Options: win-win until they put executives in hock

Last month we published an article pointing out the benefits of options, especially in times of volatility such as during COVID-19. (See HERE)

Some executives value the upside leverage, which can lead to significant wealth creation for executives who manage the company through periods of steep growth. Many shareholders like them since they only provide value to the executive if share price rises.

For any action, there is an opposite reaction; for any remuneration approach with positive aspects, there is bound to be negative ones too.

Any executive who has been the recipient of options from a private company with no exit in sight would be able to nominate at least one problem with being paid in options.

Let us say, for example, you are a technology executive who has watched the value of their company increase significantly since they were first granted options. It is time to exercise the options and pay the necessary exercise price.

Unfortunately for you, you do not have enough cash to exercise your options, at least not if your intention is to also continue to pay the mortgage on your house and pay your children’s private school fees.

If you were listed, you could pay the exercise price and then sell shares to cover your costs (unless insider trading restrictions prevent this). But as the options are in a private company, you have to find other shareholders to sell your shares to. And you are not the only one in the same predicament, so this possibility seems vanishingly small.

So you have to find the money somewhere. What do you do?

Tesla CEO Elon Musk provides a very high-profile example. (See HERE)

While Tesla is listed, its founder Elon Musk wishes to maintain his (approximately 20%) holding to ensure he can maintain influence. This means he cannot sell his shares to pay his exercise price.

Instead he sells his property empire or takes debt out using his equity as collateral or both. The later has serious connotations from a risk and corporate governance perspective. If the share price falls too far, his debtors may call in the debt, seizing the collateral. This gives Elon Musk a powerful incentive to do whatever it takes to make sure it does not, and the debtors a stranglehold if they wanted it over the CEO.

A problem on the scale of Tesla is unlikely for most executives, however, even on a small scale it can have behavioural effects.

This is why Australia’s lack of private equity, which forces technology and biotechnology companies to list much earlier than they do in the US for capital, has a positive side effect. These companies, while they are likely struggling with the administrative and regulatory burden of listing, at least are liquid for their executives who are being paid in equity. This should make Australia a talent magnet (See HERE). Unfortunately listed companies are currently not eligible for the current start-up tax concessions on equity grants – something we have written a submission about to the recent ESS taxation consultation (see HERE).

Of course, there are other ways to benefit from option-like leverage that also only pays out if the share price increases, yet does not require scrounging for cash to fund the exercise price. (Or putting up with options’ high dilution!)

This involves an instrument that recognises the increase in share price but is not converted into a share on a one-on-one basis. Rather it is settled in cash or a smaller number of shares. With the same valuation process, the same value to executives and the same benefits to shareholders, this approach looks and smells like an option, without the aftertaste.

© Guerdon Associates 2024
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