NZSA Best Practice

FREE LUNCHES - FINANCIAL HIERACHY 2

Director and employee share options have been a feature of corporate activity with ever increasing frequency over the last 15 years. In most instances the terms upon which these option programmes have been created has been a free lunch for many, and has resulted in a significant wealth transfer from owners from managers, the likes of which have not been seen outside of a revolution. There has been much research done on the US and UK markets, on the effect of share options. One analysis has shown that the expansion and the total number of shares on issue over a 20 year period, has resulted in a dilution of the original owners stake by an excess of 50%. Of course the owners don't care as the share price has increased. It's a bit like starting with a glass of orange juice, allowing someone else to drink half, filling the glass up with water and convincing yourself you have still got orange juice. There is no doubt that option arrangements are a real cost to owners that isn't recorded in the books, and accordingly financial results are distorted.

Another analysis on Microsoft, showed that if the cost to shareholders of share options was taken into the accounts as an expense, the operating results from Microsoft would have been reversed from a substantial profit into an even more substantial loss, and that loss would have been consistently reported over the company's entire life. Regulators have no interest in regulating the terms of option grants, as the gain on option contracts is accessible to employees for income tax and non-deductible to the payer (the owners) resulting in a favorable fiscal mis-match.

The use of option contracts to reward executives has significantly distorted financial reports and has added to investor disquiet, disrupting what should be a harmonious relationship between the providers of capital and management. The reality, unfortunately, appears to be no respite in the process.

Many share option programmes grant options to management on an 'in the money' basis immediately, or on the basis of current market price, with a free carry for as long as eight years. Mostly management sells out its management options prior to exercise or contemporaneously deriving a cash benefit, and the same people are usually charged with the management of share by back programmes usually funded with debt. A further study in the US has demonstrated that the expanding corporate debt over the last two decades has an almost linear correlation with share by back activity. The number of shares on issue has also expanded showing that the expansion in the US corporate debt has been to fund management remuneration recorded nowhere as an expense in the books of the effected company's. This is currently accepted commercial practice and in my view, is in fact financial hierachy.

Accountants and lawyers have become involved in what should be a simple concept and made it exceptionally complex. There is continual debate over what strike price on options should be, including detailed analysis on cost of equity including beta calculations, complex hurdles and difficult documents that analysts have difficulty interpreting. The result ... more money for the professions and in many instances, a free ride for management. Now a case for the alternative view which most will describe as hierachy.

1. Options are a simple concept. The holder of an option (management) is provided with an opportunity to acquire something at a price determined now, with the consideration payable in the future. If the value of the commodity or share is below the price at which the option is granted, the option lapses at the end of its term and no gain or loss in incurred by either party. If the commodity or share has a price in excess of the option price, the holder of the option is entitled to exercise and take delivery of the commodity or share and tender the agreed price. The option holder derives a profit and the conventional wisdom is that the granter of the option suffers no loss. The reality is that the grantee of the option suffers a loss equivalent to the holders gain and this is the value of the sip of orange juice that has been granted to the holder of the option.

2. Options, as any futures trader will tell you, have a spot value. Simplistically an options value is a function of strike price, and the options term to run. An option has more value if the strike price is low and the term is long, and less value if the strike price is high and the term is short. Returning now to share option programmes. Management are generally offered the opportunity to acquire shares at a point of time in the future, with the strike price determined with reference to the current value of the stock in question. In most instances, the strike price against one or another measure, is set at the current market price. In some instances, weighted averages are used, in other instances the lowest price in a trading period proceeding the grant of the option is used. Often the options are granted for terms of five years. Clearly an option at today's price, with a five year term, is a valuable commodity and is in effect a gift to management, or if you prefer, concealed remuneration.

Option arrangements granted to management that do not reflect the cost of equity over time, are unbalanced and considered by the writer to be inappropriate. Some agree. Here is where the complexity cuts in. The first point is that much analysis has been done on the cost of equity. Some option programmes make the exercise of the option, at an historic price, contingent on achieving a return on equity, but very few adjust the strike price to reflect the cost of equity. Complex formulas are created and lawyers and accountants profit from the complexity.

It is the writers view that the simplest way to reflect cost of equity, is the have an ever ratcheting strike price, that increases on a compounding basis over the term of the option, in line with the accessed or agreed cost of equity.

In establishing the cost of equity, the benchmark or hurdle rate has to be assessed based on a risk free return. This is easily done with reference to ten year Government Bond rates. To this sum should be a risk premium for the equity providers risk of providing share capital. Again this can be easily assessed based on the average risk premium sought within the equity markets in which the particular company operates.

For example, in New Zealand the long term Government Bond rate is approximately 6% and the average premium for equity is approximately a further 6%. If the current market price of a share being granted to management is currently $1.00, with a maximum term of five years, with an early exercise date twelve months after its grant, and thereafter at annual rests for a term of five years, the strike price at the first available exercise date should be not less than $1.12 and should be $1.76 at its last possible exercise date.

If this simple approach were taken to pricing options, all of the rhetoric on performance criteria would become academic unless management betters the cost of capital, there options will not be in the money, and won't be exercised.

To the extent that management betters the cost of capital costs, and if for example, this particular share price at the end of year five was $3.05 per share, management would profit to the tune of $1.24 which represents the value added to the business, and shareholders will also not care as they are also participating in the gain above $1.76 and have also enjoyed a return equivalent to the cost of capital.

It is submitted that simplicity is often best as all participants in business can understand simple concepts and to the extent that options are priced other than in accordance with this approach, they in essence represent concealed remuneration, and concealing anything from ones partner (the providers of ones capital) is never a sound foundation for a confident partnership.