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The Actuary The magazine of the Institute & Faculty of Actuaries

Using executive share scheme options as incentives

Share options have been a popular
form of executive compensation for
the past two decades in the US and
the UK. Most notably, share options
have allowed start-up and/or unlisted companies
the opportunity to compete with listed
corporations in recruiting highly skilled executives
and staff. The Economist (1999) suggested
that Silicon Valley was built on stock options.
A brief history of share options
Executive share options emerged in the US in
the late 1980s and gained popularity over cashbased
compensations after a corporate tax law
modification in 1993, which made salaries over
$1m non-deductible (The Economist, 2001). In
1980 just 20% of US chief executive officers’
(CEOs’) direct remuneration consisted of stock
options. By 1999 stock options in the overall
compensation of US CEOs exceeded basic pay
(The Economist, 1999).
The popularity of executive share options was
partly because of a belief that they were cost
free. Share options do not give away voting
rights until they have been exercised, and do
not require immediate cash outlay at the grant
date. Even when they are exercised, the pay-out
does not come directly from the business but
from existing shareholders through ownership
dilution. However, shareholders and managements
have recently come to recognise the full
impact of granting options, partly due to the
introduction of FRS20 and IFRS2, which require
businesses to expense option grants and disclose
them in company accounts.
With the help of options and the recent prolonged
bull market, a generation of executives
now own much bigger portions of their companies
than ever before. Although not all shareholders
are happy to dilute their ownership as
a result of above-water (in the money) option being exercised, few prefer the situation where
options go underwater (out of the money)
when share prices fall. The cost of issuing executive
share options and the resulting ownership
dilution is a form of agency cost paid by the
shareholders in order to increase share prices.
The risk premium of share options
Share options are intended to increase executives’
exposure to the specific risks of the company
and link their personal wealth to the
company and its shareholders. Executives typically
have a substantial amount of their personal
wealth invested in the company and are
unable to diversify this concentration of risk.
Trading or hedging their share and option holdings
is likely to be forbidden or severely
restricted. Therefore executive recipients face a
series of uncertainties and concentration of risks
much greater than outside investors, and will
tend to place a lower value on the share options
than their inherent fair value.
The difference between the fair value and the
value perceived by the recipients is the risk premium
paid by the company to the executives
for accepting option grants instead of risk-free
cash compensation. The fair value of the share
options is the price that the employer could
obtain from selling them in an efficient derivative
market to independent investors.
Because of this risk premium, share options are
an expensive form of remuneration. Management
who previously thought executive share
options bore zero cost to the company are now
acknowledging the full economic costs associated
to both shareholders and balance sheets.
One may question the suitability of unlisted
small companies using share options for remuneration
purposes once the advantages to the
company’s balance sheet and profit and loss
account have been removed by FRS20 and
IFRS2. Companies now face the costs of obtaining
an HMRC-approved share price (not a
straightforward exercise), in addition to accounting
and auditing the options. It could be argued
that these costs are greater than the perceived
value to recipients. It would certainly be more
straightforward if these costs were paid directly
to the employees as bonuses.
The recruitment and retention
value of share options
Executive share options provide a more powerful
incentive than bonuses or salaries. In a 2004
research study carried out by Hall and Liebman
on 478 large US companies’ executive compensation
schemes between 1980 and 1994, it
was found that stocks and options could affect
CEO wealth 50 times more than the changes
caused by bonuses and salaries, given the same
variations in firm value (Ross, 2004). Furthermore,
the pay-to-performance sensitivity of
stock options is about twice the pay-toperformance
sensitivity of stocks of the same
value (Balls, 1998).
Executive options may act as a selecting tool
in executive recruitment and retention. Lowerskilled
executives value options less than the
highly skilled, who are more confident in their
ability to positively affect the stock price. Executives
may self-select into companies where they
can maximise their utility function and skills.
Individual preferences for different incentives
and plans help the management identify the
executive’s risk aversion and belief in creating
value for the business.
Executives and employees can only be motivated
to the maximum levels of their capabilities
and responsibilities. Top executives are
concerned with the long-term strategy of the
business, which can be tied into the performance
target of the options. The lower the level
of the employees, the smaller proportion of
share-based payment their overall remuneration
should have.
The incentive and retention values of executive
option holdings should be reviewed regularly.
If the share price is volatile or the market
is unpredictable, the incentive strength and
retention value could become very weak or
even non-existent when options sink deep
underwater. At the other extreme, executives
holding very profitable options may be reluctant
to take on risky projects even though it is
in the shareholders’ interest for them to do so.
Annual or quarterly briefings will enforce the
interest alignment between executives and
shareholders. Many managers do not know the
up-to-date value of their incentive plans and
how they are affected by the changes in the
company or stock prices. Some may not know
how they could actively and positively create
value both for the business and themselves.
Others may not realise that they would forfeit
their options if they leave. The incentive and
retention value of options and other compensation
plans inevitably diminishes if managers
are not adequately informed.
The share option plan design
Executive options should have performance
conditions linked to the company’s costs of equity. Shareholders will only break even if the
total shareholders return (TSR) meets the company
costs of equity. An executive share option
plan without any performance conditions inadvertently
implies that the cost of equity capital
to the company is near zero after paying dividends
(Jensen, 2001). Any increase in share
price above the exercise price, often set at the
grant date share price, would result in increases
of pay-outs to executives even if the total shareholders’
return was still below the company’s
cost of equity. In contrast, if the exercise price
is indexed to the company costs of equity, the
executive recipients would only receive payouts
when the shareholders profit first.
Raising performance thresholds lowers the
perceived value of the options and lessens the
attractiveness of options. However, because it
simultaneously reduces the costs to the company
in granting them, companies could maintain
the overall value of the incentive plans by
granting a greater number of options. This is
where skilled and confident executives could be
distinguished from weaker performers.
Exercising options
The early exercise of options should be permitted
by companies as it reduces the costs to
shareholders and increases the perceived executive
value simultaneously. The loss of time value
and the reduction of the company costs can be
explained by the fact that early exercise
removes the potential of very large pay-outs as
a result of substantial but less probable increases
in the stock price. The recipient would value
options more since they have more freedom in
exercise timing. Directors’ option holdings affect their decisions
in paying dividends. Paying dividends
lowers the share price and consequently the
share option pay-off. Directors would certainly
find it undesirable if their option exercise date
coincided with the post-dividend stock price
fall. Withholding or reducing dividend payments
would raise market expectation of greater
future dividends and therefore inflate the stock
price in the short term. Companies should try
to avoid this unwanted effect when designing
their executive incentive plans.
Executives’ attitudes towards risks could alter,
depending on the current value of the options.
When the options are at the money or in the
money, higher volatility represents a greater
probability of the options going underwater.
Risk-averse executives, reluctant to gamble with
profits, would be unwilling to increase the company’s
volatility by undertaking risky projects.
However, if the options are already deep underwater,
executives, having nothing to lose, could
be willing to take on more risks in the hope of
dramatically increasing the share price in order
to push the options into the money. Either
behaviour might not be in the best interests of
the shareholders.
Brian Hall highlighted a classic error whereby
companies give executives the entire share
options up front in one grant (Ross, 2004). If
the options become deeply underwater the
incentive value can become almost zero. When
executives’ existing options go underwater,
companies need to reinstate incentive and
retention value. Repricing, previously a strategy
commonly used by high-tech companies where
volatility is very high, is now regarded less favourably because it incurs tax and accounting
complications. The expectation of future grants
can create an incentive in itself even when the
current holdings of options are underwater.
A much more effective option scheme is to
award options annually, either by ‘fixed value’
or ‘fixed number’. Fixed number plans are preferred,
as fixed value plans can penalise executives
for previous good performance, ie rises in
the stock price are met with the award of fewer
Options are not for all
Share options can be a powerful and effective
form of remuneration but they are not necessarily
suitable for all companies. Companies
should only consider using share options if the
benefits to the companies and shareholders
will likely outweigh the costs. Share options,
being the most expensive form of incentive,
should be limited to key employees who have
a direct impact on the company’s stock price.
When designing a share option plan, companies
need to consider not only the fair value
but also the discounted value perceived by the
recipients. Once the options are granted, companies
need to review them regularly and communicate
the costs and benefits to their
shareholders and the recipients.
The complex issues surrounding option plan
design seem both contradictory and improbable.
However, it does highlight the fact that the
plans should be as simple and straightforward
as possible. This will increase the transparency
of option grants and improve communications
between shareholders, executives and auditors,
as well as make accounting and auditing a more
straightforward task.

This article is extracted and modified from the
author’s MSc dissertation, ‘Evaluation of Economic
Costs of Executive Share Options,’ submitted to
CASS Business School in October 2006.

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