What You Thought You Paid

Over time boards and executives have become familiar with thinking of incentive pay as a certain proportion of fixed pay. We know, for instance, that in many large companies, board directors believe that 40% of fixed pay is an appropriate level of long term incentive for certain executive positions.

Why We Need to Rethink our Approach

Along with all the other new things directors have to cope with under CLERP 9, are adjustments to these familiar benchmark standards. The 40% that directors have become used to is not really 40%. It is probably not even 20%. It may be as low as 10% to 15%. Why?

Prior to June 30 last year the most common valuation method for share rights and options was the Black Scholes method. For various reasons too complex to go into here it tended to over value options and share rights. However, the move to new accounting standards that expense share rights and options provided impetus to hone up the valuation methodology. The result is a more valid measure of options and rights fair value.

While Black Scholes is still an acceptable method under the new accounting standards, most companies have discovered that the more rigorous methods also significantly reduce the valuations. These methods are generically known as lattice methods, with the binomial model being the most commonly applied. Couple this with probability assessments for performance hurdles and the valuation tumbles dramatically.

Example

The following example illustrates the effect of changing the valuation method to incorporate all the relevant inputs.

Inputs required for a Black Scholes valuation:

Share price at time of option issue: $10
Exercise price of option: $10
Term of option: 5 years
Risk free interest rate: 5.4%
Dividend yield: 0%
Volatility of share: 35%

Using traditional methodologies, these inputs produce an option value of around $4.00.

Using a binomial lattice method, the following additional variables can be taken into account:
• Vesting periods and early exercise of the option,
• Forfeiture (resignations) and
• Performance hurdles.

A minimum vesting period of 3 years coupled with an assumption that executives would be most likely to exercise when share price is 125% of exercise price would reduce the option value to $3.61.

An annual forfeiture (that is, executive turnover) rate of 10% would reduce the option price by a further 24.6% to $2.63.

A typical performance hurdle used today is to grant 50% of the options if the company reaches the 50th percentile of relative TSR performance, with 2% more vesting for each percentile increase in relative performance thereafter. The full grant is achieved if the relative TSR is at or above the 75th percentile. Incorporating this performance hurdle can further reduce the value of the option by as much as 36.7% to $1.17.

What Now?

Using this more valid method, the LTI your board has previously approved has dropped in value from 40% of fixed pay to only 12%.  This is probably in accord with the intuitive view of many executives.

It may be time for the remuneration committee and management to review the LTI framework. We have a lot of ideas for how this could be done.   But unfortunately we are running out of space!  Look out for future newsletter issues on this subject.

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