finds out in a Tuesday all-hands. The ten-year roadmap just quietly disappeared.
Brian Reed: And the CEO's options vest on schedule.
Eliza Ward: On schedule. The stock doesn't move. The workforce development — gone. The infrastructure — deferred. The competitive position three years out? That's someone else's problem after the vesting window closes.
Brian Reed: The part that I find — it's not that the CEO lied. The 'market conditions' probably were uncertain. The deferral was probably defensible on paper. That's what makes the underinvestment in long-duration assets so hard to prosecute. It looks like a judgment call every single time.
Eliza Ward: Which is exactly why reform proposals focus on the instrument, not the individual. Longer vesting, RSUs with operating-metric triggers, mandatory post-exercise holding periods — the academic argument is that you can redesign the equity so the executive's clock finally matches the asset's payoff horizon.
Brian Reed: Does that actually work though? Or does the executive just — find the new metric to game?
Eliza Ward: That's the counter-position, and it's real. The opposing view is that no vesting tweak closes the gap — because the asymmetric payoff is the problem, not the timeline. If the executive never shares the downside, they're never thinking like an owner regardless of whether the vest is three years or seven. You'd need instruments with genuine loss exposure — purchased shares, clawback-heavy restricted stock — to actually move behavior.
Brian Reed: And then there's — wait, this is the piece that actually surprised me when I read it. The manipulation problem isn't even purely structural. Cross-national data shows high-individualism cultures have measurably higher abnormal earnings management. So the vesting schedule lands differently depending on where you're running the company.
Eliza Ward: Which means you can't just export a better RSU design and expect the same result globally. The governance culture is doing something the instrument can't override.
Brian Reed: So even the reform is downstream of something harder to fix.
Eliza Ward: After thirty years of this criticism, nearly 25% of public companies still use no long-term performance-based awards at all. Zero. Pure time-vested options or plain restricted stock. That number doesn't say the debate is live. It says institutional inertia won.
Brian Reed: Which means that engineer whose roadmap got deferred on a Tuesday? She's not an edge case. That's the median outcome of a system that had thirty years to correct itself and didn't.
Eliza Ward: And that's the thing that won't leave me. Every reform we named — longer vesting, RSUs, operating-metric triggers — each one just creates a new surface to game. You extend the window to seven years, now the executive optimizes for year six. You attach it to an operating metric, now the metric gets managed. The asymmetry is still there. The upside-only payoff is still there. You've moved the problem, not solved it.
Brian Reed: Which makes me wonder if we've been asking the wrong question the whole time. Like — not 'how do we fix the vesting schedule' but whether financial incentive engineering can actually produce genuine long-term alignment at all. Ever.
Eliza Ward: That's the uncomfortable version, yeah. Because if the asymmetric payoff is the feature — not a bug, not a design flaw — then no instrument you build on top of it gets you to owner-like thinking. You'd need something structurally different. Stronger boards with actual teeth. Longer executive tenure so the person running the company in year one is still there in year eight. Stakeholder governance models where — I mean, where the board isn't just answerable to the shareholder primacy frame at all.
Brian Reed: Governance structures instead of compensation structures.
Eliza Ward: Maybe. And I'm not landing there with confidence — that's genuinely open. But the 25% number keeps pulling me back. A quarter of public companies, thirty years of this diagnosis, still running zero long-term performance awards. That's not a field still debating. That's a field that tried reform and found it easier to do nothing.
Brian Reed: The R&D drop is what I keep — I mean, it's the thing that actually settles this for me, at least partially. Five to seven percent. One year earlier on the vesting calendar. That's not a corrupted executive. That's a rational person responding to a rational instrument. The instrument said: your money is here, in this window. And capital flowed exactly there.
Eliza Ward: Rational response to a rational instrument. That's the part that makes it hard.
Brian Reed: Because you can't fix rational. You can only change what the instrument is asking for. And we — actually, no, the system — keeps choosing the instrument it knows how to build. Even when we've measured the cost.
Eliza Ward: We measured the cost and kept the instrument. That's where it lands for me too. I don't have an answer past that.
