Time to rethink executive share options
Share options as a form of executive reward have been much maligned in recent years. As a result, their usage has dropped away in Australia, as well as in the UK, Canada and the USA. But share options can be an important component of executive reward. We think it is about time that the use of share options received fresh consideration. Further, it may even be better for both executives and shareholders if these options were granted with an exercise price at a discount to the market price.
But first we need to understand why share option usage has decreased.
There have been major instances of abuse (e.g. WorldCom, Enron) when executives made many millions from option exercises while running their companies into the ground. Governance groups, particularly in the UK but also many in the US, do not like them, arguing that they encourage short term actions to increase the share price prior to exercise, rather than focussing on long term sustainable growth. In addition, research indicates that while options encourage risk taking, the risks taken are often poor ones (for the latest research see HERE).
We have highlighted these issues before (for example, see HERE)
While each of these negatives has some validity, they can just as validly be countered.
Fraud and abuse occurs because dishonest people end up running companies. Share options did not cause this dishonesty. Rather, these events were the outcome of poor board nomination and vetting processes, the absence of adequate audit and controls, and executive directors being allowed to dominate board proceedings.
Short term actions to increase share prices prior to exercise are often an outcome of poor incentive plan design. Infrequent “mega” grants provide temptation to manipulate and misrepresent short term outcomes to temporarily boost share price. Plan design with more frequent annual grants for rolling 3 year performance periods will ensure that reward is optimised for sustainable growth over the long term. In addition, requirements for continuous disclosure mean that there is less opportunity to surprise markets for a short term lift in share price just for the sake of an option exercise.
Lastly, almost all the research indicates that options provided as a reward vehicle do increase risk taking behaviour. This is desirable, and should be retained. What is not desirable is the “risk taking at any cost” to maximise the upside. It is here that recent research has identified a key flaw in executive option reward design. Options are all about upside with no downside. That is, an executive cannot incur a loss if his/her actions do not result in performance that exceeds market expectations, and instead results in a share price that hardly moves or, worse, goes south.
Ideally what is needed is a reward vehicle that encourages risk taking, but moderates this risk taking with a consideration of the downside. So far the alternatives to granting options with an exercise price equal to the market price at the time of offer have focussed on granting restricted shares or rights to fully paid shares. The thinking here is that if managers hold actual shares, and those shares go down, they are destroying the value of their shares and reducing their own compensation. This is by far the most common approach in Australia and the UK, and has been rapidly taking root in the US and Canada over the past couple of years.
But the problem with this approach is that it goes too far the other way. An agency problem still exists. But this time executives' alignment with the needs of shareholders is knocked askew because executives have more to lose. That is, a much greater proportion of their wealth is tied up in company stock and not diversified relative to investors’ wealth. What is needed is a reward vehicle that results in very focussed executive behaviour on maximising shareholder wealth, while still incorporating a degree of prudence.
This leads us to suggest something that we expect the less thoughtful governance groups will react instinctively against – at least until they take the time to think about it.
We suggest companies consider granting in-the-money options.
The idea behind this alternative is that if managers hold options that are in the money, they already have "skin in the game" and will therefore have an incentive not to take inappropriate risks. This is because if the share price goes down, managers actually stand to lose something.
We already have this now. It is common in Australia to provide share rights. These are just options with a zero exercise price. But how the wheel turns. When these were first introduced in Australia (incidentally, by a director of Guerdon Associates), several international governance groups were aghast at the granting of options with a zero exercise price. Now they are in favour.
What we are suggesting is an adjustment in thinking again.
What if Australian companies started to grant in the money options that only discounted the exercise price, say, 25% from the market price instead of the usual 100% you have with share rights?
We are pretty sure that if they were labeled discounted options there would be some governance groups falling over themselves to express outrage. But essentially there is no in-principle difference to granting share rights with a 100% discount to market price. And there are advantages over zero priced options/100% discounted share rights.
- There will be a better balance between risk taking and more conservative management, given that the executives have some “skin in the game” but also more enhanced upside share price leverage
- Because more discounted options will be granted than shares or share rights for the same company expense, executives have more leveraged upside potential reward if the share price increases. That is, for a $2 share that increases by a dollar in value to $3, an executive with 100,000 share rights will receive $300,000 reward. But if he/she were granted the equivalent value of 400,000 options with the exercise price discounted 25% from market price, the realised value received would be $600,000. That is, the executive doubled his/her incentive outcome by using share options.
- Because discounted options still require an exchange of funds to receive shares on exercise, a growing company will receive additional funds to further its growth plans
This strategy need not be confined to just performance incentive plans. Many companies have salary sacrifice shares and share rights to encourage executives to hold company stock. Why not allow executives to sacrifice salary for discounted options?
And if you think governance groups would find that hard to understand initially, call the discounted options “premium priced share rights”.
Many people believe that share options already have a built in hurdle, being the exercise price, so object to the requirement to have an additional performance hurdle (such as relative total shareholder return) imposed on top by governance standards. In theory, these governance standards should not preclude companies from providing share options in lieu of salary, providing it is presented as a trade-off for salary and not labeled and disclosed as a performance incentive plan.
And lastly, a reminder that decisions on the extent to which share options are used needs to consider the type of company that employs the executive. Share options are generally more suitable for use in growth companies. They are generally not so suitable for value companies with high dividend yields, because share options as an incentive or reward vehicle do not recognise or encourage high dividend yields (however, there are many ways that this can be tackled in option plan design, especially for companies with both growth and yield aspects).
In conclusion, there is a great deal companies can still do with share options to better attract, retain and motivate executives and other key employees. They are not appropriate for every company, but there is, we believe, still a significant place for share options for many companies in their remuneration frameworks. To that end, we encourage all stakeholders to re-consider the application of share options to executive reward.