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Marshall School of Business
University of Southern California
Superconductor Technologies, Inc.
Teaching Note
Purpose of Case
This case describes the compensation and incentive plans used by a high-technology company
for its top-30 managers. The company is unusual in that it has been in business for 17 years, yet
Suggested Assignment Questions
1. Assume that you, as an STI employee, were awarded options on 1,000 shares of STI stock
today at the current market price.
a. Without doing a detailed numerical calculation, make your best-guess estimate as to the
2. Evaluate the performance measurement and incentive system that STI uses for its top-30
managers. Among the questions you should consider:
a. Will the system attract managers attention and influence behavior in the desired ways?
b. Is the system achieving other (non-motivational) purposes which it is also intended to
serve?
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3. Should the accounting rule change requiring the immediate expensing of the value of stock
options granted (which has now happened) cause STI to make any changes to its system? If
so, which?
Case Analysis
1. The Company Situation
It is useful in starting the case discussion to spend a little time clarifying the companys
situation. In this discussion, the following are among the points that can be made:
STI is the technology and market leader in the area of high-temperature super-
conductivity. It is trying to derive commercial value from a scientific breakthrough in
this area.
2. The Compensation Package
Useful points can be brought up about the individual elements of the companys
compensation system for the top-30 managers and the overall package. The system consists
of three elements.
A. Base salary
Base salary is intended to be competitive. Raises are generally modest. There is not
much to be discussed here.
B. Cash bonuses
Up through 2002, bonus awards were based on a judgment from the Compensation
After 2002, the bonus awards were based 75% on corporate performance and 25% on individual
performance, with judgments about both areas of performance still made by the Compensation
Committee. Individual performance was judged on the basis of a tailored set of performance
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
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C. Stock options
All STI employees received stock options. Lower-level employees received only a few
hundred options. But STIs CEO received 125,000 options in 2002 (see Exhibit 4 of the
case).
Depending on the audience, instructors can get into more detail about how options work and
how they should be valued. Some audiences, such as undergraduate and some foreign students,
know almost nothing about options, so some time has to be spent here to ensure that they can
participate in the evaluative discussion. If instructors wish to do a mini-lecture on stock options,
here are some of the key points to emphasize:
Options are call options. Holders have the right, but not the obligation, to purchase the
shares at a specific exercise or strike price, which is typically the stock price at the time
of the grant.
Suggested assignment question (1a) is aimed at getting students to think intuitively about what
options are worth and whether they affect peoples behaviors. The question is phrased in terms
of the companys current market price. If it phrased in terms of an historical price (e.g., January
1, 2007), students have a tendency to log onto the Internet to see what the current price is. Then
their judgments are affected by hindsight bias. To clarify the issue, we think that the best way
to ask this question in class is as follows:
You have been given 1,000 options today. What is the minimum price at which you would
be willing to sell them to me?
Record the students responses in ranges on the board, and you will find huge disparities in the
answers. In actuality, most people do not have a good intuitive feel for what options are worth.
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
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It is possible to look at recent financial statement filings to see how the company has valued its
options. That disclosure is now mandatory. With the stock at prices less than $5 per share, the
value of a single STI option is less than $2.00.
3. Issues that Might Be Discussed
1. Is this the right mix of incentives? In particular, why not pay all salary or all
performance-dependent compensation?
Answering this question requires an understanding of the purposes served by the various
elements of compensation. They include:
a. Attract and retain the right people;
The use of more than one compensation element is typically necessary to serve all the
desired purposes. The performance-dependent elements are aimed at one or more of the first
four purposes. They help motivate, share the wealth, make expenses more variable with
24 See, for example, J. E. Ingersoll, Jr. (2006), The subjective and objective evaluation of incentive stock options, Journal of
Business, 79, pp. 453487; and S. Huddart and M. Lang (1996), Employee stock options exercises: an empirical analysis, Journal
of Accounting & Economics, 21, pp. 543.
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2. Are the measures considered in the bonus plan the right ones?
This is a difficult question to answer. The corporate performance scorecard includes 12
measures that are not weighted or even prioritized formally. Are these the right measures?
Are they contemporaneous or leading indicators of value creation? They are typical
measures, but certainly examples can be cited where improvements in some of these
3. For bonus award purposes, why is performance evaluated subjectively?
Some companies use formula-based bonus plans; others assign bonuses subjectively. There
are advantages and disadvantages to both approaches, many of which apply in the STI
situation.25 The advantages of subjectivity include:
a. It provides flexibility. Evaluators can exploit the full set of information that is available
at the end of the evaluation period, some of which might not have been anticipated or
The disadvantages of subjectivity include:
a. The criteria used in the evaluations can be vague. Those being evaluated might not be
told how their performance was evaluated.
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4. Does having options make people do anything differently?
This is question (1b) in the suggested assignment question list.
People like having options. They have value, and they provide a sense of ownership of the
firm. The sense of ownership can provide cultural control benefits. Employees whose
fortunes are intertwined can control each others behaviors to some extent.
However, other than this cultural control effect, for lower-level employees, we think the
5. Should the new accounting rule requiring the expensing of the value of stock options
granted change what the company does?
This is suggested assignment question (3). The answers are complex. FAS #123R, requiring
the expensing of the costs of stock option grants, became effective in mid-2005. Research
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
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This issue can be applied to the STI case. Pose the following question to the students:
No effect:
1. This is just an accounting change. There are no real cash flow effects. Financial
2. The other benefits of the use of stock option compensation, such as the ability to
Yes, less use of stock options:
1. Because STI makes significant use of stock options, the companys net income will
2. After seeing the amount of expense that they are forced to record in their financial
6. What should the company do if and when it expands internationally?
This is suggested assignment question (4). The answers to this question are also complex.
Should national differences, such as in cultures, tax rates, or labor markets, affect the use
and effects of stock options? The answer is probably yes, although all these effects are not
well understood.
One important factor to consider when moving internationally is employee understanding
Pedagogy
This teaching note is laid out in the order in which we have raised the issues in class. Instructors
will have to consider the backgrounds of their students carefully in using this case and, in
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Exhibit TN-1
BlackScholes Option Pricing Formula
BlackScholes Option Pricing Formula
C = S N(d1) X e rT N(d2)
Where:
C = price of the call option
Assumptions:
Option is exercised only at
